Macroeconomic Objectives and Policies Study Notes

Possible Macroeconomic Objectives

• Definition of Macroeconomic Intervention: Governments intervene in the economy to improve economic performance.

• Key Macroeconomic Objectives:     * Economic Growth:         * In the UK, the long-run trend of economic growth is approximately $2.5\%$.         * Governments aim for sustainable long-run growth.         * In emerging and developing economies, the focus may shift to economic development (improving living standards, life expectancy, and literacy rates) before growth.     * Low Unemployment:         * The goal is to achieve near-full employment.         * Frictional unemployment is accounted for by targeting an unemployment rate of around $3\%$.         * The labor force should be engaged in productive work.     * Low and Stable Inflation:         * The UK target is $2\%$, measured by the Consumer Price Index (CPI).         * This provides price stability for firms and consumers, facilitating long-run decision-making.         * If inflation deviates by more than $1\%$ from the target, the Governor of the Bank of England must write an explanatory letter to the Chancellor of the Exchequer detailing the cause and intended actions.     * Balance of Payments Equilibrium on the Current Account:         * Ensuring the country can sustainably finance the current account is critical for long-term growth.

• Other Macroeconomic Objectives:     * Balance Government Budget: Control state borrowing to prevent national debt from escalating, allowing for cheap future borrowing and easier repayments.     * Protection of the Environment: Aiming for long-run environmental stability and sustainable resource use (e.g., oil and natural gas) for future generations while preventing excessive pollution.     * Greater Income Equality: Minimizing the gap between rich and poor to foster a fairer society.

• Management Strategies:     * Recession: Governments often increase Aggregate Demand (AD) to boost employment and growth.     * Boom: Governments decrease AD to reduce inflationary pressures.     * Supply-Side Policies: Used to bring about long-term growth.

Demand-Side Policies: Monetary Policy

• Definition: Demand-side policies manipulate consumer demand.     * Expansionary Policy: Increases AD to bring about growth.     * Deflationary Policy: Decreases AD to control inflation.

• Monetary Policy Overview: Attempting to control AD by altering base interest rates or the money supply. This is conducted by the central bank or regulatory authority.

• Interest Rates:     * Repo Rate: The price of money charged by the Bank of England for short-term loans to other financial institutions. Changes in the repo rate affect market rates offered to consumers/businesses because the Bank of England is the "lender of last resort."     * Mechanisms of a Rise in Interest Rates reducing AD:         * Cost of Borrowing: Increases costs for firms and consumers, leading to a fall in investment and consumption (specifically consumer durables and housing). Higher rates require higher returns for investment.         * Savings Incentive: Savings become more attractive due to higher interest earned.         * Asset Prices and Wealth Effect: Demand for stocks, shares, and bonds falls, leading to lower asset prices. This creates a negative wealth effect, reducing consumption. Investment becomes less attractive as firms anticipate lower profits.         * Confidence and Disposable Income: Rising rates lower consumer and business confidence. Increased mortgage/loan repayment costs reduce discretionary income for goods and services.         * Exchange Rate (Hot Money): Higher rates attract foreign investment into British banks. The demand for pounds increases, causing the currency to appreciate. This makes imports cheaper and exports more expensive, decreasing net trade.

• Problems with Monetary Policy Management:     * Significant currency appreciation can lead to a balance of trade deficit.     * Time Lags: Changes can take up to $2$ years to have full effect.     * Small changes may not influence decision-making.     * Liquidity Trap: Interest rates may reach a point so low that they cannot be decreased further to stimulate demand.     * Base Rate Limitations: Not all market interest rates are affected by the Bank of England base rate.     * Lack of Confidence: If confidence is low, banks may not lend and consumers/businesses may not borrow regardless of rates.     * Long-term high interest rates discourage investment and can decrease Long-Run Aggregate Supply (LRAS).

• Quantitative Easing (QE):     * Definition: The Bank of England buys assets (private sector securities, bonds, or increasing bank reserves) to increase the money supply and stimulate the economy when demand is low.     * Mechanisms:         * Asset Price Increase: High demand for assets raises their prices, creating a positive wealth effect and lowering the cost of borrowing (lower yields).         * Money Supply Increase: Increases liquidity for banks and private sector companies, encouraging lending and spending.         * Lower Commercial Rates: Increased money supply lowers the "price of money," encouraging borrowing.     * Problems with QE:         * Risk of high inflation or hyperinflation.         * May only stimulate demand for second-hand goods (e.g., existing houses) rather than new production.         * Wealth effect is not guaranteed if confidence is low.         * Increases inequality as asset owners (the rich) see gains while others do not.         * Concerns regarding economic dependency on QE (e.g., within the Eurozone).

The Role of the Bank of England

• Monetary Policy Committee (MPC): A nine-member committee responsible for base rates and QE decisions. It includes five members from the Bank (including the Governor) and four independent experts (economists).

• Inflation Targeting: Main goal is $2\%$ inflation measured by CPI. Letters to the Chancellor are required if inflation is below $1\%$ or above $3\%$.

• Historical Timeline:     * 2009: Bank rate kept at $0.5\%$.     * Brexit Vote: Rate reduced to $0.25\%$.     * November 2017: Rate rose due to inflation caused by a weak pound.     * Current plan is to raise rates once the negative output gap is eliminated.

Demand-Side Policies: Fiscal Policy

• Definition: Use of government spending, taxation, and borrowing to manipulate AD.

• Instruments:     * Taxes: Income tax (affects disposable income/consumption) and Corporation tax (affects post-tax profits/investment).     * Spending: Government spending is a direct component of AD.

• Budget Positions:     * Budget Deficit: Spending > Revenue.     * Budget Surplus: Revenue > Spending.

• Direct vs. Indirect Taxation:     * Direct Taxes: Paid directly to the government (e.g., Income Tax, Corporation Tax).     * Indirect Taxes: Cost can be passed from the supplier to the consumer (e.g., VAT).     * Top Revenue Sources: Income Tax, National Insurance, VAT, and Corporation Tax.

• UK Specific Tax Rates (as of Summer 2018):     * Income Tax: Largest revenue source ($25\%$). Tax-free threshold: $\pounds 11,850$. Basic rate: $20\%$. Higher rate: $40\%$. Additional rate: $45\%$ (for income over $\pounds 150,000$).     * VAT: Standard rate is $20\%$. Zero-rated items: food and children's clothes. Domestic fuel/power: $5\%$.

• Evaluation of Fiscal Policy:     * Spending cuts can negatively impact LRAS (e.g., education and R&D quality).     * Impact on inequality and work incentives.     * Political constraints: Governments may fear raising taxes due to election risks.     * Austerity periods make expansionary policy difficult.     * The Multiplier: The total impact on AD depends on the size of the multiplier. Keynesians argue it can be large; Classicals argue it is close to zero.

Evaluation of Demand-Side Policies

• Classical vs. Keynesian Views:     * Classicals: Demand management has no effect on long-run output; it only increases prices. Use supply-side policies instead.     * Keynesians: The economy can be in long-run disequilibrium for years. The impact of AD changes depends on where the economy operates on the LRAS curve (e.g., if at full employment, AD increases only raise prices; if high unemployment, AD increases raise output).

• Time Lags: Both monetary and fiscal policies suffer from significant lags.

• Trade-offs: Expansionary policy tends to be inflationary; deflationary policy tends to cause unemployment.

• Policy Comparison:     * Monetary: Easier to increase demand without increasing the fiscal deficit.     * Fiscal: Can impact the supply side (e.g., education) and target specific social groups to reduce poverty.

Historical Context: The Great Depression

• Overview: UK unemployment exceeded $15\%$; US unemployment reached nearly $25\%$. Primary and manufacturing industries were hardest hit due to the collapse of world trade.

• Causes:     1. Wall Street Crash (1929): Loss of confidence and sharp fall in share prices.     2. US Banking System: Excessive lending in the 1920s; government allowed banks to fail after the crash, reducing liquidity.     3. Protectionism: Smoot-Hawley Tariff Act (1930) in the USA led to retaliatory tariffs and collapsed world trade.     4. Gold Standard: The UK re-joined in 1925 at an overvalued rate (1914 levels), making exports expensive.

• UK Policy Response:     * Initial focus on a balanced budget. Emergency budget cut public sector wages and unemployment benefits by $10\%$; income tax raised from $22.5\%$ to $25\%$.     * High interest rates were used to defend the pound on the Gold Standard.     * September 21, 1931: UK forced off the Gold Standard. Pound fell by $25\%$, interest rates cut by $2.5\%$, stimulating recovery.

• USA Policy Response:     * Franklin Roosevelt’s "New Deal" (1932): Public sector investment, work schemes, and fiscal stimulus.     * Full employment reached in 1943 (coinciding with WWII).

Historical Context: Global Financial Crisis (2008/9)

• Causes:     * USA Mortgage Lending: Poor households were encouraged to take sub-prime mortgages (Moral Hazard). Interest rates eventually rose, leading to defaults and Negative Equity.     * Securitization: Prime and sub-prime mortgages were packaged together and sold to investors, hiding the underlying risk.     * Banking Collapse: Inter-bank lending stopped due to fear. Lehman Brothers failed in 2008. Northern Rock (UK) faced a bank run in 2007.

• Policy Responses:     * Nationalization: Governments bought stakes in banks (e.g., Northern Rock, RBS, Lloyds) to guarantee savings.     * Expansionary Monetary Policy: Record low interest rates and QE.     * USA: Used more aggressive expansionary fiscal policy, leading to a faster recovery than the UK.     * UK: Prioritized reducing National Debt (Austerity) over stimulus in 2010.

Supply-Side Policies

• Definition: Government policies aimed at increasing the productive potential of the economy (shifting the supply curve right).

• Approaches:     * Market-based: Removing barriers to the free market (e.g., reducing government role).     * Interventionist: Correcting market failures (e.g., government provision of education or encouraging long-term investment).

• Methods to Increase Incentives:     * Lower taxes/benefits: Increases the opportunity cost of being out of work (e.g., Universal Credit).     * Subsidies for low-income workers (Income tax credits).     * Free childcare and flexible hours to encourage females into the workforce.     * Reducing National Insurance Contributions for firms.     * Lowering/removing minimum wage to encourage employment.     * Lowering taxes on investment returns to encourage risk-taking.

• Promoting Competition:     * Privatization: Selling state-owned companies.     * Deregulation: Reducing restrictions/entry barriers.     * Competition Policy: Competition and Markets Authority (CMA) enforces the Competition Act (1998) and Enterprise Act (2002).

• Reforming the Labor Market:     * Increasing the retirement age.     * Weakening trade unions (e.g., postal ballots, banning secondary picketing, 14-day strike notice).     * Zero-hour contracts.     * Improving mobility of labor: housing affordability (cutting VAT/relaxing planning laws), flexible pensions, job vacancy information.

• Improving Skills/Quality:     * Education spending (T-Levels as A-level equivalent; free university tuition).     * Apprenticeship Levy: A tax on salaries in large companies to fund training (though quality concerns exist).     * High-skilled migration policy.

• Improving Infrastructure:     * Tax incentives for investment; plan to reduce corporation tax to $18\%$ in 2020.     * Enterprise Investment Scheme (EIS) tax relief.     * Direct spending: HS2, CrossRail, Transforming Cities Fund.

• Evaluation of Supply-Side Policies:     * Can increase output while decreasing prices.     * Long-term focus; can improve the balance of payments by increasing exports.     * Ineffective when LRAS is elastic (Keynesian view); demand-side policies may still be needed.     * Can lead to budget deficits, increased inequality (via benefit/tax cuts), and long execution time lags.

Conflicts and Trade-offs

• Economic Growth vs. Environment: Growth requires resource use/pollution (e.g., China). Sustainable growth is slower and more expensive.

• Economic Growth vs. Balance of Payments: Domestic growth can lead to import surges (e.g., India). Exception: Export-led growth (e.g., China).

• Unemployment vs. Inflation (Phillips Curve): Lowering unemployment often requires higher wages, which firms pass on as higher prices. Stagflation in the 1970s challenged this relationship.

• Expansionary vs. Deflationary Trade-offs: Expansionary policies increase growth/employment but raise inflation and worsen BoP. Deflationary policies control inflation but hurt growth/employment.

• Interest Rate Impacts: High rates for inflation control can hurt long-term investment and appreciate the pound (hurting BoP). High rates benefit savers (often older people); low rates increase income inequality as the rich hold wealth in non-money assets.

• Supply-Side Conflicts: Policies for growth (reducing union power/benefits) may increase income inequality. Investment-driven growth can be inflationary in the short term by increasing AD.

• Fiscal Deficit Reduction: Spending cuts and tax rises to reduce debt can decrease growth and disproportionately hurt the poor who rely on public services.