Economics for Management

GSB728

Topic 11:

Macroeconomic Policy

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Note: This lecture note was prepared based on the teaching material provided

by the publisher of the textbook Principles of Economics.

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Learning Objectives1. Fiscal policy – How can government expenditure

and taxation be used to affect the level of economic activity?

2. Monetary policy – How can interest rates be controlled?

3. The effectiveness of fiscal and monetary policies – Are macroeconomic policies reliable means of controlling the economy?

4. Demand-side policies – What will be the effect of attempts by government to control the level of spending in the economy? 3

Learning Objectives (contd.)

5. Supply-side policies – Policies towards economic growth?

6. Long-term economic growth – Why is income per head today much higher than a generation ago?

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Time0

National output

Contraction

Trend output

GD

A

BC

E

F

Y

Expansion

Period

Business Cycle, Employment and Inflation

• The business cycle presents the fluctuation in the level of economic activity.

• It generally has a regular pattern with expanding activity following by contracting activity.

5Source: Adapted from Sloman et al. (2014).

Business Cycle, Employment and Inflation

• High unemployment is associated with recessions because GDP falls below the full employment level.

• In contrast, if output is above the full employment level, unemployment is generally low.

• If a shock increases aggregate demand inflation is expected to increase and unemployment fall.

• Alternatively, if a shock on the supply side of the economy happens and supply contracts then inflation and unemployment may rise simultaneously.

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Fiscal Policy• Fiscal policy: aimed to affect aggregate demand by

changing government expenditure and taxation.

• Budget deficits and surpluses:• Fiscal balance: difference between the government

receipts and expenditure.• Budget surplus: excess of government receipts over

expenditure.• Budget deficit: excess of government expenditure

over receipts.

– Financing a deficit: the government will have to borrow money by selling government securities.

– Next slide presents past fiscal balances in Australia. 7

Australia’s Fiscal Balance 2000-01 to 2011-12

8

% of GDP

2000-01 0.8

2001-02 -0.4

2002-03 0.7

2003-04 0.7

2004-05 1.3

2005-06 1.7

2006-07 1.6

2007-08 1.8

2008-09 -2.4

2009-2010 -4.2

2010-2011 -3.7

2011-2012 -3.0

Source: Australian Government (2013).

Fiscal Policy (contd.)• Using fiscal policy:

– Automatic fiscal stabilisers: Tax revenues that rise and government expenditure that falls as GDP increases (e.g.: proportional and progressive income taxes, and transfer payments).

– Discretionary fiscal policy: Deliberate changes in tax rates or government expenditure made to influence the level of aggregate demand (e.g.: public works, public employment projects and variation of tax rates).

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Fiscal Policy Effectiveness• Discretionary fiscal policy: problems of magnitude.

• Difficulties in predicting the effect of changes in government expenditure.

• Crowding out: when increased public expenditure diverts money or resources away from the private sector.

• Difficulties in predicting the effect of changes in taxes.

• Difficulties in predicting the resulting multiplied effect on GDP:

– Size of the multiplier.

– Accelerator effects.

• Random shocks. 10

Monetary Policy• Objective of monetary policy: price stability.

– Instruments used:• Interest rates, supply of money and credit.

• Open market operations: purchase or sale of government securities by the Reserve Bank to stabilise or change the official cash rate.

• Monetary control• Changing the cash rate (interest rate charged on

overnight loans, under control of RBA).• Changing the money supply (through open market

operations).

• The transmission mechanism of monetary policy.11

0

Rat

e of

inte

rest

Md

Quantity of money

MS0

r0

Changing the Interest RateMS1

r1

b

a

An increase in the the interest rate

and reduction in the money supply

lead to a movement along the money demand curve,

from from ‘a’ to ‘b’.

12Source: Sloman et al. (2014).

Interest Rates

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• Official rates– Official cash rate

• Open market rates– Money market rates– Bank bill rates– Certificate of deposit rates– Treasury bond rates– Commercial bond rates

• Bank rates– Prime rate– Mortgage rate– Personal loan rates– Credit card rates

The Transmission Mechanism of Monetary Policy

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Source: Bank of England (1999).

Market rates

Asset prices

Expectations/confidence

Exchange rate

Official rate

Domestic demand

Net external demand

Total demand

Domestic inflationary

pressure

Import prices

Inflation

• Using monetary policy:• Imprecise means of controlling aggregate demand.

– Expansionary policy less reliable, when there is a recession people could decide not to borrow money.

– Time lags.

– Interest rates are used to control inflation, but if the rates are low (e.g.: 0.25%), the it will be not possible to cut the interest rate.

– Australia’s target inflation rate: 2-3% average over the business cycle. This rate is sufficiently low, so it does not distort economic decisions.

Monetary Policy (contd.)

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• Fiscal and monetary policies have the problem of timing:

• Time lags.

• Policy may be destabilising.

• Consumption may respond slowly to changes in taxation.

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Timing of Fiscal and Monetary Policies

0

Rea

l GD

P

Time

1

2

4 1

24

Path (a): no intervention

Macroeconomic Policies: Stabilising or Destabilising?

3

3

17Source: Sloman et al. (2014).

0Time

1

2

4

12

4

Path (a): no interventionPath (b): policy stabilises

Rea

l GD

P

3

3

Macroeconomic Policies: Stabilising or Destabilising?

18Source: Sloman et al. (2014).

0Time

1

2

4

1

2

4

Rea

l GD

P

Path (a): no intervention

Path (c): policy destabilisesPath (b): policy stabilises

3

3

Macroeconomic Policies: Stabilising or Destabilising?

19Source: Sloman et al. (2014).

‘Demand-Side’ Policies

• Should the government pursue an active aggregate demand management policy or merely apply a set

of policy rules?• Rules:

• Help to reduce inflationary expectations.• Create a stable environment for investment and

growth.• Discretion:

• Allows governments to respond to shocks.• Difficulties with choice of target.• Consider Goodhart’s Law.• Use of a Taylor rule.

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‘Supply-Side’ Policies

• Focus is on potential GDP!!• Shift AS curve to the right.

• In the short-run: increase output and reduce inflation.

• In the long-run: increase the rate of economic growth.

– Market-oriented policies: such as policies encouraging private enterprise, risk taking and competition.

– Interventionist policies: focus on means of counteracting market failures.

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– Policies to encourage competition:

• Anti-competitive legislation.

• Deregulation (such as removal of monopoly rights).

• Privatisation (sale of government trading enterprises to the private sector).

• Increasing competition in the public sector (government business enterprises have been corporatised, applying commercial principles and accountability systems or have contracted out part of their operations to the private sector).

‘Supply-Side’ Policies in Australia

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– Increasing labour market flexibility.

– Tax reform.

– Support for research and development.

– Results of supply-side policies:

• Increase the efficiency with which inputs are used.

• Total factor productivity: difference between the growth of output and the growth of all inputs.

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‘Supply-Side’ Policies in Australia (contd.)

Long-Term Economic Growth• Growth over the decades due to a growth of potential

output.

• The causes of economic growth in the long-term (growth in potential output):

• An increase in quantity of factors.• An increase in productivity of factors.

• So, capital accumulation will lead to economic growth.

– A simple model of economic growth (assuming that the size of workforce is constant) shows:

• An increase in capital will increase output.• Diminishing returns.• Steady-state national income (or GDP). 24

Y/L, I/L and D/L

Capital stock per worker (K/L)

O

Output (Y)

Investment (I)

(Y/L)0

(K/L)1

Depreciation (D)

(Y/L)1

(K/L)0

(I/L)0

(D/L)0

a

b

c

f

g

‘Steady-State’ Output

25Source: Adapted from Sloman et al. (2014).

– What are the effects of an increase in the saving and investment rates?

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Long-Term Economic Growth (contd.)

Saving and Investment Rates:The Effects of an Increase

Y/L, I/L and D/L

Capital stock per worker (K/L)

O

Output (Y)

I2

(Y/L)1

(K/L)2

Depreciation (D)

(Y/L)2

(K/L)1

I1

f

h

g

n

m

27Source: Adapted from Sloman et al. (2014).

• Technological progress:– What are the effects of technological progress

on output?

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Long-Term Economic Growth (contd.)

Effects of a Technological Advance

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Y/L, I/L and D/L

Capital stock per worker (K/L)

O

Output (Y)

I2

(Y/L)1

(K/L)2

Depreciation (D)

(Y/L)2

(K/L)1

(I/L)1

(D/L)1 I1

f

h

g

n

p

Source: Adapted from Sloman et al. (2014).

• Technological progress:– Effect of technological progress on output.– Endogenous growth theory:

• Rate of economic growth depends on the rate of technological progress and diffusion.

• Both depend on institutions, incentives and the role of government.

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Long-Term Economic Growth (contd.)

ReferencesAustralian Government (2013). Historical Australian

government data. Retrieved from http://www.budget.gov.au/2011-12/content/fbo/ html/appendixb.htm.

Bank of England (1999). The transmission mechanism of monetary policy. The monetary policy committee. Retrieved from http://www.bankofengland.co.uk/publications/Documents/other/monetary/montrans.pdf.

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References (contd.)

Morales, L. E., Simons, P. and Valle de Souza, S. (2014). GSB728: Economics for Management [Topic Notes]. Armidale, Australia: University of New England, Graduate School of Business.

Sloman, J., Norris, K and Garratt, D. (2014). Principles of Economics (4th ed.). French Forest, Australia: Pearson.

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