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Transcript of As Economics Notes
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Chapter six
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What are the types of policies govt uses to achieve
their macroeconomic objectives and influence
economic activity? Fiscal policy
Monetary policy
Supply side policies
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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.
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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.
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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
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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.
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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
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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.
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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
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Budget surplus
When tax revenue is greater than govt
spending
allows the govt to repay some of its debt.
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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
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Monetary policy
Demand side policy
Monetary policies include: rate of interest,
money supply and the exchange rate.
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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.
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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.
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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
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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.
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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
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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
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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
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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
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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
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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
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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
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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
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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
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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
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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
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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.
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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
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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
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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.
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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.
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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
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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
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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.
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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.
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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.
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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
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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
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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
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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.
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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
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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.
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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
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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.
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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.
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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
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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
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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
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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
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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.
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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
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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