Chapter six

What are the types of policies govt uses to achieve their macroeconomic objectives and influence economic activity?

Fiscal policy Monetary policy Supply side policies

Do lower taxes really help to increase the active labour supply in the economy? It seems obvious that lower taxes should boost the incentive to work because tax cuts increase the reward from a job. But some people may choose to work the same number of hours and simply take a rise in their post-tax income! Millions of other workers have little choice over the hours that they work.

What is the aim of fiscal policy 6

The main aim is to influence AD The govt can increase AD by increasing govt spending or by reducing taxes. -this is known as reflationary/ expansionary/ loose fiscal policy Sometimes the aim is to encourage the consumption of merit goods and discouraging consumption of de-merit goods Altering the distribution of income Altering incentives and simplifying the system.

Nature of fiscal policy 5

Gov may want to influence demand so that it matches AS which will avoid unemployment and inflation Gov may want to increase AD if private sector demand is low (C+I+(X-M)) If private sector demand is too high the govt will want to reduce AD -such action is referred to as acting counter cyclically meaning the govt seek to increase economic stability by offsetting changes in private sector spending -to achieve this a govt can use discretionary fiscal policy or allow automatic stabilisers to operate

The budget
In the UK the Chancellor of the Exchequer outlines govt spending proposals in 3 year spending reviews Any tax changes are announced in the annual budget in March The budget also included info on the budget position in the previous year and predictions for future years.

The budget position

Shows the relationship between govt spending and tax revenue A balanced budget is when the 2 are equal In practice budget surplus and deficits occur often

Budget deficit 3
when govt spend more than they receive in tax revenue In such a case the govt will have to borrow to finance some of its spending In this situation the only way to remove the deficit is to cut spending and/or raise taxes to increase tax revenue.

When does a budget deficit occur?

Occurs when there is a high level of economic activity May suggest there is something wrong with the structure of govt spending and taxation May be an imbalance e.g. gov too committed to spending too much relative to tax revenue

Budget surplus
When tax revenue is greater than govt spending allows the govt to repay some of its debt.

Cause of a budget deficit or surplus?

Cyclical or structural factors In a recession, tax revenue falls and govt spending on benefits is likely to increase due to the operation of automatic stabilisers Govt may also use discretionary fiscal policy to try to increase economic activity In such case the deficit may decrease as the economy grows

Monetary policy
Demand side policy Monetary policies include: rate of interest, money supply and the exchange rate.

Relationship between the rate of interest and the money supply

Changes in money supply and rate of interest are inversely related. - because an increase in money supply by increasing the amount banks have to lend will reduce the interest rate.

What is the effect of a rise in interest rate on AD? 7

When a central bank raises the rate of interest commercial banks usually increase their rates too A higher interest rate tend to reduce consumption and lower firms investment Also likely to encourage foreigners to put more of their money in UK financial institutions because they will get a higher return The rise of demand for will increase the value of the A higher exchange rate will make imports cheaper and exports more expensive Reduce net exports So a rise in interest rates is likely to reduce AD by reducing, consumption, investment and net exports.

 Cause foreigners to be concerned about the economys growth prospects So they fund other countries So the exchange rate may fall

How can a rise in the rate of interest not significantly affect C and I?

How can change in money supply affect AD?

Increase in money supply is likely to increase AD If govt prints more money or makes it easier for banks to lend more money, people will have more to spend.

How can a central bank influence the exchange rate

A central bank can influence the value of the currency by dealing in the foreign exchange market If it wants to reduce the ER it can lower the interest rate or sell pounds shown on a diagram where supply decreases and the price decreases, demand remains the same, output increases A central bank may want to reduce the exchange rate to improve the current account position of the balance of payments and to stimulate economic activity

How can a central bank raise the exchange rate

it can increase the interest rate and/or buy foreign currency. This is an example of deflationary/ contractionary monetary policy

 Fiscal and monetary policies aim to influence AD, but supply side policies aim to influence AS F and M aim to increase or decrease AD depending on the level of economic acitivity, sp always aim to increase AS F and M seek to improve macroeconomic performance by influencing the whole economy but ssp aim to raise microeconomic performance by improving the performance of particular markets

Difference between supply side policies and monetary &fiscal policies

Examples of supply side policies

Education and training Privatisation Govt assistance to new firms Reduction in direct taxes National minimum wage (NMW) Reduction in unemployment benefits Reduction in other benefits Reduction in trade union power deregulation

Education and training

Govt investment in education and training and encouragement to firms to increase their training may increase the occupational mobility of labour and labour productivity. If output per worker hour rises, the potential output of the economy rises. Which will shift AS right Govt may insist those who are unemployed undergo training UK govt welfare at work approach encourages those who have been unemployed for some time to do a subsidised job, education or training course or voluntary work. In order to develop skills, confidence and work experience

Govt assistance to new firms

New, small firms provide employment, develop entrepreneurial skills and introduce new ideas. May find it difficult to break into established markets. Govt help by providing grants and charging them a low rate of corporation tax

Reduction in direct taxes

Lower taxes can increase both AS and AD Lower direct taxes will increase incentives to firms, workers and potential workers A cut in corporation tax will increase the amount firms can invest and the return from investment If I rises the productive capacity of the economy increases. Encourage some workers to work overtime, accept promotions, enter or re enter in the labour force and stay longer. -This will increase quantity of labour force and its use. -this will be true especially if more people enter the labour force at the going wage rate as their disposable income will be higher

Reduction in direct tax not increase AS?

Lower income tax may encourage workers to take more leisure time As they can gain the same disposable income working fewer hours If there is high unemployment due to lack of jobs then there wont be much affect

NMW
Debate on whether it is a supply side policy The main determinant is whether it encourages people to enter the labour force or reduces the efficiency of the labour market

Reduction in unemployment benefit

Decrease in job seekers allowance will increase the gap between income from employment and the benefit May force some of the unemployed to seek work more actively and to accept unemployment at lower wage rates If this is the outcome the labour force will be used more This doesnt increase productive capacity but it reduces the negative output gap and move output closer to full capacity

How can a reduction in unemployment benefit increase unemployment? If it is cyclical unemployment there will be no jobs available for the unemployed Cutting their benefits will reduce consumption Which will decrease AD Cause firms to decrease their output and may make some workers redundant May also increase income inequality

Reduction in other beneftis

Those that support people who are economically inactive will increase the productive capacity of the economy if it encourages them to enter the labour force. But if these people are unable to seek work it will just reduce the income of the benefit recipient.

Reduction in trade union power

May increase the efficiency of labour markets This will happen if trade unions reduce unemployment by pushing wage rate above the equilibrium level and encouraging workers to be involved in restrictive practices Reducing their power will increase labour productivity and reduce the cost of employing labour Firms will be encouraged to employ more workers and increase output

Privatisation
Some economists argue that govt intervention should be minimised Private sector is best to make decisions about what and how to produce and its price Because they are subject to discipline of the market They will go out of business if they dont provide what consumers want at competitive prices

Policies to reduce unemployment

Range of measure govt can use to do this Choice is influenced by the cause, rate and duration of unemployment and the state of other macroeconomic objectives.

Demand side policies

If the economy is operating below it productive capacity, unemployment can be decreased by an increase in AD. So an expansionary fiscal policy and/ or a monetary policy can be used to create jobs A govt using fiscal policy could increase spending &/or cut tax rates to increase AD -A rise in govt spending is likely to have more of an impact that a reduction in tax rates on AD -For example a govt spending rise of 10bn will raise AD by that amount but a cut in taxes of that amount will lead to an injection of only what is spent, savings and imports will be a leakage. Increases in the money supply or lower interest rates may increase AD Because it will stimulate consumption and investment May cause an increase in net exports if it causes a fall in the exchange rate. Expansionary monetary policy causes AD to decrease but LRAS stays the same.

Negative effects of expansionary fiscal and monetary policies

An increase in AD may increase the price level if the economy move close to full employment (I would say capacity) The higher level of spending may increase an existing deficit on the current account on the balance of payments as UK residents buy more imported products

Use of fiscal and monetary policy in recent years

Not often used primarily to influence unemployment directly. Fiscal policy used mainly to promote economic stability Monetary policy (in the form of interest rate changes) used mainly to achieve the govt inflation target. Although the BoE has been instructed by the govt to not only maintain price stability but to support its economic policies, including objectives for growth and employment. Economic stability and low inflation will make low unemployment likely by encouraging investment and maintaining or increasing international competitiveness

Can unemployment exist if AD is high?

Yes, if there is supply side problems Those who are unemployed when AD is high and there are no shortage of job vacancies are likely to be in between jobs -lacking the appropriate skills -geographically or occupationally immobile -have family circumstances that restrict their ability to work -or are lacking the incentives to find employment and not receive benefits.

Factors that determine unemployment

Quality of job information influences time taken to find another job (frictional unemployment) Many of those who are long term unemployed lack qualifications, have poor communication skills and are geographically immobile Also some may not have the habit to work, cant afford child care may believe they are better off on benefits. In such cases increasing AD wont increase employment. The attractiveness of work to the unemployed and the unemployed to employers must increase.

Why are supply side policies implemented?

To increase economic incentives and the quality of labour services offered to the unemployed. Increase the quantity and quality of info available to the unemployed about job vacancies and to employers about those seeking jobs Improve education and trained and the provision of work experience may improve the skills of the unemployed. Greater provision of low cost childcare may able more single parents to work Legislation and the subsiding of special equipment and adaptation to buildings may facilitate the employment of more disabled workers.

How can you increase the economic incentive to work?

Increasing the gap between the income received and from working and the income received from benefits Achieved by a decrease in income tax rates Some economists argue in favour of cutting rules and regulations that firms have to follow during the process of hiring, employing and firing workers. Such can make them reluctant to employ workers

Measures to control cost push inflation in the short term

-if it is caused by excessive increases in wage rates govt will try to directly restrict wage rises -done in the public sector by restricting wage rises in govt spending allocated to the pay of public sector workers -done in both sectors by introducing an incomes policy e.g. govt limit wage increases of a certain percentage or amount -this will reduce inflation without causing unemployment -may cause inflexibility in labour markets -firms that want to expand will be limited on how much they can offer to attract new workers

Measures to control cost push inflation in the long term

Govt can reduce corporation tax to lower firms cost. This will also encourage investment Subsidies so that firms can cover the rising costs without having to put up their prices. -if some is spent on investment it may reduces cost in the long run -Danger that firms may become reliant on subsidies and not strive to keep their costs down.

Measures to control demand pull inflation

Deflationary fiscal &/or monetary policy which reduce inflation by reducing AD or the growth of AD Raise income tax decrease disposable income- so decrease their ability to spend Changes in interest rate is the main short run anti-inflationary policy being used in the UK and other countries -higher interest rate will reduce consumption, net exports and investment so reduce AD.

What is inflation targeting

Lowers the chance of demand pull and cost push inflation by reducing the expectations of inflation. If people are convinced that a bank has the ability, determination and experience to meet its target they will act in a way that doesnt cause inflation First adopted by the Reserve Bank of New Zealand in 1990 and now is used across the world Makes monetary policy more transparent and the central bank more accountable. If it is successful in keeping inflation low and stable the interest rate will be low This may encourage investment and economic growth

How will a govt try to reduce inflationary pressure in the long term?
Increasing AS If the productive capacity of the economy increases in line with AD (means right shift in AD matched with right shift in AS) -the economy can grow without the price level rising If this occurs people will be able to enjoy more goods and services without inflation in the economy and a balance of payment problems Supply side policies may be used to increase AS Such policies are a long run approach to controlling inflationary pressure This is since most policies take time to have their full impact on productive capacity. Do not have the risk of adverse short term side effects on employment and output that deflationary fiscal & monetary policies have.

Short term policies that promote economic growth

Expansionary fiscal or monetary policy can increase AD which will increase output. The advantage of this is that some policies of this nature have the potential to increase both AS and AD E.g. a lower interest rate may increase consumption and investment Higher investment will increase AS Increases in some forms of govt spending (education and research) will increase AS

What long term policies that promote economic growth?

Supply side policies increase the productive capacity of an economy which increases output. They are long term because they increase the quality &/or quantity of resources Measures that increase investment will increase AS. The extent AS increases depends on the amount of extra investment, its type and how efficiently its used To use capital efficiently there must be educated and healthy workers. -investment in human capital will increase productive capacity of the economy Dependent on the appropriateness and quality of investment. To be productive workers need a range of skills including numeracy, literacy, ICT and interpersonal skills.

How can stable growth promote economic growth?

When seeking economic growth most govt aim for stable growth Objective is for actual growth to match trend growth and for trend growth to rise over time Govt try to avoid AD rising faster than the trend growth rate permits because it can cause the economy overheating with inflation and balance of payments problems Also try to avoid AD rising more slowly than trend growth rate because this would mean a negative output gap developing with unemployed resources Overall govt avoid economic cycles.

Policies that improve the balance of payments in the short run?

Try to raise export revenue &/or reduce import expenditure in order to correct the current account deficit Cause a fall in the exchange rate which reduces demand for all products regardless of their source and reduce demand for imports. Done in 3 ways: exchange rate adjustment, deflationary demand management and import restrictions

Exchange rate adjustment

A govt may want to reduce exchange rate if its current level is too high due to products being uncompetitive against product of rival countries A central bank will want to reduce the exchange rate by selling its own currency &/or reducing its interest rate. Cause decrease in price in exports and rise in imports To successfully increase export revenue and reduce import expenditure demand for exports and imports must be price elastic This is so that other countries dont devalue and increase import restrictions Lower exchange rate increases AD & so in short term employment and output, but may increase inflationary pressure

Deflationary demand management

Deflationary fiscal and monetary policy are used to discourage import expenditure Domestic spending can be decreased by higher taxation, lower govt spending and/or higher interest rates. Risk that less spending may cause aggregate output to fall and unemployment to rise

Import restrictions
Used to restrict expenditure on imports (tariffs and quotas) Have inflationary side effects Membership of an economic bloc (EU) or a multinational organisation (World Trade Organisation) can limit the independent action a country can take on import restrictions

Risks of import restrictions

Tariffs will increase the price of some products bought in the country, - raise the cost of imported raw materials - and reduce competitive pressure on domestic firms to keep costs down and prices low May provoke retaliation. -if other countries respond by increasing their restrictions, the country may spend less on imports but earn less from exports.

Long run policies to improve the balance of payments

Supply side policies A G may give subsidies to industries if they believe they have potential to grow and become internationally competitive Increase funds for research & development at universities to encourage invention and innovation The success of such policies depends on the appropriateness of the policies E.g. training in the right areas and firms and workers have to respond in a positive way to the incentives given May take long time to have an effect Very expensive 4 G

How to reduce/ remove a Current account surplus ?

May cause a balance of payments disequilibrium Want to be remove/ reduced to avoid inflationary pressure and raise the amount of imports it can enjoy Raise the value of its currency Introduce reflationary fiscal and monetary policies &/or reduce import restrictions