Chapter27: Monetary & Supply-Side Policy Notes

The Money Supply

• The money supply is the total amount of money in an economy at a given time.

• Narrow Measure:

  • Includes notes, coins, and current accounts at commercial banks.

  • Primarily used as a medium of exchange.

• Broad Measure:

  • Includes notes, coins, current accounts, and deposit accounts.

  • Used as a medium of exchange and store of value.

• Example (India, 2016):

  • The government attempted to reduce forgeries by instructing people to exchange 500 and 1000 rupee notes.

  • New 500 and 2000 rupee notes were to be issued, but delays caused chaos.

  • Cash transactions are common in India (a fifth of all transactions).

Monetary Policy

• Monetary policy involves decisions about the money supply, interest rates, and exchange rates.

• Aim: To influence aggregate demand.

• Implementation: Typically carried out by central banks on behalf of governments.

• Key Definition:

  • Monetary Policy: Decisions on the money supply, interest rates, and exchange rates taken to influence aggregate demand.

Changes in the Money Supply

• Increasing the Money Supply:

  • Printing more money.

  • Buying back government bonds (increases commercial banks' lending capacity).

  • Encouraging commercial banks to lend more (reduces lending restrictions).

• Impact of Increased Money Supply:

  • Likely increase in consumer spending and investment.

  • Potential increase in output.

• Example (China, 2016):

  • Money supply increased by 11.2%, raising concerns about excessive aggregate demand.

Changes in the Rate of Interest

• Mechanism: Central banks alter the interest rate charged to commercial banks.

• Impact:

  • Reduces aggregate demand by lowering consumer expenditure and investment.

• Three Main Ways:

  • Increased interest payments on existing loans reduce disposable income.

  • More expensive borrowing discourages new loans.

  • Higher interest rates incentivize saving (increasing the opportunity cost of spending).

• Impact on Savers:

  • Some savers may spend more due to increased interest earned, but borrowers are more likely to spend extra money than savers.

  • Overall Effect: Probably a reduction in consumer expenditure.

• Impact on Exchange Rates:

  • Higher interest rates can increase the foreign exchange rate, lowering net exports by raising export prices and lowering import prices.

• Maintaining Unchanged Interest Rates:

  • Central banks may keep interest rates constant for extended periods to promote certainty and encourage investment.

• Example (China, February 2017):

  • The People’s Bank of China unexpectedly raised interest rates from 2.25% to 2.35% due to concerns about excessive commercial bank lending.

Changes in the Exchange Rate

• Central banks may directly change or influence the country’s foreign exchange rate.

• Goal: Governments may want to lower the exchange rate to encourage exports.

Effects of Monetary Policy on Government Macroeconomic Aims

• Expansionary Monetary Policy:

  • Used to increase aggregate demand.

  • Involves reducing interest rates or increasing the money supply to boost economic growth and reduce unemployment.

• Contractionary Monetary Policy:

  • Used to control inflation.

  • Involves increasing interest rates or reducing the growth of the money supply to reduce aggregate demand and upward pressure on prices.

• Example (Pakistan, March 2017):

  • The Monetary Policy Committee (MPC) of the State Bank of Pakistan (SBP) kept the interest rate unchanged at 5.75%, despite rising aggregate demand, inflation, and imports.

Chapter 28: Supply-Side Policy

• Supply-side policies are designed to increase aggregate supply and productive potential.

• Aim: To increase the quantity and quality of resources and raise the efficiency of product and factor markets.

• Measures:

  • Improving education and training.

  • Cutting direct taxes and benefits.

  • Reforming trade unions.

  • Privatization.

Improving Education and Training

• Goal: To increase the skills and productivity of workers.

• Impact: Higher labor productivity can reduce production costs and improve product quality, increasing firms' ability to sell more.

• Benefits:

  • More skillful workers are more occupationally mobile.

  • Supply can adjust more quickly to demand changes.

• Considerations:

  • Training must be in relevant areas.

• Example (Mauritius, 2016):

  • The government paid people to train in high-demand technical skills and for jobs in cruise and shipping firms.

Lowering Direct Taxes and Increasing Incentives

• Aim: To increase the incentive to work and invest.

• Reducing Income Tax:

  • Increases the reward from working.

  • May encourage the unemployed to seek work actively and increase the labor force.

• Potential Drawbacks:

  • Some workers may reduce working hours.

  • Ineffective if there are no jobs available.

  • Cutting unemployment benefits could reduce aggregate demand and worsen unemployment.

• Cutting Corporation Tax:

  • May increase the incentive to invest, as firms can keep more profits.

• Potential Drawbacks:

  • Firms may lack confidence in the future and not invest.

• Example (Malaysia, 2015-2016):

  • The government cut income tax rates in 2015 and increased the number of income tax bands in 2016 to make the tax system more progressive.

Deregulation

• Definition: The reduction or elimination of rules and regulations enforced by laws.

• Aims:

  • To remove barriers to market entry.

  • To reduce compliance costs.

  • To reduce government regulation costs.

• Potential Benefits:

  • Increased competition and efficiency, leading to lower production costs and prices.

• Potential Drawbacks:

  • May not prevent monopolies from developing.

  • May reduce consumer protection if restrictions on certain occupations are removed.

• Example (Indonesia, 2016):

  • The government continued its deregulation policy to reduce bureaucratic red tape, aiming to increase investment and promote economic growth.

Privatization

• Aim: To increase competition and efficiency by increasing the role of market forces.

• Potential Benefits:

  • Industries may become more responsive to consumer demand.

  • Increased productive capacity if private sector firms invest more and work more efficiently.

• Potential Drawbacks:

  • May not ensure greater competition.

  • Private sector firms may be less inclined to consider social costs and benefits and may be more willing to make workers redundant.

Labor Market Reforms

• Aims: To make labor markets work more efficiently, increasing the quality, quantity, and flexibility of labor.

• Measures:

  • Better training.

  • Removal of barriers to entry and exit from labor markets.

  • Easier hiring and firing processes.

• Potential Benefits:

  • Firms can adjust their supply to changing market conditions more easily.

  • Firms may employ more workers if they can easily reduce staff when demand falls.

• Potential Drawbacks:

  • Firms may spend less on training if they think workers may not stay long.

• Trade Union Reform:

  • Reducing the power of trade unions may reduce industrial action and increase flexibility.

  • However, it may also reduce the benefits that trade unions provide to workers and the economy.

• Employment Laws:

  • Designed to protect workers' rights (e.g., maternity leave, maximum working hours).

• Subsidies:

  • Governments may provide subsidies to firms to increase competition or encourage investment in new capital equipment.

  • Considerations: Whether this is the best use of government spending and the risk that firms may become dependent on subsidies.

Effects of Supply-Side Policy on Government Macroeconomic Aims

• Long-Run Benefits:

  • All government macroeconomic aims can potentially benefit from supply-side policies.

  • Increasing aggregate supply enables an economy to grow in a non-inflationary way.

  • Improved productive potential and efficiency can improve a country’s balance of payments position.

• Time Lags and Costs:

  • Some supply-side measures can take time to have an effect and can be expensive.

• Increasing the Effectiveness of Macroeconomic Policies:

  • Using multiple policies.

  • Having accurate information.

  • Implementing policies quickly to avoid harming the economy.

• Pakistan Example:

  • The government is keen to encourage increased investment through supply-side policy measures to achieve its macroeconomic aims.

Chapter 29:Economic Growth

• Definition: Increase in the amount of goods and services produced per head of the population over a period of time.

  • Why Economic Growth?: Governments want it to have more benefits for households, firms, and the government.

• Gross Domestic Product (GDP):

  • Definition: The total output produced in a country.

• Circular Flow of Income:
  Output \rightarrow Expenditure \rightarrow Income

• Methods of Calculating GDP:

  • Output method.

  • Income method.

  • Expenditure method.

• Circular flow of income: the movement of expenditure, income and output around the economy.

• Value added: the difference between the sales revenue received and the cost of raw materials used.

• Transfer payments: transfers of income from one group to another not in return for providing a good or service.

• Nominal GDP: GDP at current market prices and so not adjusted for inflation.
  GDP = C + I + G + (X-M)

• Nominal vs. Real GDP:

  • Nominal GDP is measured at current prices.

  • Real GDP is adjusted for inflation.

• Formula to calculate Real GDP:
  Real GDP = \frac{Nominal GDP * Price Index{base year}}{Price Index{current year}}

Real GDP per head

To find out what is happening to people’s living standards, economists calculate real GDP per head, which is also referred to as real GDP per capita. It is found by dividing real GDP by population.
Real GDP capita = \frac{Real GDP}{Population}

The diff iculty of measuring real GDP

GDP figures tend to understate the true level of output. This is because of the existence of unrecorded economic activity, both legal and illegal, and non-marketed goods and services

• Subsistence agriculture: the output of agricultural goods for farmers’ personal use.

Recession

• Definition: When real GDP declines over a period of six months or more.

• Causes of a Recession:

  • A decrease in aggregate demand or a decrease in aggregate supply.

Consequences of a Recession

*   With lower output, unemployment is likely to rise.
*   The reduction in output and incomes will be expected to lower living standards.
*   Investment, including from foreign multinational  companies, is likely to be discouraged which will endanger future economic growth.

Economic Growth

• Causes of Economic Growth:

  • In the short run, an increase in aggregate demand may stimulate a rise in output if the economy has unused resources.

  • In the long run, an economy can continue to experience economic growth only if the quantity or quality of resources increases.

Consequences of Economic Growth

• International Monetary Fund (IMF): an international organisation which promotes international cooperation and helps countries with balance of payments problems.
  Can improve living standards of people
  Can increase governments tax revenue
  Improve political and economic standing and influence

• It is important to avoid the confusion between a fall in the economic growth rate and a fall in national output.

• Sustainable economic growth: economic growth that does not endanger the country’s ability to grow in the future.

The policies to promote economic growth

• If an economy is operating with spare capacity, a government may use expansionary fiscal and/or monetary policy to promote economic growth.

• To increase productive potential, for example, a government may seek to improve education and training

• There is, of course, no guarantee that supply-side policy measures will work.

Chapter 30: Employment and Unemployment

Emploment

People are in employment if they are paid employees or self-employed

Unemployment

People are unemployed if they are willing and able to work, but cannot find a job.

Full employment

Full employment occurs when unemployment is at its lowest possible rate.

Changes in the patterns of employment

• Industrial structure
  As economies develop, employment moves from the primary to the secondary and then to the tertiary sector

• Proportion of women in employment
  The number and proportion of women in employment and in the labour force is increasing in most countries.

• Proportion of workers in the private and public sectors
  The proportion of workers employed in the public sector in a number of countries is declining while the proportion employed in the private sector is increasing

• Full-time and part-time work
  Most workers work full-time. Some, however, work part-time. Some opt to work part-time

• Employed and self-employed
  In some countries, including the UK, USA and most of Europe, most people work for someone else

• Informal and formal economies
  People who work in the informal economy do not have the same access to the social security benefits, employment protection and rights as workers in the formal economy.

• High and low quality employment
  High quality employment is skilled work which is interesting and which provides workers with the opportunity to progress, access to training, good working conditions and a relatively high degree of job security.

Flexible employment

Global competition is putting pressure on firms to ensure that their labour force is flexible.

• Numerical flexibility

• Temporal flexibility

• Locational flexibility

• Functional flexibility

• Wage flexibility
  The labour force participation rate is the proportion of
  the working-age population who are in the labour force
  Economically active: those in the labour force, both the employed and the unemployed.
  Economically inactive: those not in the labour force.

The labour force participation rate

*The wages on off er
High wages will encourage more people to seek work and will persuade some to stay in the labour force, past the usual retirement age.
*Social attitudes to working women
In countries where it is acceptable for women to work, there will be a larger labour force and a greater participation rate.

• Provision for the care of children and the elderly
  The greater the availability of nursery places and retirement homes, the higher is the labour participation rate.
  *Social attitudes and provision for the disabled to work
  The greater the number of people willing to accept disabled people working and the easier it is made for the disabled to work

• The proportion of school leavers who go into higher education
  The more people there are in full-time education, the lower the participation rate.
  Claimant count: a measure of unemployment which counts as unemployed those in receipt of unemployment benefits.
  Labour Force Survey (ILO) Measure: a measure of unemployment which counts as unemployed people who identify as such in a survey

The measures of unemployment

• count those in receipt of unemployment-related benefits.

• carry out labour force surveys.

The causes and types of unemployment

• Frictional unemployment
  Casual unemployment
  Seasonal unemployment

• Structural unemployment
  Regional unemployment: unemployment caused by a decline in job opportunities in a particular area of the country.
  Technological unemployment: unemployment caused by workers being replaced by capital equipment

• Cyclical unemployment
  The costs of unemployment The existence of unemployed workers makes it easier for firms, wishing to expand, to recruit new workers.
  The effects on the unemployed
  The effects on firms
  The effects on the economy unemployment also means that government tax revenue will be lower than possible.

Policies to reduce unemployment

The policies a government will adopt to reduce unemployment will be determined by what it thinks are the cause or causes of unemployment.
to reduce cyclical unemployment, a government will use expansionary fiscal and monetary policy. An increase in government spending, a reduction in tax rates and a cut in the rate of interest, for instance, may be used to raise aggregate demand

Inflation and Deflation

Inflation and Deflation

While inflation is a rise in the prices of goods and services, deflation is a fall in the prices of goods and services.

• Disinflation is when the rate of inflation falls.

• Measurement of Inflation and Deflation
  To measure rises and falls in the price level, governments construct price indices (also referred to as price indexes).

• Consumer prices index (CPI): a measure of the weighted average of the prices of a representative basket of goods and services
  Constructing a price index

• Selecting a base year

• Finding out how households spend their money

• Finding out price changes

• Constructing a weighted price index

Three causes of inflation

• Cost-push inflation
  Cost-push inflation occurs when the price level is pushed up by increases in the costs of production.

• Demand-pull inflation
  Demand-pull inflation occurs when the price level is pulled up by an excess demand.

• Monetary Inflation
  Monetary inflation is a form of demand-pull inflation. In this case, excess demand is created by an excessive growth of the money supply

Three concequences of inflation

• harmful effects of inflation
  inflation causes a fall in the value of money
  Inflation redistributes income in an unplanned way
  the existence of inflation imposes extra costs on firms

• Hyperinflation: a very rapid and large rise in the price level.

• Index-linking: changing payments in line with changes in the inflation rate.

• Menu costs: costs involved in having to change prices as a result of inflation.

• Shoe-leather costs: costs involved in moving money around to gain high interest rates.