Theme 2 - Macroeconomic Objectives and Policies Flashcards
(74 cards)
1
Q
What are the macroeconomic objectives for the government?
A
Key:
Economic growth
Low unemployment
Low and stable inflation
Balance of payments equilibrium on the current account
Other:
Balance government budget
Protection of the environment
Greater income equality
2
Q
Government objectives: economic growth
A
UK long run trend is about 2.5%.
Governments aim to have sustainable economic growth for the long run. In emerging and developing economies governments may aim to increase economic development before economic growth, which will improve living standards, increase life expectancy and improve literacy rates
3
Q
Government objectives: low unemployment
A
Governments aim to have as near full employment as possible. They account for frictional unemployment by aiming for an unemployment rate of around 3%. The labour force should also be employed in productive work
4
Q
Government objectives: low and stable inflation
A
In the UK, the government target is 2%, measured by CPI
This aims to provide price stability for firms and consumers and will help them make decisions for the long run. If the inflation rate falls 1% outside the target, the governor of the Bank of England has to write a letter to the Chancellor to explain why this has happened and what they plan to do about it
5
Q
Government objectives: balance of payments equilibrium on the current account
A
This is important to allow the country to sustainable finance the current account, which is important for long term growth
6
Q
Government objectives: balance government budget
A
This ensures the government keeps control of state borrowing so the national debt doesn’t escalate. This allows governments to borrow cheaply in the future should they need to and makes repayments easier
7
Q
Government objectives: protection of the environment
A
This aims to provide long run environmental stability. It ensures resources used are not exploited, such as oil and natural gas, and that they are used sustainably, so future generations can access them too. It also means there is not excessive pollution
8
Q
Government objectives: greater income equality
A
Minimises the gap between rich and poor. Generally associated with a fairer society
9
Q
What are demand side policies?
A
Policies designed to manipulate consumer demand
Expansionary policies aim at increasing AD to bring about growth
Deflationary policies aim at reducing AD to control inflation
10
Q
What is monetary policy?
A
Where the central bank or regulatory authority attempts to control the level of AD by altering base interest rates of the amount of money in the economy
11
Q
What is fiscal policy?
A
The use of borrowing, government spending and taxation to manipulate the level of aggregate demand and improve macroeconomic performance
12
Q
What is the repo rate?
A
The rate the Bank of England will charge for short-term loans to other banks or financial institutions. A change in the repo rate adducts market rates offered by banks to consumers and businesses as the BoE is the lender of last resort
13
Q
How does a rise in interest rates cause a fall in AD?
A
- Increases the cost of borrowing for firms and consumers. Leads to a fall in investment and consumption. In particular, consumption of consumer durables and houses will fall. Also makes saving more attractive
- As people borrow less and save more, there is a fall in demand for assets such as stocks, shares and bonds, causing a fall in the prices of these assets. Consumers experience a negative wealth effect, which will lead to a fall in consumption, and investment is less attractive as firms are likely to see lower profits if prices fall
- People become less confident about borrowing and spending, causing a fall in consumption and investment. Other loans also become more expensive to repay so consumers have to dedicate more of their income to paying these back, so consumption will fall
- Higher rates increase incentive for foreigners to hold their money in British banks as they see a higher rate of return. This increases the demand for pounds and the value of the pound will rise, so imports cheaper and exports more expensive, which decreases net trade.
14
Q
What are the problems with using interest rates to manage levels of aggregate demand (monetary policy)?
A
- if exchange rate affected so much that exports fall and imports rise significantly, there could be a balance of trade deficit
- Time lags; changes in interest take up to 2 years to have their full effect, and some may not even affect peoples decisions
- Sometimes interest rates are so low that they cant be decreased further to stimulate demand
- Range of interest rates, and not all are affected by the BoE base rate
- Lack of confidence may mean that consumers and producers don’t want to borrow, no mater how low interest is
- High rates over a long period of time discourage investment and decrease LRAS
15
Q
What is quantitative easing?
A
When the BoE buys assets in exchange for money to increase the money supply and prevent the liquidity trap (where even low interest rates can’t stimulate AD)
16
Q
What is the effect of QE?
A
Increases consumption and investment
17
Q
How does QE increase consumption and investment?
A
- Since the bank is buying assets, there is a rise in demand, so asset prices rise, causing a positive wealth effect, increasing consumption. Cost of borrowing decreases as higher asset prices mean lower yields making it cheaper for households to finance spending
- The money supply increases. private sector companies receive more money which they can spend on goods and services, or other financial assets, which may increase investment, or consumption and therefore increase AD. It may also push asset prices up further. Banks have higher reserves so they can increase lending to households and businesses so consumption and investment increase as people can buy on credit
18
Q
What are the problems with using QE?
A
- It is very risky, and if not controlled properly could cause high inflation, or hyperinflation
- Could only lead to increased demand for secondhand goods, which pushes up prices but doesnt increase AD
- No guarantee that higher asset prices lead to higher consumption through the wealth effect
- Had a large effect on the housing market by stimulating demand and leading to rapid price rises by 2013, worsening issues of geographical immobility
- Led to rising share prices which increases inequality
- Over-dependence on QE
19
Q
Alternative methods to QE
A
- Open market operations; to reduce monetary supply, the central bank can sell more government securities on the open market. Securities are a promise by the government to pay a certain amount of money to the owner at a certain time and their are bought for less than their actual value; their price is determined by the demand for them. When people buy securities they pay for them with money drawn from banks and so there is a fall in the bank balances. This means banks meed to reduce their lending so monetary supply will fall. If they want to increase monetary supply the central bank can buy government securities
- The central bank can force banks to hold certain assets as a percentage of their total assets, known as monetary base or reserve assets. This means they can control the amount of money that is loaned out and therefore the money supply
- The central bank can restrict a bank’s ability to lend money, or who they are allowed to lend it to
20
Q
What is the role of the Bank of England?
A
- Its monetary policy committee controls monetary policy
- Main aim is to keep inflation at 2%, and if it goes below 1% or above 3% the governor of the BoE has to write a letter to the Chancellor explaining why and what they are doing to bring it back
Since 2009, the MPC has kept the bank rate at 0.5% and policy has become focussed on boosting economic growth and employment. It was reduced to 0.25% following the Brexit vote but rose again in November 2017 due to the inflation that the weak pound brought about. They plan to raise the interest rate once the negative output gap has been eliminated and the economy is growing strongly. - The Committee is made up of nine people: five are from of the Bank of England, including the Governor of the Bank of England, and the other four are independent outside experts, mainly economists.
21
Q
What are the two main ways a government can increase AD through fiscal policy?
A
- Rise in income tax will cause a fall in disposable income, leading to reduced consumption, and a fall in AD
- Rise in govt. spending will increase AD
22
Q
Government budgets
A
The government’s fiscal plans are outlined in the budget. A budget deficit is when the government spends more money than they receive. A budget surplus is when the government receives more money than they spend.
23
Q
What are the problems with fiscal policy?
A
- Gov spending can also impact LRAS
- Taxes and spending have an impact on inequality and incentives
- Government also has to worry about political issues
- Expansionary fiscal policy difficult during a period of austerity
- Impact depends on the multiplier; classical argue multiplier is almost 0, Keynesian say it is large
24
Q
Evaluation of demand side policies
A
Classical economists argue that any demand management, whether fiscal or monetary, will have no effect on long-run output so supply side policies should be used. They believe that increasing AD during a depression will have no effect other than to increase prices. If the economy is in short-run disequilibrium, it will quickly return to long run equilibrium, whilst Keynesians argue that it can be in long-run equilibrium for years.
● On a Keynesian LRAS, the impact of changes in AD depend on where the economy is operating: if the economy is at full employment then a rise in AD will only lead to higher prices. However, if unemployment is very high, then a rise in AD will only lead to higher output.
● Both policies see significant time lags between their introduction and their full effect.
● The biggest issue of demand-side policies is that, in most cases, an expansionary policy is inflationary whilst a deflationary policy brings unemployment. This depends on the elasticity of the curve and the curve which you perceive to be correct (Keynesian or classical), but holds in most scenarios. Thus, through demand management, the government cannot bring about both low and stable inflation and high economic growth/low unemployment.
25
Monetary vs Fiscal policy
Monetary policy is useful as the government is able to increase demand without having to increase their spending, which would result in a larger fiscal deficit. Classicists argue that if demand management is going to be done only monetary policy should be used
Fiscal policy can have significant impacts on the supply side of the economy, for example increases in spending on education to increase AD will also increase LRAS. Moreover, it is more effective at targeting specific groups and reduce poverty, for example by increasing benefits it can increase AD and reduce inequality.
26
What is discretionary fiscal policy?
Where the government actively influences AD by changing its expenditure or taxes
27
What are automatic stabilisers?
Forms of government spending and taxation that changes automatically due to the stage of the economic cycle without any deliberate change in government policy
28
Limitations of monetary policy
- Time lag
- Banks may not adopt the change
- May not alter spending as people may be optimistic about the future
- Some countries have limited control over base rate
- Ultra low interest rates make expansionary monetary policy less flexible
- Proportion of people that are homeowners will influence the effect
- Pensioners incomes
- Inflation
- Other factors
29
Limitations of Fiscal Policy
- Speed of adjustment
- National debt
- Size of the multiplier
- Time lag
- Tax avoidance/evasion
- Inequalities
30
How the the yield of a bond calculated?
coupon / market price x 100
31
What is a bond?
A financial instrument issued by a government or business as a means of borrowing long term funds
32
What is the process of QE?
Central bank creates money
To buy bond from financial institutions
Which reduces interest rates
leading to people and businesses borrowing more
so they spend more and create jobs
to boost the economy
33
What are supply-side policies?
Supply side policies aim to increase the quantity and/or efficiency of the factors or production. The policies aim to increase productive capacity in the economy
34
What are interventionist supply-side policies?
Involve government intervention to overcome market failure
35
What are free-market supply-side policies?
Involve policies to increase competitiveness and free-market efficiency
36
Examples of free-market supply side policies?
- Reduction in direct tax
- reduce/remove national minimum wage
- Reform the benefits system and increase incentives to work
- Reduce trade union power (stricter rules surrounding strikes)
- Privatisation/deregulation
- Competition policy
37
Examples of interventionist supply-side policies
- Education and training
- Infrastructure and healthcare spending
- Government assistance to new firms
38
What are the limitations of supply-side policies?
Time lags
Opportunity cost
Resistance to policies
Equity issues
Unintended effects
Countries with a large negative output gap
Policy might be counter productive
39
How does privatisation shift LRAS?
Profit incentives encourage innovation, firms become more efficient and increase output
40
How can supply-side policies cause equity issues?
Removing minimum wage or cutting benefits will increase inequality
41
How can supply-side policies impact countries with a large negative output gap?
Supply-side policies will have little impact as shifting LRAS won't impact AD
42
What are the government's objectives?
Low and stable inflation
Low unemployment
Economic growth
Fair distribution of income
Balanced budget
External stability (balance of payments)
Concern for environment
43
What is the relationship between unemployment and inflation?
If unemployment is low, demand pull inflation is likely
High unemployment = lower wages = lower costs of production = no cost-push inflation
Low unemployment = high wages = increased costs of production = cost push inflation
44
What does the original Phillips curve show?
Shows the rate of wage inflation against the unemployment rate:
- As unemployment rises, wage inflation falls
- If unemployment falls wage inflation rises as there is less availability of labour
Movement along the curve is caused by a change in AD
A shift is caused by a change in AS (oil prices)
45
Who was AW Phillips?
- He noticed a correlation between unemployment levels and the speed at which wages rise
- He noticed that in the previous 100 years, that when wages were rising fast, there was very low unemployment. In years where unemployment was high, he noticed wages were not rising fast, and sometimes even fell
- He noticed that there was an inverse relationship between unemployment and wage rate rises
46
How was the original Phillips curve amended?
It was amended from 'changes in wages' to 'inflation', this was because increased wages will cause cost-push inflation
47
What is the long-run Phillips curve?
The long run curve is showing the natural rate of unemployment - the natural rate accounts for frictional unemployment, structural unemployment and seasonal unemployment
In long-run, there is no relationship between inflation and unemployment increasing AD won't increase growth in the long run, and supply side policies are needed.
A supply side policy would shift the long run Phillips curve to the left
48
What are the limitations of the Phillips curve?
In the 1970s the UK experienced both a high unemployment rate and high inflation simultaneously (stagflation), suggesting a setback to the Phillips curve theory - the Phillips curve only works in the short run
49
What are the monetary policy instruments?
Interest rates
Quantitative easing
50
What were the causes of the great depression?
The Great Depression was set off by the Wall Street Crash of 1929 when share prices fell sharply on the New York Stock Exchange. There are a variety of possible causes:
- A loss of consumer and business confidence shareholders lost money in the crash, others became worried about what would happen, and firms cut back investment which led to a downward spiral in AD.
- Banks had lent too much money in the 1920s, creating an unsustainable boom and the system couldn't deal with the issues following the crash, the government then allowed banks to fail after the crash, further reducing confidence
- Protectionism; reduced world trade which decreased AD and lowered confidence, and firms involved in exports were unable to pay back their loans which caused bank failures. America introduced the Smoot-Hawley Tariff Act which decreased imports to the USA. Countries which traded with America saw a reduction in exports which decreased in AD in their countries. America also suffered from a fall in exports as other countries retaliated.
- The UK was also affected by its commitment to the gold standard, in which its currency was fixed to the value of gold and therefore fixed to other currencies. It left the gold standard in 1914 but re-joined in 1925 at the 1914 level and value, despite the fact the value of the pound had fallen. The rejoining of the gold standard meant the pound was appreciated rapidly and exports fell as they became more expensive. The UK went into the Great Depression with an overvalued exchange rate.
51
What were the policy responses to the Great Depression in the UK?
- Government believed that balancing the budget was the key to recovery and borrowing money would prevent the private sector from doing so. An emergency budget was introduced which cut public sector wages and unemployment benefits by 10% and raised income tax from 22.5% to 25%. This reduced AD at a time when it needed to be increased.
- The pound came under attack from speculators and needed to be defended to prevent the UK being forced out of the gold standard. A balanced budget meant the UK didn’t have to borrow from abroad, which helped the exchange rate as did the high interest rates used to defend the high exchange rate. However, the high interest rates also decreased demand.
- The UK was forced to leave the gold standard on 21st September 1931 due to continued speculation against it. This caused the value of the pound to fall by 25% compared to other currencies and allowed the Bank of England to cut interest rates by 2.5%, both of which helped the increase AD by increasing exports or increasing consumption/investment.
52
What were the policy responses to the Great Depression in the USA?
● The US government originally had the same view over a balanced budget as the UK.
● However, Franklin Roosevelt was elected in 1932 with his New Deal which promised public sector investment, work schemes for the unemployed and fiscal stimulus.
● The USA reached full employment in 1943 (two years after joining the war- the same as Britain). Roosevelt’s New Deal is an example of Keynesian expansionary fiscal policy but can be argued it was not large enough to be successful, although it did have a large impact as the US unemployment figure was so high.
53
What caused the global financial crisis?
● The 2008 crisis was started by issues in mortgage lending in the USA. In the early 2000s, relatively poor people were encouraged by the government and banks to take out mortgages to buy their own homes. This was an example of moral hazard, as the bank workers saw higher bonuses for selling more mortgages. They were given low interest rates on the loan for the first few years, but many were no longer able to continue paying with the higher repayments. Houses were repossessed, demand fell, and prices fell meaning the value of the houses was now less than the mortgage of the house. This is known as negative equity.
● At the same time, banks had been grouping ‘prime’ mortgages (people who were likely to pay back their loans) and ‘sub-prime’ mortgages (those who weren’t) and selling packages to other banks and investors as if they were all prime mortgages. The aim was to reduce risk since it meant no bank was highly dependent on risky mortgages. However, it increased risk as many were now holding assets worth less than they had paid for them; it spread the effects of the housing crash and the unpaid loans.
● When this was revealed, there was a fall in confidence and banks stopped lending between each other, fearing that they would lose money if the other bank were to collapse. Similar events occurred in the UK, Ireland, Spain and Portugal. Northern Rock Building Society was the first affected in the UK in 2007 with too many loans not being repaid, and savers beginning to withdraw their money. In 2008, Lehman Brothers, an investment bank, was allowed to fail. This caused panic as people believed bank after bank would be allowed to collapse, leading to losses for savers.
54
What were the UK and USA's policy responses to the global financial crisis?
● Both governments were forced to nationalise banks and building societies and guarantee savers their money in order to prevent the chaos of a collapsed banking system. For example, the British government bought Northern Rock and most of Royal Bank of Scotland and Lloyds Bank.
● They used expansionary monetary policies with record low interest rates and quantitative easing. The Bank of England said the QE led to lower unemployment and higher growth than would otherwise have been the case.
● However, the USA government had a more expansionary fiscal policy and this is perhaps why it recovered faster. In 2010, the UK prioritised reducing National Debt over providing a fiscal stimulus, but the USA did not make this decision until 2013.
55
What are the potential conflicts and trade-offs between the macroeconomic objectives?
Economic growth vs inflation:
Economic growth vs the current account:
Economic growth vs the government budget deficit:
Economic growth vs the environment:
Unemployment vs inflation:
56
What are potential policy conflicts and trade-offs?
This occurs when one macroeconomic policy has a larger impact than another, which conflicts with the other policy or reduces its effectiveness. Every policy is likely to have unintended consequences; these are some examples:
Environment vs competitiveness:
Fiscal vs monetary policy:
Interest rate vs inequality:
57
How does QE ensure the country meets its inflation target?
- Commercial banks may lower their interest rates as they are receiving money from the BoE and can offer very low interest deals to their customers. The increased money supply means that the price of money falls, which will encourage borrowing and therefore increase investment and consumption, so increase AD. If many banks decide to lower their interest rates the same mechanisms will apply as those following a reduction in the base rate
58
What is the conflict between economic growth and inflation?
A growing economy is likely to experience inflationary pressures on the average price level. This is especially true when there is a positive output gap and AD increases faster than AS.
59
What is the conflict between economic growth and the current account?
During periods of economic growth, consumers have high levels of spending. In the UK, consumers have a high marginal propensity to import, so there is likely to be more spending on imports. This leads to a worsening of the current account deficit. However, export-led growth, such as that of China and Germany, means a country can run a current account surplus and have high levels of economic growth.
60
What is the conflict between economic growth and the government budget deficit?
Reducing a budget deficit requires less expenditure and more tax revenue. This would lead to a fall in AD, however, and as a result there will be less economic growth.
61
What is the conflict between economic growth and the environment?
High rates of economic growth are likely to result in high levels of negative externalities, such as pollution and the usage of non-renewable resources. This is because of more manufacturing, which is associated with higher levels of carbon dioxide emissions.
62
What is the conflict between unemployment and inflation?
In the short run, there is a trade-off between the level of unemployment and the inflation rate. This is illustrated with a Phillips curve.
As economic growth increases, unemployment falls due to more jobs being created. However, this causes wages to increase, which can lead to more consumer spending and an increase in the average price level.
63
What is the conflict between environment and competitiveness?
If ‘green taxes’ are implemented, such as carbon taxes, or if there are minimum prices on pollution permits, the competitiveness of domestic firms could be compromised. This is because they are limited in their production.
64
What is the conflict between fiscal and monetary policy?
Expansionary fiscal policies involve more government borrowing, which could cause interest rates and the inflation rate to rise.
65
What is the conflict between interest rate and inequality?
The low interest rate could affect the distribution of income. Savers only receive a small return on their savings.
66
What is a central bank?
The banker to the government, performing a range of functions, which may include issues of coins and bank notes, acting as the banker to commercial banks and regulating the financial system. Also has the role of 'lender of last resort' - protects commercial banks if they go bankrupt
67
What are retail banks?
Banks that provide high-street services to depositors. These banks accept households and small firms deposits. and make loans, mainly on a relatively small scale.
68
What are wholesale banks?
Banks that deal with companies and other banks on a larger scale. The banks take deposits and make loans to companies and other banks. These include investment banks
69
What are universal banks?
Banks that operate in both retail and wholesale markets
70
What are investment banks?
Banks that help companies with mergers/aquisitions, do consultancy and help firms 'list' on the stock market
71
What are building societies?
Mutual financial institutions that are owned by their members. Their primary function is to receive deposits from members and lend money for members to purchase a property. Property acts as a collateral on the debt. Deregulation allowed most building societies to rebrand themselves as retail banks.
72
What are insurance companies?
Financial institutions that guarantees compensation for a specified loss, damage, illness or death, in return for a premium
73
What is a moral hazard?
A situation in which a person who has taken out insurance is prone to taking more risks
74
What is adverse selection?
A situation in which a person at risk is more likely to take out insurance
