What is the role of the state in promoting growth and development?

Macroeconomic Policies Main Policy Objectives

1. 2. 3. 4. 5. 6. 7. Price stability Full employment Balance of payments Economic growth Protection of the environment Income redistribution Correcting market failure

Aggregate Supply and Demand

Short-Run Aggregate Supply: SAS: short-run aggregate supply curve. An increase in price due to a shift in AD along the SAS is shown in the graph. There is no reason why the equilibrium shown in the graph can be sustained.

Shifts may occur due to: - Changes in wage costs increased wages will raise costs of production. - New legislation new health and safety regulations or environmental regulations, for example, would raise costs. - Changes in the prices of raw materials and components a fall in commodity prices would cause the SAS to shift to the right. - Changes in taxation on firms employers are required to pay national insurance contributions in the UK, so if employers contributions are increased, the SAS will shift to the left.

Long-Run Aggregate Supply: There has been debate over the shape of the long-run AS curve. Monetarist School argued that the economy would always converge on an equilibrium level of output called the natural rate of output. Associated with this is the idea of a natural rate of unemployment (unemployment leve when the economy is in long-run equilibrium). On the graph, Y* is the natural rate of output. In other words, a change in the overall price level doesnt affect aggregate output.

The Keynesian school, however, believe that the macro economy wasnt flexible enough to enable continuous full employment. They argued that the economy could settle at an equilibrium position below full employment, at least in the medium term. They argued that inflexibilities in the labour markets would prevent adjustment. If firms had pessimistic expectations about AD, for example, and reduced their supply, this would lead to lower incomes because of the workers being laid off self fulfilling. These arguments led to a belief that there would be a range of output over which AS would be upward sloping.

The policy implications of the monetarist AS curve are that if an economy converges rapidly on the fullemployment level of output, no manipulation of AD can have any effect other than on price level. Shifts may occur due to: - Technological change new and more efficient methods of production. - Size of the labour force this can be influenced both by the natural rate of increase or decrease in the population, as well as migration. - Human capital skills, knowledge and expertise of the workforce gained through education and training. - Capital stock if the capital stock increases relative to the workforce (capital deepening), then productivity should increase. - Raw materials discovery of new raw materials will cause the LRAS to shift to the right.

Aggregate Demand: C + G + I + (X M) Relationship between the quantity of real GDP demanded and the price level. Shifts may occur due to changes in: - Asset prices. - Interest rates. - FDI. - Tax rates. - Expectations about the future state of the economy. - Government expenditure decisions. - The exchange rate.

Monetary Policy
Monetary policy: the use of interest rates, money supply and exchange rates in order to influence the level of economic activity in a country. Inflation targets: These are used by many countries to maintain a low rate of inflation. In the UK, there is a target of 2% 1%. However, in April 2011 inflation was at 4.5%. The ECB has a target of a maximum rate of inflation of 2%. Inflation levels in the Eurozone were at 3.1% in March 2011, but variations within the zone are considerable. Latin America has generally had higher inflation rates than the rest of the world. Until 2007, inflation targeting was generally regarded as an effective way of controlling inflation, although countries without targets didnt seem to suffer from significantly higher rates. However, following the financial crisis, many economists have argued that an inflation target based on CPI is too narrow instead, there should be targets relating to other variables, such as asset prices, in order to prevent asset price bubbles from occurring. Interest rates: Interest rate changes are used to achieve the inflation target. E.g. if the inflation rate is predicted to rise above its target, the Bank of England increases the base rate. This is because as interest rates rise, the cost of borrowing rises, mortgage repayments rise, hire purchase will be more expensive. Interest rates can be regarded as the opportunity cost of holding money if the money were to be spent on some sort of financial asset, interest would be earned on the asset. However, the use of interest rates has various disadvantages, e.g. the full effect of an increase in the rate takes between 18 and 24 months to work through the economy. Business costs rise, the exchange rate of the currency may increase due to hot money, making a countrys goods less price competitive X will fall and M will rise. All these changes shift the AD curve to the left with multiplier effects. Economic growth is compromised by increased interest rates. In the UK, an important aspect of monetary policy since 1997 has been the delegation of responsibility to the MPC effectiveness of monetary policy depends on peoples expectations, and it operates more effectively if people believe it is going to work. The MPC meets each month to decide interest rates this is to ensure that the governments inflation target is met. In reaching its decisions, the MPC takes a long-term view, projecting inflation ahead over then next 2 years this is why interest rates are currently so low. Other factors than inflation are taken into account e.g. in 2008 when inflation was accelerating rapidly, the MPC did not increase interest rates as it would have pushed the economy further into recession and damaged house prices. Delegating responsibility to the Bank of England increases the credibility of policy it becomes more effective, and the government cant be tempted to use it as a tool for electoral success. Currently in the UK, interest rates are very low, at 0.5%. They are higher in the Eurozone, at 1.25% (up from 1% in April), but lower in the USA at 0.25%. For the first decade after the creation of the MPC, monetary policy was highly effective in achieving the inflation target it remained within the upper and lower bounds for the entire decade. However, after the global financial crisis, the inflation rate of the UK, and many other countries, have accelerated. Expansionary monetary policy would be damaging if the economy were at, or nearly at, full employment, as the main impact would be on the price level, and not economic growth. Quantitative Easing: This is sometimes, mistakenly, referred to as printing money. It relates to the action of the Central Bank in buying up government bonds and corporate bonds from the commercial banks and other financial institutions.

This has the effect of increasing their deposits, thereby giving them the ability to lend more easily to private and business companies. The Bank of England began this in 2009, the combat the threat of deflation. However, some argue that this policy is unlikely to be effective if the banks are risk averse and remain unwilling to lend unless the loan is risk free. There is also the danger that the increased supply of money in the economy could unleash a serious bout of inflation. An increase in the money supply could also cause the depreciation in the exchange rate, which, in turn, would result in an increase in net exports and so increase AD.

Fiscal Policy
Fiscal policy: the use of government expenditure and taxation in order to influence the level of economic activity in a country. From 1980-2008, its primary role was to ensure stable public finances, however post-2008 it has assumed a role in the macroeconomic policy of the UK, China and the USA, as well as many other countries. Automatic Stabilisers: Some forms of government expenditure and revenues from some taxes change automatically in line with changes in GDP and the state of the economy. These stabilisers help to reduce fluctuations caused by the trade/business cycle. For example, progressive taxation and welfare payments such as unemployment pay. Discretionary Fiscal Policy: Deliberate changes in taxes and public expenditure designed to achieve the governments macroeconomic objectives. For example the global economic crisis has led many countries to introduce a fiscal stimulus to prevent severe recession. These have included increases in public expenditure on infrastructure (e.g. bridges in the US), green technology, targeted subsidies to distressed industries (e.g. the car industry) and tax cuts. Evaluation: Increased government expenditure can cause crowding out of private-sector activity by the public sector if the government finances its expenditure through borrowing, a side-effect is to put upward pressure on interest rates, which may cause private-sector spending to decline as the cost of borrowing increases. The government should only use discretionary fiscal policy if there is spare capacity in the economy, otherwise they will just push up the price level. In LDCs, tax collection can be a challenge no effective administration in place. In addition, where subsistence activity is significant, taxation cannot be effectively implemented, e.g. in Mozambique. Mozambique has seen fiscal reforms of late, including the implementation of a value added tax, however it still depends on foreign assistance for much of its budget. Governments could try printing money to increase inflation, but this can have disastrous inflationary results e.g. in Zimbabwe in the late 00s there was hyperinflation. In the UK over the past 50 years, government expenditure has been decreasing overall, due to privatisation however, government expenditure and tax revenues still remain comparatively high. There have been questions of how sustainable fiscal policy is future generations may have to pay back the debts of past generations. The Chancellor of the Exchequer is committed to following the Golden Rule of fiscal policy over the economic cycle net government borrowing should be for investment only, and not for current spending. There is also a commitment to keep public sector net-debt below 40% of GDP bank bailouts have had a significant impact on public sector net debt, which was estimated to be 150% in March 2011. Excluding financial interventions, public sector net debt is only 60%. Savage spending cuts in Portugal, Spain, Greece and Ireland have impacted on the Eurozone, with Greece having to be bailed out with 155bn in 2010.

UK Budget 2011: Camerons government initiated a 5-year austerity program in 2010, aiming to lower the budget deficit. As of June 2011, the budget deficit has been narrowing since 2009. In the 2011 budget, revenue-raising plans for the government were announced. The 2011-12 growth forecast was downgraded. Income Tax: - The tax-free allowance has been increased to just over 8,000. - 50% top rate of tax to remain. - Employee National Insurance Contributions are to rise from 11 to 12%. - Those above the upper earnings limit will see an increase of 1 to 2%. Benefits: - Tax-relief pension allowance will be reduced. - Plan for a 140 state pension. - Child benefit will be frozen for three years from April. Corporation tax: - This will fall by 2%, with more reductions to come in subsequent years. Jobs and Skills: - Increase in University fees. - Funding for 12 further technical colleges. - Extra 40,000 apprenticeships. - 100,000 new work experience placements.

Supply-Side Policy
Labour Market: Reduction in trade union power making strikes without a secret ballot illegal, making sympathy strikes illegal etc. Reduction in unemployment benefits increase incentive for unemployed workers to take jobs in the UK there have been plans to reassess those on incapacity benefits. Improvements in human capital increased provision and quality of education and training to increase productivity. Reduction in employment protection legislation making it easier to hire and fire workers more flexible workforce Reduction in income tax rates increase incentives to work shown on the Laffer Curve. Product Market: Privatisation, deregulation and contracting out: - Privatisation sale of state-owned enterprises to the private sector has been adopted around the globe and is a condition for IMF loans no longer very relevant in the UK. - Deregulation government removes official barriers to competition e.g. licences and quality standards. - Contracting out parts of services operated by the public sector are put out to tender so that the private sector can compete for business. Trade liberalisation removal or reduction in trade barriers and the adoption of policies which allow free capital flows between countries makes it more attractive for TNCs to invest in the country. Promotion of new/small firms e.g. through tax breaks, short-term loans for new businesses and loan guarantees. Capital Market: Deregulation of financial markets reduction of restrictive practices in the city and stock exchange. Reduction in corporation tax or increases in tax allowances on investment by firms. Criticisms: Increased Inequality: it is argued that they are based on the idea that the rich will work harder if you pay them more and the poor will work harder if you pay them less. Time lags: some of the measures take a long time to have any impact on the supply side of the economy.

Incentives may be over-estimated in the USA, tax cuts resulted in an increase in labour supply of less than 1% little evidence that tax cuts have any significant impact on productivity. Ineffectiveness: if AD is low enough, these policies may not have any effect. Adverse effects on deregulation: competition might lead to undesirable consequences, e.g. deregulation of financial markets resulted in excessive risk-taking, leading to the near-collapse of the banking system. However, they are very important in that they influence the long term state of the economy.

Problems faced by policy makers

Inaccurate information: For example, information regarding GDP, the current account and retail sales is notoriously inaccurate. Information is often subject to revisions. Risks and uncertainties: For example, there is considerable uncertainty about the impact of quantitative easing. Some monetarists argue that it could risk unleashing a massive bout of inflation, because money supply is being increased. Others consider that previous experience in other countries success that it will have little effect on the economy. Trade-offs: Economic growth and the environment. Unemployment and Inflation: - Discovered by the Australian economist Bill Phillips. - 1958 Phillips argued that he had found a relationship between unemployment and inflation. - Phillips curve shows that as inflation decreases, unemployment increases. - Idea that when demand for labour is high firms will be prepared to bid up wages to attract labour higher wages are then passed on in the form of higher prices. - If this holds, then attempts to reduce the rate of unemployment are likely to raise inflation. - Suggests that it might be difficult to hold low inflation and high employment. - However, this theory suffered a setback in the UK in the 1970s, when stagflation was experienced both high unemployment and high inflation. - One possibility uses the natural rate of unemployment if an economy starts at the natural rate, and the government allows inflation to rise, the short-term Phillips curve may move, leading unemployment to fall. - However, as people begin to adjust their expectations due to higher inflation, wage negotiations are affected. - This Phillips curve the shifts outwards, and the unemployment returns to the natural rate, but with higher inflation. - The original position can only be achieved again if people expect inflation to fall this means that the economy has to push up unemployment in order to reduce inflation. - If this takes a long time, then the costs in terms of unemployment will be high. - The Phillips Curve has been relatively irrelevant in the UK, France and Sweden, among other countries, since 1986. Economic growth and the current account: - An increase in economic growth resulting in higher real incomes could lead to an increase in imports of goods and services. - In the UK, residents spend a higher proportion of their additional income abroad (high MPM). - This was a major problem of the fixed exchange rate era of the 1950s and 60s, when any deficit of the current account had to be met by running down foreign exchange reserves. - This led to a stop-go cycle of macroeconomic policy, where every time growth began to accelerate the current account went into deficit, and then growth had to be decelerated to deal with the deficit.

Public Expenditure
There are three types of expenditure by local and central government: 1. Current Expenditure: day-to-day expenditure on goods and services, e.g. salaries of teachers, nurses and drugs used by the NHS. 2. Capital Expenditure: expenditure on long-term investment projects such as new hospitals and roads. 3. Transfer payments: payments made by the state (from tax revenues) to individuals in the form of benefits for which there is no production in return. E.g. child benefit, state pensions and JSA. The objectives of public expenditure include: - Provision of public goods. - Defence and internal security. - Provision of goods and services which yield external benefits, and/or where there may be information gaps and asymmetric information, e.g. health and education. - Redistribution of income. - Expenditure to deal with external costs such as pollution and waste.

Analysis of public expenditure

Amount of public expenditure is likely to be restricted in any one year e.g. by expected tax revenues increase in expenditure on one area (such as education) will incur an opportunity cost (e.g. hospitals). Increasing expectations relating to healthcare and education are associated with increasing real incomes, so demand for these services may be income elastic. Increases in public expenditure result in a multiplier effect on GDP AD will increase and expenditure on areas such as education, infrastructure and health might cause an increase in LRAS. Part of public expenditure might be used for dealing with external costs. Public expenditure could result in government failure, i.e. where intervention by the government results in a net welfare loss. There is the issue of crowding out, which might result from increased public expenditure this might be crowding out of resources (lack of resources) or finances (driving up interest rates).

Influences on Public Expenditure

GDP: Demand for healthcare and education is income elastic. As incomes increase, the demand for many government-provided services rises more than proportionately, because demand is income elastic. However, although GDP per capita in the UK is considerably higher than in countries in Sub-Saharan Africa, the prevalence of HIV/AIDS means that this is unlikely to be the main cause for differences in Public Expenditure.

Size and age distribution of the population: An increase in the size of the population, e.g. though immigration, is likely to put extra pressure on public services. Countries with higher dependency ratios will likely have increased demand for medical services and social services to the elderly. Political priorities: Labour government placed particular emphasis on the quality of the health and education services. Redistribution of income: Expenditure on those in relative poverty and those with disabilities has increased significantly in recent years. There has been an increase in means-tested benefits such as family tax credits and pensioners credits.

Discretionary fiscal policy: Credit crunch has led to the resurrection of fiscal policy as a means of managing the economy. Debt interest: Increase in fiscal deficits from 2008 is leading to sharp rises in the public sector net debt. This will result in higher interest payments on the national debt.

Taxation Progressive, Proportional and Regressive

Progressive tax: one in which the proportion of income paid in tax rises as income increases, e.g. income tax. Regressive tax: one in which the proportion of income paid in tax falls as income increases, e.g. VAT. Proportional tax: one in which the proportion of income paid in tax remains constant as income increases.

Direct and Indirect

Direct taxes: Taxes levied on income of various kinds. E.g. personal income tax. Such taxes are designed to be progressive, and so can be effective in redistributing income. A higher income tax rate can be charged to those earning higher incomes, e.g. in the UK. They are taxes for which the tax burden cannot be passed onto anyone else. Indirect taxes: Many indirect taxes, such as VAT and excise duties, tend to be regressive. As poorer households tend to spend a higher proportion of their income on items that are subject to excise duties, a greater share of their income is taken up by indirect taxes. Even VAT can be regressive if higher income households save a greater proportion of their incomes. There was a switch towards indirect taxation under Margaret Thatcher, with increases in VAT and decreases in the rate of personal income tax. In support of this move, it was pointed out that if an income tax scheme becomes too progressive it could provide a disincentive towards effort. If people feel that a high proportion of their income is being taken in tax, their incentives to provide work effort are reduced (Laffer Curve). A switch from direct to indirect taxation could be regarded as a sort of supply-side policy, intended to influence the position of AS. Indirect taxes can be imposed on specific instances of market failure hence the high excise duties on tobacco and petrol.

Effects of Taxation
Analysis: Increase in taxes represents a leakage from the circular flow downward multiplier effect on GDP. Increase in indirect tax on a product would cause a leftward shift in the supply curve incidence of the tax on consumers and producers depends on PED. Indirect taxes might me applied to products that cause external costs. Increase in indirect taxes could cause inflation via a wage-price spiral if VAT rises, price rises, which could lead to workers demanding higher wages for the increase in prices etc. In LDCs where average incomes are low and tax collection systems are undeveloped, governments have difficulty in generating a revenue flow domestically. d Effects of an increase in income tax rates in the UK: Income distribution: Tax system is more progressive income redistribution.

Incentives: Might lead to a disincentive to work for the unemployed, or those not currently participating in the workforce people may be less willing to do overtime or seek promotion. - BUT people at the top income band likely to accept promotions anyway, as they still receive an increase in income overall. - There has also been an increase in the tax-free allowance people may be more willing to enter the workforce to receive lower wages. Tax revenue: If tax rates are increased too much, tax revenues may actually fall because the disincentives to work are so great if the higher rate of income tax is increased, there is likely to be an increase in tax avoidance and evasion. This is shown on the Laffer curve:

An increase in the tax rate from T to V causes a fall in revenues from R to S. Economic activity: An increase in income tax rates would cause a fall in disposable income, which would cause a reduction in consumption and a fall in AD it may also be argued that the disincentive effects of a higher income tax would cause a leftward shift in the AS curve.

Effects of an increase in indirect taxation: Income distribution: tends to be regressive, such as VAT, so this would result in increased inequality. Incentives to work: less obvious impact on incentives, but it is possible that an increase in indirect taxes would encourage people to work harder to maintain their standard of living. On tax revenues: raising indirect taxes would increase tax revenues to the government as long as demand for the products and services affected is price inelastic. Inflation: an increase in VAT will raise the price of most goods and services. If workers and trade unions respond by demanding wage increases to compensate for price rises, then an inflationary wage-price spiral could ensue. Economic Activity: a rise in VAT would at as a leakage from the circular flow of income the real incomes of consumers would fall, causing a fall in AD. From a business perspective, costs would rise, so causing a fall in AS.

Public Sector Borrowing and Public Sector Debt Borrowing

PSNB (Public sector net borrowing) is the difference between public expenditure and tax revenue. It is significant for the following reasons: Excessive borrowing can be inflationary, because AD would be increasing. Public sector net borrowing bust not exceed 3% of GDP to meet the criteria for entry into the euro. Taxes as a percentage of GDP give an insight into the size of the state sector relative to the whole economy this might have a significance for FDI, since high taxes may act as a deterrent.

Until 2009, borrowing could only be for capital expenditure over the course of the business cycle to meet the requirements of the Golden Rule (now abandoned).

Debt
PNSD, formerly known as the national debt, is the cumulative total of past government borrowing. To meet the sustainable investment rule, it shouldnt exceed 40% of GDP, and to meet the conditions for entry into the Euro, it shouldnt exceed 60% of GDP. As with the PNSB, the absolute size of the PNSD is less important than its size relative to GDP, as this provides an indication for how easily it can be serviced. Until 2007, the PNSD was below 40% of GDP, but the global financial crisis is having a dramatic effect. It is expected to reach around 80% of GDP, excluding financial bailouts, by 2014. The PNSD is still much lower than many other countries, such as Italy.

Do large PNSDs matter? If the money is being used to finance improvements in infrastructure and other capital projects, then a large PNSD might be justified because it would be increasing a countrys future productive potential, so making it easier to repay in the future. However, there is an opportunity cost for future generations interest payments on the debt means that less money will be available for public services. Crowding out if the increasing size of the national debt is an indication of an increase in the size of the public sector, then resource or financial crowding out could occur. Danger of inflation if the rising PNSD has been caused by successive fiscal deficits, there is a danger that inflationary pressures will develop, since injections will be rising relative to leakages. In the long-run, governments may be forced to raise taxes and/or cut public expenditure so that the national debt can be reduced.