MACROECONOMIC POLICIES

1. GOVERNMENT POLICY
1.1. Government objectives
a) Growth: Actual growth and potential growth
b) Inflation: Cost push / demandpull inflation
c) Unemployment: New Classical / Keynesian analysis
d) Balance of Payments: Causes of current account deficit and financial account
surplus.

1.2. Government policies

Policies are used to achieve macroeconomic objectives. Once objectives are set, policy
instruments will be chosen:
Investment.
Taxation.
Money supply, etc.
There are two types of policies: 1) Demandside policies and 2) Supplyside policies
*1) Government tries to influence AGGREGATE DEMAND. Main policies are fiscal
policies (spending and taxation) and monetary policies (money supply, interest rates.)
*2) Government tries to shift LRAS to the right Potential growth.

1.3. Policy conflicts

Supplyside policies are the main channel to fulfill the objectives.
Demandside policies may cause CONFLICT:
a) Government spending
| Growth, lower unemployment.
b) Less government spending | Good for inflation and balance of payments.

A) TAX CUTS and GOVERNMENT

SPENDING:

B) TAX RAISE and CUT IN

GOVERNMENT SPENDING:

[To reduce unemployment]

[To reduce inflation]

1) Increase in aggregate demand.

1) Decrease in aggregate demand.

More disposable income, more

spending.

2) Firms lay off staff.

Higher unemployment.

2) Firms expand output.

They take on staff (lower
unemployment)

3) Lower demand lower prices.

Less inflation.

3) Higher demand higher prices.

4) Raising unemployment less

inflationary pressure.
Unemployed spend less.
Wages drop.

4) Falling unemployment inflationary

pressure.
Newly employed spend more.
Wages rise.

5) Lower inflation higher

unemployment.

5) Lower unemployment higher

inflation.

1.4. Policy conflicts today

Risks

are decreasing: international competitiveness and low inflationary

expectations.

Technology can adapt to increases in AD and potential growth.

[END 1]
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2. FISCAL POLICY
Changes in spending + taxation
Influence AGGREGATE DEMAND (demand side) and AGGREGATE SUPPLY
(supply-side) to improve performance in certain markets.

2.1. Government policy

There are three main types:

a) Fiscal policy: Taxation and government spending.

b) Monetary policy: Money supply and government spending.
c) Supplyside policies: To stimulate supply and shift LRAS right.

2.2. The budget

- Announced annually in ANNUAL BUDGET

a) THERE MAY BE:
I. Budget deficit . More expenditure than revenue
(Expenditure>revenue)
II. Budget surplus . More revenue than expenditure
(Expenditure<revenue)
~ BALANCED BUDGET ~ Where expenditure

= revenue

b) IMPORTANT AREAS OF GOVERNMENT SPENDING:

I.

Social security

II. Health
III. Education
II. Defense
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2.3. Government taxation

A) DIRECT TAXES

On income and wealth

On individuals and firms*1
*1 INCOME TAX, CORPORATION TAX and INHERITANCE TAX

B) INDIRECT TAXES

On SPENDING of goods and services *2

*2 VAT and EXCISE DUTIES

2.4. Budget and economic cycle

boom

slump

During Boom :
Tax revenues will be high
Benefit spending will be low
SURPLUS

During Recession :
Tax revenues will be low
Benefit spending will be high
DEFICIT

2.5. Government actions

Ways to alter AD by automatic stabilizers
discretionary policies*1
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*1: Changing spending levels and lowering tax rates.

EXPANSIONARY FISCAL POLICY Seeks to raise AD.
CONTRACTIONARY FISCAL POLICY Seeks to decrease AD.
KEYNESIAN VIEW ON FISCAL
POLICIES

Intervention during downturn

Inject into circular flow

AD2

increase gvmnt. spending and

PL

AD

AD1

reducing taxation.

Multiplier effect = AD to AD1

Problem when demand rises faster
than supply at YFE

REAL OUTPUT (Y)

2.6. FISCAL POLICY AND

I. EMPLOYMENT

If cyclical unemployment economy operating below YFE.

Usage of EXPANSIONARY FISCAL POLICY:
- Cutting indirect taxes and income tax: Increases consumption and
more disposable income.

- Cutting corporation tax and higher consumption: Stimulates

INVESTMENT.

- As a result: AGGREGATE DEMAND will increase.

II. ECONMIC GROWTH

If below YFE government increases output through an increase in AD.

AGGREGATE SUPPLY needs to match output growth: Productive capacity
needs to increase.

LRAS
AD

AD1

AD2

LRAS1

KEYNESIAN VIEW ON
ECONOMIC GROWTH

Firstly Expansionary to boost

PL

AD.

Secondly Increase AS to avoid

supply constraints.

REAL OUTPUT (Y)

LRAS

LRAS1

CLASSICAL ECONOMICS VIEW

ON ECONOMIC GROWTH

Were already at YFE. Boosting

PL

demand = inflation

LRAS shift is needed for economy

to grow.
REAL OUTPUT (Y)

TO INCREASE LRAS:
a) Investment education and training high quality labour.
b) Cut corporation tax stimulates investment. Increase in AD and AS.
c) Cut income tax encourage more work.
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III. INFLATION

- Contractionary fiscal policies to reduce AD (demand-pull inflation cases).

Caution to avoid drops in employment and output due to the implementation
of the policy.

- By INCREASING AS as a longterm measure by growth of PRODUCTIVE

POTENTIAL through investment subsidies.
IV. BALANCE OF PAYMENTS

AIM:
achieve surplus
1. INCREASE TAX + CUT GOVERNMENT SPENDING

Reduce spending on all products.

Domestic firms export due to shrink in domestic market.
2. EXPENDITURE SWITCHING METHODS
Encourage consumers to switch from foreign to domestic products.

- TARIFFS: Foreign products more expensive.

- SUBSIDIES: To help foreign producers become more competitive.
- EXHIBITIONS: Attract consumers.
LONG RUN Government introduces fiscal policy to increase LRAS
(boost productivity)

2.6. Effectiveness of fiscal policy

I.

Very effective especially with multiplier effect.

II. Targeted at PRODUCTS, AREAS of a country and GROUPS.

III. Influence components of AD and AS, shifting LRAS.
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[END 2]

3. MONETARY POLICY
3.1. What is Monetary Policy?

Measures that influence price and quantity of money.

It affects:

- Exchange rate: Value of currency

> Decreasing value of currency:

- Output and employment rise.

- Exports cheaper, imports more expensive.
- AD and AS (if operating below YFE) rise.
> Increasing value of currency:

- Exports dearer, imports expensive EXERTS DOWNWARDS PRESSURE

ON INFLATION*1

*1

Domestic firms under pressure to lower prices

Costs of material fall (raw materials cheaper) Cheaper exports

- Money supply:
Controlled by central banks

> Restrict money supply:

- DOWNWARD INFLATIONARY PRESSURE

> Increase money supply:

- Increase output and employment.

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- Increases AD.
MONETARISTS: cause of inflation and unchanged employment.

- Rate of interest:
A. AS A POLICY TOOL

Monetary policy committee meets each month to set rate of interest and evaluate
the economic status.

They set target for inflation.

- Inflation:
CAUSE OF INFLATION Interest rate increase.
- Lower AD.
- Saving instead of spending
- Brings hot money into country values currency and creates current account
deficit.

- Economic growth:
CUT INTEREST RATES When risk of UNEMPLOYMENT.
- Increase output and employment.
- Stimulate consumption
- Increase investment

- Net exports rise.

3.2. Monetary policy now

Used to get money moving

Interest rates can be cut once.

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