CHAPTER 30 & 31 MACROECONOMIC POLICY

CHAPTER OUTLINE
Alternative policies in attempts to influence/manage the economy: 1. DEMAND SIDE POLICY: to regulate AD
a. Fiscal Policy b. Monetary Policy c. Attitudes Towards Demand Management

2. SUPPLY SIDE POLICY: to regulate AS

a. b. c. d. Supply-Side Problems Market-Oriented Supply-Side Policies Interventionist Supply-Side Policies Regional Policy
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Topic 1. DEMAND SIDE POLICY

Fiscal Policy
Definition: policy to affect AD by altering govt expenditure and/or taxes
Expansionary raising govt expenditure / reduce taxes increasing AD Contractionary cutting govt expenditure / increasing taxes decreasing AD

Why changing level of AD?

To prevent economy from severe/prolonged depression To prevent economy from over-heating To smooth out fluctuations in economy: fine-tuning minimize output gaps

Also relevant for changing AS

Increasing expenditure on infrastructure Tax incentives for investment
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Government Deficits and Surpluses

2 types of government expenditure
Deficits: Excess of govt spending over its tax receipts incur debt Surpluses: Excess of govt tax receipts over its spending increase revenue

Public sector deficits: when public sector spends more than what it earns Spending > Revenue Commonly, govt runs budget deficits:
Efforts are being to reduce budget deficits Greater budget deficits during economic uncertainties Weaker private sector activities Example: during 2007/2008 global recession
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General government deficits/surpluses and debt as % of GDP

Country General government deficits () or surpluses (+) Average 19915 Belgium France Germany Greece Ireland Italy Japan Netherlands Sweden UK USA Euro area 6.5 4.7 2.9 11.2 2.5 9.9 1.6 3.5 7.4 6.0 4.5 5.2 Average 19962000 1.3 2.6 1.7 4.0 +2.1 3.1 5.8 0.2 +1.1 0.3 0.0 2.1 Average 20018 0.3 2.9 2.5 4.3 +0.7 3.1 5.0 0.6 +1.4 2.6 3.5 2.0 General government debt Average 19915 139.2 51.2 46.6 99.3 90.8 127.6 75.0 91.6 74.9 44.7 73.8 70.9 Average 19962000 125.2 68.3 61.6 108.9 55.8 131.0 113.2 79.6 76.9 50.9 66.9 80.8 Average 20018 93.7 62.6 64.0 97.6 29.1 105.2 168.2 49.2 47.9 41.1 61.3 68.2

Public Finance
Concerning finances of public sector: comprising central and local govts, and public corporations Components of total public expenditure
Current expenditure: recurrent spending on goods and factor payments, include payments of wages and salaries of public sector Capital expenditure: investment expenditure; expenditure on assets give streams of benefits over time, like infrastructure spending

Types of govt expenditure

Final expenditures: expenditure on goods and services; included in GDP; part of AD; injection Transfers: transfer of money from taxpayers to recipients of benefits and subsidies; not injection but are negative tax
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Use of Fiscal Policy

1. Automatic Fiscal Stabiliser: reduce magnitude of macro fluctuations automatically
Govt expenditure and taxation have automatic stabilizing effects on economy Eg: as national income rises amt of taxes people pay automatically rises withdrawals increase damp rise in national income

2. Discretionary Fiscal Policy: deliberate changes in tax rates/gov expenditure in order to influence level of AD
Challenge: choosing suitable fiscal policy to be implemented
-Increased govt expenditure multiplied rise in national income; multiplier effects -Cutting taxes has smaller impact on national income: not all being spent, but could be saved
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Effectiveness of Fiscal Policy

2 major complications in using fiscal policy: magnitude and timing
1. Problems of Magnitude: before implementing fiscal policy, govt needs to calculate effects of such changes on national income, employment and inflation; often unreliable/difficult i. Predicting effect of changes in govt expenditure
-replacements effects: govt expenditure reduces private expenditure -crowding out effects: increased public expenditure diverts resources away from private sector

ii.

Predicting effect of changes in taxes

-cut in taxes could increase spending as well as saving

iii.

Predicting resulting multiplied effect on national income

-Diff to predict size of multiplier effect which include peoples expectations -Diff to predict accelerator which relies on business confidence

iv.

Random shocks: unforeseen circumstances

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Effectiveness of Fiscal Policy

2. Problems of Timing: Fiscal policy involves considerable lags
-planning stage: needs time to recognize nature of problems: identification, planning and implementation -implementation stage: needs time to filter through the economy

Substantial time lags could be de-stabilizing on economy

-worsen the problem of overheating and deepen recession

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Fiscal policy: stabilising or destabilising?

Path (a): no intervention

Real national income

3 4 3 4 2 1 2

1 O

Time

Fiscal policy: stabilising or destabilising?

Path (a): no intervention Path (b): policy stabilises 3 4 3 4 2 1 2

Real national income

1 O

Time

Fiscal policy: stabilising or destabilising?

Path (a): no intervention Path (b): policy stabilises Path (c): policy destabilises 3 4 3 4 2 1 2

Real national income

1 O

Time

Fiscal Rules
A more passive approach to fiscal policy due to problems in pursuing active fiscal policy: active vs passive Fiscal rule: as an alternative to avoid possible complications in adopting discretionary fiscal policy
A rule is set for the level of public finance Rule is applied year after year, with taxes and govt expenditure being planned to meet the rules -Eg: A target set for public-sector deficit Normal economic conditions vs during crisis

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Monetary Policy
Definition: management of money supply and interest rates by the central banks Involves the CB intervening in the money market to ensure that money supply and interest rate level is suitable for healthy growth of economy Monetary policy has major influence on the macroeconomy, particularly in short-term Help to steer direction of economy

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Major Considerations in MP
CBs must decide on what goals of monetary policy are: inflation, output, exchange rate, employment? -Based on objective assessment of economic conditions Is it a major /sole macro-policy or is it part / one of several macro-policies Decision to be made of how to carry-out the policy
-Goal restrictions? -Instrument restrictions? -Both restrictions?

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Monetary Policy Measures

Can be to influence money supply or interest rates. All measures will have impact on interest rates and other macroindicators Can be short term and medium/long term measures
1. Short term monetary measures Various techniques to control MS and ir Through various MP instruments Issue: bank can go around the problem of liquidity through secondary marketing 2. Medium/LT measures Controlling Liquidity of Banks: directed lending/credit ceiling Controlling Public Sector Finances: control public sector borrowings/deficits
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1. Techniques to Control MS
Manipulating liquid assets of banking system with aim to influence MS by affecting ability of banks to create credit
1. Open market Operations -Sale/purchase of govt securities in open market in order to reduce/increase MS 2. Central Bank lending to Banks -discount loan at discount rate 3. Funding -altering balance of bills and bonds for any given level of govt borrowings 4. Variable minimum reserve ratio -specified ratio of cash to deposits that CBs require banks to hold

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The demand for and supply of money

MS

'

MS

Rate of interest

r2

r1

Md

Q2

Q1 Money

2. Techniques to Control Interest Rates

CBs make announcements of ir changes and OMO conducted to ensure that MS is adjusted to make the announced ir as equilibrium ir Effectiveness of changes in interest rates
1. Problems of inelastic demand for loans -Any attemps to reduce demand for money involve large increases in ir -Evidence shows that demand for loans is inelastic: borrowing commitments 2. Problems of an unstable demand: CBs need to predict peoples expectations

Using monetary policy: based on objective evaluation of economy

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Attitudes Towards Demand Management

General agreement : combination of fiscal and monetary policies will have more powerful effects on demand Debate: extend to which govt out to pursue active demand management (discretion) or adhere to a set of policy rules (rules) Keynesian-discretion vs Monetarists-rules

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Case for Rules and Policy Frameworks: Monetarists

1. Political behavior
Political behaviour - gvt if not constrained by rules, may overstimulate economy Lose credibility for sound economic management-lead to higher inflationary expectations, uncertainty, lower long term investment

2. Time lags with discretionary policy

Both policies involve substantial time lags: ineffective and destabilizing; forecasting tends to be unreliable By having rules, people expectations of inflation will be reduced, making target easier to achieve sound and stable monetary environment, encourage firms to take longer term perspective and plan ahead

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Taylor Rule
Definition: takes 2 objectives into account: -Inflation
-either economic growth rate or unemployment

Central bank has to trade off inflation stability against real income stability Rule:
for every 1% that GDP rises above sustainable GDP, real interest rate should be raised by 0.5 percentage points, and for every 1% that inflation rises above its target level, real interest rates should be raised by 0.5 percentage points (or nominal interest rate should be raised by 1.5 percentage points)
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Case for Discretion: Keynesian

1. Demand is highly unstable
-Shocks to demand occur at irregular intervals and are of diff magnitudes, thus economy is likely to experience cycles of irregular duration and varying intensity -Govt needs to actively intervene to stabilize the economy

2. Difficulties to choose target under rule-based policy

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Topic 2. SUPPLY-SIDE POLICY

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Supply-Side Policy
Definition: Govt policies that attempt to influence AS directly, rather than through AD Objective: To increase economys potential output (recall: when firms operating at normal levels of capacity utilization)
-Raising rate at which level of potential output grows over time -To affect long-run growth of the economy

Long term measures: take time to become evident

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Supply-Side Issues (1)

Related to economys factors of production: policies to influence quantity and quality of factors employed

1. Labour Market: involves policies to -to raise quantity and quality/productivity/effectiveness of labor force -to reduce unemployment: identify various rigidities or imperfections in labor market
- increase labor mkt flexibility, better job information, support re-training; workers to be more responsive to job opportunities -make employers more adaptable & willing to operate within existing labor mkt constraints

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Supply-Side Issues (2)

Relate to economys factors of production: influence quantity and quality of factors employed

2. Investment -policies to attract more investments: wages and other factors

-policies to increase quality of investment: type of investment

-to influences rate of technological progress -to achieve conditions for most effective propagation of innovation and technological progress: leads to more innovation -need for govt intervention for education, training, R&D, provision of infrastructure

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Supply-Side Issues (3)

SS side policy also concerns price level: cost push inflation

Cost pressure can be reduced via:

Encouraging more competition in ss of labor/goods/services; eg. Telcos inds Encouraging increases in productivity: -retraining of labor/investment grants to firm/ tax incentives -through higher adoption of technology

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Types of Supply-Side Policy

1. Market-oriented:
i. ii. iii. Freeing up market Provide incentives, and reward initiative, hard-work and productivity Encourage private enterprises, risk taking and competition

2. Interventionist: active govt intervention to counteract deficiencies of

free market

3. Regional: to reduce regional imbalances, helping out each other, to

ensure stability

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Market-Oriented Supply-Side Policy

Adopted by Thatcher and Reagan administrations in 1980s In essence: policies to encourage and reward individual enterprise and initiatives, reduce role of government, put more reliance on market forces and competition, and less govt intervention and regulation Specific measures include
1. 2. 3. 4. 5. Reducing govt expenditure Reducing/cut tax Reducing power of labor Reducing welfare Policies to encourage competition
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Market-Oriented Supply-Side Policy

1. Reducing govt expenditure
Reduce size of public sector deficit, reduce MS, reduce inflation
-private investmentpublic investment stable AD no price pressure

Public sector: bureaucratic, less efficient than private sector

-Big public sector requires greater resources on admin and non-productive activities

2. Tax cuts: 3 implications

Tax on labor income labor supply: increase labor supply hours Tax on interest income funds available for investment: more money invested Tax on firms profits capital expenditure on firms: more capital expenditure Issues: substitution and income effects
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Market-Oriented Supply-Side Policy

3. Reducing power of labor
Labor costs firms profit investment economic output Specific measures: Curtail power of unions, short-term contracts, globalization erode power of labor

4. Reducing welfare
Unemployment benefits>take home pay Voluntary unemployment Poverty trap Solution: cut unemployment benefits; policy to re-train labor; conditional unemployment benefits (job seekers allowance)

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Market-Oriented Supply-Side Policy

5. Policies to encourage competition: greater output and lower prices
i. Privatisation: -Transfer of natural monopoly: increase efficiency, more consumer choices, lower prices -Introducing private services into public sector (eg. Private contractors for garbage collection, maintenance, gardening)

ii.
iii.

Deregulation: removal of monopoly rights (eg. Telcos)

Introducing market relationships into public sector: specific department of public sector to become SBUs: encourage competition and efficiency greater financial autonomy in purchasing, employment, investment

iv.

Private Finance Initiatives: private companies, after competitive tenders, contracted by govt to finance and build project; Govt then pays for maintenance or buy the services (eg: university)
Free trade and capital movements: remove controls, eg. EU as a single 34 market for goods & services, capital & labor

v.

Interventionists Supply-Side Policies

Involve active govt intervention as free market (private sector) is likely to avoid from participating in projects with high start-up costs, R&D, training and investment Types of interventionist policy
1. 2. 3. 4. 5. 6. 7. Nationalisation Direct provision Funding R&D Training and education Assistance to small firms Advice and persuasion Information

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Interventionists Supply-Side Policies

1. Nationalisation
-most extreme form of intervention -costly industries better under public ownership; eg. Transport and power industries, eg. French and Japanese govts -due to 2007/2008 crisis nationalization of financial institutions

2. Direct provision
-infrastructure: highways for benefit of industries, facilitate economic activity -factories/equipment for specific industries

3. Funding R&D
-grants under ministry for R&D -other incentives: tax credits on expenditures incurred for R&D activities in form of tax relief or cash redemption
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Interventionists Supply-Side Policies

4. Training and education
-set up training schemes, encourage edu. institutions to make their courses vocationally relevant, introduce new vocational qualifications -Grants/tax relief to firms which themselves provide training schemes (eg. banks)

5. Assistance to small firms

-advisory services, grants, tax concessions, lower bureaucratic controls

6. Advice and persuasion

-govt engages in discussions with private firms to understand their needs and improve efficiency and innovation (eg. Pre-budget dialogue) -bringing firms together to exchange info to coordinate decisions, greater certainty, industrial harmony

7. Information
-provide information services to firms: technical assistance, results of public research, info on markets
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