macro 2.6 - macroeconomic objectives and policies Flashcards
expansionary fiscal policy
fiscal policy —> changes to government spending and taxation in order to influence AD
expansionary fiscal policy —> tax decreases and government spending increases —> AD increases
aims of expansionary fiscal policy? (macro economic objectives)
- boost growth
- reduce unemployment —> if AD increases —> demands for goods increase —> demand for labour increases —> labour is a derived demand
- increase inflation to hit inflation target
expansionary fiscal policy examples:
- reduction in income tax —> increased disposable income —> MPC increases —> consumption increases —> AD shifts right —> econ growth —> as a result of econ growth, this could attract investors and incentive them to invest —> I increases —> I is a component of AD —> AD shifts right —> econ growth —> positive multiplier effect
- reduction in corporation tax —> increased retained profit —> MPI increases —> investment increases —> AD shifts right
- increase in government spending e.g. healthcare —> boost G in AD equation
- reduction in VAT —> VAT is a regressive tax - burdens the poor more than it burdens the rich —> disposable income increases more for the poor more than the rich —> poor have high MPC —> consumption increases —> AD shifts right
expansionary fiscal policy side effects (LRAS)
- main purpose of fiscal policy is to boost AD —> increase in LRAS may be a side effect
- reduction in income tax —> incentivise inactive to become active —> increase quantity of labour —> LRAS shifts right// for those in work —> incentive to work harder as they can keep more income —> productivity increases —> quality of labour increases —> LRAS shifts right
- reduction in corporation tax —> boost investment —> increase in quantity/quality of capital and increase in productive efficiency —> LRAS shifts right
- increase in government spending —> e.g. spending on education/health —> productivity of labour increases as people are healthier and have stronger human capital —> quality of labour increases —> LRAS shifts right// e.g. spending on infrastructure —> productive efficiency and quantity/quality of capital increases —> LRAS shifts right
conflicts:
- demand pull inflation —> AD increases —> higher demand pull inflation
- current account deficit —> economic growth —> AD shifts right and price level increases —> UK competitiveness decreases—> export expenditure decreases in the long run —> worsening of current account deficit// AD increases —> higher incomes —> more spending on imports
- economic growth —> negative impact on environment
- worsening of government finances —> more government spending and less taxation —> national debt/budget deficit could rise// may lead to cuts to government spending in other areas of the economy/ opportunity cost is created as they’re paying off debt
evaluation:
- low consumer/business confidence —> income tax cuts might be saved —> consumption decreases// businesses —> increased retained profit may not be used to invest
- size of the output gap —> small negative output gap —> there won’t be much growth and not much reduction in unemployment rates —> we will see demand pull inflation
- time lags —> tax cuts takes time to feed through into the economy e.g. households will take time before income tax cut is spent, corporation tax cut will take time before businesses invest
- ricardian equivalence —> consumers anticipate the future so if they receive a tax cut, they anticipate future taxes will rise —> consumer spending remains unchanged as they’re saving for the tax rise —> tax cut won’t increase AD because consumers would save the tax cut to pay the future tax increases
- in the SR, debt levels may be high but in the LR, the returns outweigh the debt —> increased gov spending and tax cuts can lead to long term growth
contractionary fiscal policy
fiscal policy —> changes to government spending and taxation in order to influence AD
contractionary fiscal policy —> taxes increase and government spending decreases —> decreases AD
aims of contractionary fiscal policy?
- reduce inflation to reach inflation target
- reduce budget deficit/national debt —> government spending decreases —> government borrowing decreases
- redistribute income —> higher taxation on the rich and redistribute it to the poor
- reduce current account deficit —> AD is reduced because of contractionary fiscal policy —> incomes lower —> less imports
contractionary fiscal
expansionary monetary policy
monetary policy —> changes to interest rates, the money supply and the exchange rate by the central bank in order to influence AD
expansionary monetary policy —> policies to increase AD
aims of expansionary monetary policy?
1. increase inflation to hit inflation target —> AD increases —> demand pull inflation increases (use keynesian graph)
2. increase economic growth
3. reduce unemployment
examples of expansionary monetary policy?
interest rates:
central bank will cut interest rates —> cut works through the monetary policy transmission mechanism
- low credit card interest rates —> cheaper to borrow —> greater incentive to borrow —> MPC increases —> consumption increases —> AD increases
- saving interest rates will fall —> ROR on savings decreases —> reduces incentive to save and increases incentive to spend —> consumption increases —> AD increases
- mortgage interest rates will decrease (money that needs to be paid back decreases) —> households will be paying less monthly towards their mortgage payments —> more disposable income —> MPC increases —> consumption increases —> AD increases
- lower interest rates on business loans —> cheaper to borrow —> greater incentive for businesses to borrow —> MP to invest increases —> investment increases —> AD increases
exchange rates:
- exchange rate —> the value of one currency in respect to another
depreciation —> value of currency in the UK falls in respect to other countries —> UK is more price competitive —> demand for exports increases —> export revenue increases —> net exports increases (improves current account deficit) —> AD shifts right
money supply:
- quantitative easing —> increase in the money supply —> this is through increasing the demand for bonds or electronic printing
- government demand more bonds —> price of bonds increases —> bonds and yields (interest rates) are inversely related —> interest rates decrease —> cost of borrowing decreases and ROR on savings decreases —> incentivises firms to invest and consumers to spend —> C and I increases —> C and I are components of AD —> economic growth occurs
quantitative easing diagram:
- y axis - IR (interest rates)
- x axis - QM (quantity of money supply)
- demand curve - Dm
- supply curve - inelastic at MS1 —> shift curve to the right at MS2
- as a result of quantitative easing, money supply increases from MS1 to MS2 (QM1 and QM2) —> this leads to a fall in interest rates —> this is because banks will be more willing to lend as they have more money —> as interest rates fall from IR1 to IR2, cost of borrowing decreases and ROR on savings decreases —> incentivises firms to invest and consumers to spend —> C and I are components of AD —> economic growth occurs
conflicts:
- demand pull inflation —> AD increases —> higher demand pull inflation
- current account deficit —> economic growth —> higher incomes —> more spending on imports
- economic growth —> negative impact on environment
expansionary monetary policy side effects (LRAS)?
- interest rates on business loans decrease —> businesses borrow more and invest —> investment increases —> quality/quantity of capital/productive efficiency increases —> LRAS shifts right
evaluation expansionary monetary policy
evaluation:
- consumer confidence —> consumption may not increase despite low interest rates as consumer confidence may be low —> due to the state of the economy and low job security
- business confidence —> investment may not increase despite low interest rates as business confidence may be low —> due to the state of the economy
- hot money outflows could occur - this is the idea that investors chase the best interest rate —> if the UK lower their interest rates, investors will move their savings to economies where interest rates are higher
- size of the rate cut —> bigger cut in IR boosts AD more than a smaller cut in IR —> greater incentive to borrow and spend —> consumption/investment increases
- liquidity trap —> situation where agents prefer to keep their savings instead of spending them despite zero/very low-interest rates —> monetary policy becomes ineffective
- time lags —> takes long time for interest rate cut to fully feed through the different channels of the transmission mechanism —> takes long time to have a full impact on AD
- size of the output gap —> small negative output gap (economy is close to YFE) —> cuts in interest rates may boost AD but there won’t be much growth and not much reduction in unemployment rates —> we will see demand pull inflation
contractionary monetary policy
monetary policy —> changes to interest rates, the money supply and the exchange rate by the central bank in order to influence AD
contractionary monetary policy —> policies to decrease AD
- reduce inflation to hit inflation target —> AD decreases —> demand pull inflation decreases
- prevent asset/credit bubbles (prevent excessive growth of house prices and prevent excessive borrowing —> if there’s excessive growth of house prices and excessive borrowing then there’s a risk to the financial sector
- reduce excess debt + promotes saving —> interest rates increase —> reduces incentive to borrow money and increases incentive to save
- reduces current account deficit —> AD falls —> growth falls —> income falls —> less spending on imports
increase IR —> cost of borrowing increases —> less consumers and investors will borrow —> both C and I decreases —> AD shift left, causing a fall in the level of inflation
contractionary monetary policy pros and cons
contractionary monetary policy —> higher interest rates
pros:
- reduce inflation —> higher interest rates —> cost of borrowing increases —> decreases incentive to borrow and spend —> decrease demand for goods/services —> reduce inflation
- discourage household/corporate debt —> higher interest rates —> cost of borrowing increases —> less incentive to borrow —> discourage debt —> debt is bad —> chance of bank failure —> banking sector is very interdependent —> 1 bank failure can ripple across entire sector and bring down lots of other banks —> we want to discourage debt to reduce the overall risks of recession
- more sustainable borrowing/lending —> only those that need to borrow/can afford to borrow will enter the market —> less likely to get unsustainable growth (borrowing fuelled consumption and investment) —> more consumption from saving and more investment from profit —> sustainable growth and less likely to get asset price bubbles —> less chance of recessions
bubble forms when there’s unsustainable growth —> when bubbles burst —> guaranteed recession
- more affordable housing —> high interest rates —> increase cost of mortgages —> demand for housing decreases —> lower house prices —> houses are more affordable for first time buyers or low income households —> improves living standards and reduces inequality
- reduce current account deficit —> high interest rates —> less incentive to borrow and spend —> AD decreases —> incomes decrease —> less spending on imports
- flexibility for expansionary monetary policy —> when interest rates increase as part of contractionary monetary policy, it provides room for future interest rate cuts —> if economy faces challenges in the future, the central bank has the option to lower interest rates
cons:
- lower growth (discourages consumption, investment and strengthening exchange rate)
- higher unemployment (keynesian graph)
- impact on the indebted —> interest rates increase —> harder to repay debts —> may lead to homelessness and bankruptcy —> impacts living standards// businesses —> can’t afford to repay business loans —> business bankruptcy —> rising unemployment —> impacts living standards
- reduces investment —> interest rates increase —> incentive to borrow and invest decreases —> bad for SR and LR growth
- worsening current account deficit via exchange rate strengthening —> high interest rates in UK —> hot money inflows —> savings from abroad will flood into the UK —> demand for pound increases —> value of pound increases —> pound appreciates —> imports cheaper —> current account deficit
automatic stabilisers
automatic stabilisers- fiscal policy tools to influence GDP and counter fluctuations in the economic cycle
- automatic stabilisers prevent you from reaching boom/bust
bust:
- government spending increases as employment levels are low —> increased spending on benefits
- income tax decreases —> people receive less income —> pay less tax
- corporation tax decreases —> businesses receive less profit —> pay less tax
- (acts as expansionary fiscal policy as G increases and T decreases)
boom:
- employment levels are high —> decreased spending on benefits —> gov spending decreases
- income tax increases —> people receive more income —> pay more tax
- corporation tax increases —> people receive less income —> pay less tax
- (acts as contractionary fiscal policy as G decreases and T increases)
this all happens automatically —> when we reach a boom, gov naturally have to spend less money —> reduces extent of boom and vice versa with bust
if role of automatic stabilisers in a recession is large —> reduces need for discretionary fiscal policy (expansionary fiscal policy on top of automatic stabilisers) —> government spending doesn’t have to increase by a lot and taxes don’t have to decrease by a lot—> reduces impact on government finances
supply side policies
supply side policies —> policies designed to increase the productive capacity of the economy, shifting LRAS to the right —> if successful then all 4 main macro economic objectives will improve
- lower unemployment
- growth
- reduction in inflation
- current account deficit improves —> reduction in inflation —> exports cheaper —> more internationally competitive —> demand for exports increases —> net exports increase
2 types of supply side policies?
interventionist (role of government)
- government spending on education/training —> human capital increases —> productivity increases —> quality of labour increases —> LRAS shifts right
- government spending on healthcare —> more ppl treated and therefore less absenteeism —> quality of labour improves —> LRAS shifts right
- government spending on infrastructure —> e.g. transport infrastructure —> productive efficiency increases —> LRAS shifts right// new infrastructure —> increases quantity of capital —> LRAS shifts right
- subsidies to firms to promote investment —> quality/quality of capital increases/productive efficiency increases —> LRAS shifts right
- government spending on housing supply/transportation —> reduces labour immobility —> quantity of labour increases —> LRAS shifts right
market based (take away role of government)
deregulation —> reduced barriers to entry —> more firms in an industry —> increases competition —> firms will be more efficient to lower COP —> productive efficiency increases —> LRAS shifts right
removing red tape/regulations —> (less costs involved e.g. health and safety) —> COP falls —> profit for firms is higher —> incentivises firms to invest —> quantity/quality of capital increases —> shifts LRAS right// incentivises new firms to enter —> increases comp —> enterprise increases —> LRAS shifts right
privatisation —> promotes competition —> will be more efficient and lower COP —> productive efficiency increases —> LRAS shifts right
tax reform
- lower income tax —> incentive for inactive economically to enter the labour force —> increase quantity of labour// for those in work, there’s an incentive to work harder as they can keep more of their money as disposable income —> increase quality of labour —> LRAS shifts right
- lower corporation tax —> higher retained profit —> investment increases —> increases quality/quantity of capital and productive efficiency increases
labour market reform
- reduce benefits —> strong incentive for economically inactive to enter the labour force —> increase quantity of labour
- reduce minimum wages —> reduce LR COP —> productive efficiency increases
- reduce trade union power —> reduce LR COP —> productive efficiency increases
competition policy
- privatisation
- deregulation
- trade liberalisation
all boost competition —> firms have to reduce LR COP to be more competitive —> productive efficiency increases —> LRAS shifts right
cons/evaluation
- no guarantee of success e.g. no guarantee that gov spending on education/training will boost productivity of workforce// no guarantee that subsidies to firms will be used for investment purposes// no guarantee that lower corporation tax will lead to lower investment// no guarantee that competition policies will boost competition
- cost —> risk of wasteful spending on supply side policies as there’s no guarantee of success// opportunist cost comes with paying debt interest, taxes may rise to fund it etc
- time lags —> e.g. gov spending on infrastructure —> takes a long time before infrastructure project is completed// gov spending on education and training —> take several years before we see an increase in productivity/ tax cuts —> takes a long time before we see investment take place
- negative stakeholder impacts —> e.g. deregulation can impact consumer/producer safety
- output gap —> if economy in recession the supply side policies will be useless
if booming/at YFE —> supply side policies will be useful
- need for targeted supply side policies
laffer curve
diagram:
- y axis - tax revenue
- x axis - tax rate
- n shaped curve
- increasing taxes will increase tax revenue up to a point
- however increasing taxes beyond the efficient tax rate will see a reduction in tax revenue
3 reasons why tax revenue decreases beyond efficient tax rate:
1. tax rate increases —> less incentive to work as workers keep less of their income —> workers are working less —> less income —> tax revenue decreases
2. tax rate increases —> emigration —> highly skilled workers will move elsewhere (most of these workers are the highest tax payers to the government) —> tax revenue decreases
3. tax rate increases —> tax evasion/tax avoidance increases —> tax revenue decreases
