As Economics Notes

8/3/2019 As Economics Notes

1/53

Chapter six


2/53

What are the types of policies govt uses to achieve

their macroeconomic objectives and influence

economic activity? Fiscal policy

Monetary policy

Supply side policies


3/53

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.


4/53

What is the aim of fiscal policy 6

The main aim is to influence AD

The govt can increase AD by increasing govtspending or by reducing taxes.

-this is known as reflationary/ expansionary/ loosefiscal policy

Sometimes the aim is to encourage theconsumption of merit goods and discouraging

consumption of de-merit goods Altering the distribution of income

Altering incentives and simplifying the system.


5/53

Nature of fiscal policy 5

Gov may want to influence demand so that it matches ASwhich will avoid unemployment and inflation

Gov may want to increase AD if private sector demand islow (C+I+(X-M))

If private sector demand is too high the govt will want toreduce AD

-such action is referred to as acting counter cyclicallymeaning 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


6/53

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.


7/53

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


8/53

Budget deficit 3

when govt spend more than they receive

in tax revenue

In such a case the govt will have to borrowto 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.


9/53

When does a budget deficit occur?

Occurs when there is a high level of

economic activity

May suggest there is something wrongwith the structure of govt spending and

taxation

May be an imbalance e.g. gov too

committed to spending too much relative

to tax revenue


10/53

Budget surplus

When tax revenue is greater than govt

spending

allows the govt to repay some of its debt.


11/53

Cause of a budget deficit or

surplus? Cyclical or structural factors

In a recession, tax revenue falls and govtspending on benefits is likely to increasedue to the operation of automaticstabilisers

Govt may also use discretionary fiscal

policy to try to increase economic activity In such case the deficit may decrease as

the economy grows


12/53

Monetary policy

Demand side policy

Monetary policies include: rate of interest,

money supply and the exchange rate.


13/53

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 byincreasing the amount banks have to lend

will reduce the interest rate.


14/53

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 firmsinvestment

Also likely to encourage foreigners to put more of their money in UKfinancial 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 moreexpensive

Reduce net exports

So a rise in interest rates is likely to reduce AD by reducing,consumption, investment and net exports.


15/53

How can a rise in the rate of

interest not significantly affect C

and I? Cause foreigners to be concerned about

the economys growth prospects

So they fund other countries So the exchange rate may fall


16/53

How can change in money supply

affect AD

? Increase in money supply is likely to

increase AD

If govt prints more money or makes iteasier for banks to lend more money,

people will have more to spend.


17/53

How can a central bank influence

the exchange rate A central bank can influence the value of thecurrency by dealing in the foreign exchangemarket

If it wants to reduce the ER it can lower theinterest rate or sell pounds

shown on a diagram where supply decreasesand the price decreases, demand remains thesame, output increases

A central bank may want to reduce theexchange rate to improve the current accountposition of the balance of payments and tostimulate economic activity


18/53

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


19/53

Difference between supply side

policies and monetary &fiscal

policies Fiscal and monetary policies aim to influenceAD, but supply side policies aim to influence AS

F and M aim to increase or decrease AD

depending on the level of economic acitivity, spalways aim to increase AS

F and M seek to improve macroeconomicperformance by influencing the whole economy

but ssp aim to raise microeconomic performanceby improving the performance of particularmarkets


20/53

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

R

eduction in other benefits Reduction in trade union power

deregulation


21/53

Education and training

Govt investment in education and training andencouragement to firms to increase their training mayincrease the occupational mobility of labour and labourproductivity.

If output per worker hour rises, the potential output of theeconomy rises. Which will shift AS right

Govt may insist those who are unemployed undergotraining

UK govt welfare at work approach encourages thosewho have been unemployed for some time to do asubsidised job, education or training course or voluntarywork.

In order to develop skills, confidence and workexperience


22/53

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


23/53

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 caninvest and the return from investment

If I rises the productive capacity of the economyincreases.

Encourage some workers to work overtime, acceptpromotions, 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 labourforce at the going wage rate as their disposable incomewill be higher


24/53

Reduction in direct tax not increase

AS?

Lower income tax may encourage workers

to take more leisure time

As they can gain the same disposableincome working fewer hours

If there is high unemployment due to lack

of jobs then there wont be much affect


25/53

NMW

Debate on whether it is a supply side

policy

The main determinant is whether itencourages people to enter the labour

force or reduces the efficiency of the

labour market


26/53

Reduction in unemployment benefit

Decrease in job seekers allowance will increasethe gap between income from employment andthe benefit

May force some of the unemployed to seek workmore actively and to accept unemployment atlower wage rates

If this is the outcome the labour force will beused more

This doesnt increase productive capacity but itreduces the negative output gap and moveoutput closer to full capacity


27/53

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 reduceconsumption

Which will decrease AD

Cause firms to decrease their output andmay make some workers redundant

May also increase income inequality


28/53

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.


29/53

Reduction in trade union power

May increase the efficiency of labour markets

This will happen if trade unions reduceunemployment by pushing wage rate above the

equilibrium level and encouraging workers to beinvolved in restrictive practices

Reducing their power will increase labourproductivity and reduce the cost of employing

labour Firms will be encouraged to employ more

workers and increase output


30/53

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 providewhat consumers want at competitive prices


31/53

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 thestate of other macroeconomic objectives.


32/53

Demand side policies

If the economy is operating below it productive capacity, unemployment canbe decreased by an increase in AD.

So an expansionary fiscal policy and/ or a monetary policy can be used tocreate jobs

A govt using fiscal policy could increase spending &/or cut tax rates toincrease AD

-A rise in govt spending is likely to have more of an impact that a reduction intax rates on AD

-For example a govt spending rise of 10bn will raise AD by that amount but acut 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 thesame.


33/53

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


34/53

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 notonly maintain price stability but to support its economicpolicies, including objectives for growth and employment.

Economic stability and low inflation will make lowunemployment likely by encouraging investment andmaintaining or increasing international competitiveness


35/53

Can unemployment exist if AD is

high?

Yes, if there is supply side problems

Those who are unemployed when AD is highand 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.


36/53

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 lackqualifications, 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 increaseemployment.

The attractiveness of work to the unemployed and theunemployed to employers must increase.


37/53

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 theunemployed 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 moresingle parents to work

Legislation and the subsiding of special equipment andadaptation to buildings may facilitate the employment ofmore disabled workers.


38/53

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


39/53

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 govtspending 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 oramount

-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


40/53

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

-D

anger that firms may become reliant onsubsidies and not strive to keep their costs

down.

Measures to control cost push

inflation in the long term


41/53

Measures to control demand pull

inflation

Deflationary fiscal &/or monetary policy whichreduce inflation by reducing AD or the growth of

AD

Raise income tax decrease disposableincome- so decrease their ability to spend

Changes in interest rate is the main short runanti-inflationary policy being used in the UK and

other countries -higher interest rate will reduce consumption, netexports and investment so reduce AD.


42/53

What is inflation targeting

Lowers the chance of demand pull and cost pushinflation 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 ofNew Zealand in

1990 and now is used across the world

Makes monetary policy more transparent and the centralbank more accountable.

If it is successful in keeping inflation low and stable theinterest rate will be low

This may encourage investment and economic growth


43/53

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 inflationarypressure

This is since most policies take time to have their full impact onproductive capacity.

Do not have the risk of adverse short term side effects onemployment and output that deflationary fiscal & monetary policieshave.


44/53

Short term policies that promote

economic growth

Expansionary fiscal or monetary policy canincrease AD which will increase output.

The advantage of this is that some policies of

this nature have the potential to increase bothAS and AD

E.g. a lower interest rate may increaseconsumption and investment

Higher investment will increase AS Increases in some forms of govt spending

(education and research) will increase AS


45/53

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 quantityof resources

Measures that increase investment will increase AS.

The extent AS increases depends on the amount of extrainvestment, its type and how efficiently its used

To use capital efficiently there must be educated and healthyworkers.

-investment in human capital will increase productive capacity of theeconomy

Dependent on the appropriateness and quality of investment. To be productive workers need a range of skills including numeracy,

literacy, ICT and interpersonal skills.


46/53

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 andfor trend growth to rise over time

Govt try to avoid AD rising faster than the trend growthrate permits because it can cause the economyoverheating with inflation and balance of paymentsproblems

Also try to avoid AD rising more slowly than trend growthrate because this would mean a negative output gapdeveloping with unemployed resources

Overall govt avoid economic cycles.


47/53

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 reducesdemand 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


48/53

Exchange rate adjustment

A govt may want to reduce exchange rate if its currentlevel is too high due to products being uncompetitiveagainst product of rival countries

A central bank will want to reduce the exchange rate byselling its own currency &/or reducing its interest rate.

Cause decrease in price in exports and rise in imports

To successfully increase export revenue and reduceimport expenditure demand for exports and imports mustbe price elastic

This is so that other countries dont devalue andincrease import restrictions

Lower exchange rate increases AD & so in short termemployment and output, but may increase inflationarypressure


49/53

Deflationary demand management

Deflationary fiscal and monetary policy are

used to discourage import expenditure

D

omestic spending can be decreased byhigher taxation, lower govt spending

and/or higher interest rates.

Risk that less spending may cause

aggregate output to fall and

unemployment to rise


50/53

Import restrictions

Used to restrict expenditure on imports

(tariffs and quotas)

H

ave 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


51/53

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 domesticfirms to keep costs down and prices low

May provoke retaliation.

-if other countries respond by increasing theirrestrictions, the country may spend less on

imports but earn less from exports.


52/53

Long run policies to improve the

balance of payments Supply side policies

A G may give subsidies to industries if they believe theyhave potential to grow and become internationallycompetitive

Increase funds for research & development atuniversities to encourage invention and innovation

The success of such policies depends on theappropriateness of the policies

E.g. training in the right areas and firms and workershave to respond in a positive way to the incentives given

May take long time to have an effect

Very expensive 4 G


53/53

How to reduce/ remove a Current

account surplus ?

May cause a balance of payments

disequilibrium

W

ant to be remove/ reduced to avoidinflationary 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

As Economics Notes

Documents

Transcript of As Economics Notes