Chapter 6. The application of macroeconomic policy instruments and the international economy.

Demand-side policies.

Fiscal policy. It includes taxation and spending decisions of a government. The government can change tax rates, the types of taxes it imposes and what it taxes, amount and timing of government spending. The main aim of fiscal policy is to influence Aggregate Demand (AD).

Increasing government spending and reduction taxes – increase in AD.

Rises in government spending and cuts in taxes designed to increase AD are referred to as reflationary (aim – increase AD), expansionary or loose fiscal policy.  In contrast, deflationary (aim – decrease AD), contractionary or tight fiscal policy involves measures that reduce AD, that is, cuts in government spending and/or rises in taxes.

The nature of fiscal policy.

The main target of the government is to influence AD to match AS and so avoid both unemployment and inflation. This objective can be achieved by using what is called discretionary fiscal policy (deliberate changes in government spending and taxation designed to influence aggregate demand) or allow automatic stabilisers (forms of government spending and taxation that change automatically to offset fluctuations in economic activity) to operate. Not all forms of government spending and taxation are automatic stabilisers. For instance, spending on child benefits is not linked to the economic cycle (this is the tendency for economic activity to fluctuate its trend growth rate, moving from a high level of economic stability to negative economic growth.)

Types of taxes.

The most imposed tax in the UK is income tax. Income tax is a direct and progressive tax( higher percentage from the income of the rich). Another tax is VAT (value added tax). This is an indirect tax and largely regressive tax ( grater percentage from the income of the poor). Other taxes include excise duty, capital gains tax, corporation tax and inheritance tax.

 

Government spending

- Capital expenditure – e.g. hospitals, schools, roads.

- Current spending – public services (e.g. teachers´ pay)

- Transfer payments – money transferred from taxpayer to recipients of benefits (e.g. pensioners and unemployed)

- Debt interest payments – money transferred from holders of government debt (e.g. interest paid to holders of National Savings certificate)

The five most important individual areas of government spending in the UK recently have been social protection, health, education, defence and debt interest.

 

The budget. The budget position shows the relationships between government spending and tax revenue. When the two are equal it means that the budget is balanced.

Government spending exceeds tax revenue – budget deficit.

Tax revenue exceeds government spending – budget surplus.

 

Monetary policy.  Includes the rate of interest, the money supply and exchange rate. The most used instrument of monetary policy is interest rate. A higher interest rate tends to reduce consumption and lower firms` investment. This is also likely to encourage foreigners to place more money into UK financial institutions because of their higher return. This would rise  demand for pounds, which  would push up the value of the pound. A higher exchange rate will make exports more expensive and imports cheaper. This is likely to reduce net exports. So, a rise in the interest rate is likely to decrease AD by reducing consumption and investment. Money supply can also be used to influence AD. An increase in money supply is likely to increase AD. If the government prints more money( devaluate ) or makes it easier for banks to lend  money, people will have more money to spend. Changes in money supply and interest rates are inversely related. A rise in the money supply, by increasing the amount that banks have to lend, reduces the interest rate.

 

The monetary policy committee.

The monetary policy committee (MPC) of the Bank of England sets the rate of interest with the main objective of achieving the government’s target annual rate of inflation of 2%, as measured by the consumer price index.

 

Supply-side policies.

 

Education and training. The government encourages firms to increase their training, that should raise the occupational mobility of labour and labour productivity. This will shift AS curve to the right.

 

Government assistance to new firms. The government  helps new businesses establish by  providing them with grant and low corporation tax.

 

Reduction in direct taxes. A cut on direct taxes such as corporation tax would increase incentives to firms, workers and potential workers, which would lead to increase in AS.

 

National minimum wage (NMW) . By providing a high NMW the government could encourage people to enter the labour market, that tends to increase in AS.

 

Reduction in unemployment benefit. A reduction in job seeker’s allowance the government would encourage unemployed to enter the labour market, that tends to increase in AS.

 

Reduction in other benefits. The government could reduce other benefits for those who are economically inactive.

 

Reduction in trade union power. This may cause either an increase in the efficiency in labour markets if a reduce in employment by pushing wage rates above the equilibrium level causes people to engage restrictive practices. But this can also work the other way if it helps labour markets work efficiently.

 

Privatisation. Some economists argue that there should be more power in the private sector because they believe private sector firms are in the best position to make decisions about what to produce, how to produce and what to charge. On the other side it is argued that government ownership of firms is beneficial in a number of cases where there is a high risk of market failure.

 

Deregulation: Deregulation is the removal of rules and regulations that affect firms in the belief that will give the firms greater freedom to make their own decisions and to increase competition by making it easier for new firms to enter an industry.

 

Policies to reduce unemployment.

 

Demand-side policies.

Expansionary fiscal and/or monetary policy can be used to create jobs. A government by using fiscal policy could increase its spending and/or cut taxes in order to raise AD. Increases in money supply or lower interest rates are also likely to raise AD. For instance, a fall in interest rates and/or an increase in the money supply should stimulate consumption and investment. It may also raise net exports if it causes a fall in the exchange rate.

 

Supply-side policies.

Supply-side policies can be used to increase economic incentives and the quality of labour services offered by the unemployed. The quantity and quality of information available to the unemployed about job vacancies and to employers about those seeking jobs can be increased. Improved education and training and the provision of work experience may raise the skills of the unemployed. Greater provision of low-cost child-care may enable more lone parents to work. Legislation and the subsidising of special equipment and adaptation of buildings may facilitate the employment of more disabled workers.

 

Policies to control inflation.

 

Cost-push inflation.

A government may try to reduce firms’ cost by reducing corporation tax. This will also have the advantage of stimulating investment.

A government also can provide subsides that would help firms to cover their cost, that lead to falling in prices. There is a danger that the firms may become reliant on subsidies and do not strive to keep their costs down.

 

Demand-pull inflation.

To reduce inflation a government may use deflationary fiscal and/or monetary policy instruments. These are ones that seek to reduce AD or at least a growth in AD by raising income tax, for instance.

 

Inflation targeting.

This can lower both cost-push and demand-pull inflation by reducing expectations of inflation. If people are convinced that a central bank has the determination, experience and ability to meet its target, they will act in a way that does not cause inflation. In the long run, a government is likely to seek to reduce the possibility of inflationary pressure by increasing AD. If the productive capacity of the economy grows in line with AD, with rightwards shifts in the AD curve being matched by rightwards shifts in the AS curve, the economy can grow with the price level rising. To ensure the quantity and quality of resources rise to supply more products, supply-side policies may be used.

 

Policies to promote economic growth

Short run.

Increases in output in the short run can occur due to increases in AD if the economy is initially producing below full capacity. Such an increase may be stimulated by expansionary or fiscal policy. Some monetary and fiscal policies have the ability to change both AD and AS. For instance, a lower rate of interest is likely to stimulate both consumption and investment.

Long run.

In the long run, increases in the country’s output can continue to be achieved only if the productive capacity of the economy increases. This is why AS is so important. For instance, measures that raise investment will increase AS. The extent of increase will depend on the amount of extra investment, its type, and how efficiently it is used. A way to increase  the productive capacity of the economy is through investment in human capital. Human capital is education, training and experience that a worker, or group of workers, possesses.

Stable growth.

Stable growth is for actual growth to match trend growth and for that trend growth to rise over time. Governments try to avoid AD increasing faster than the trend growth rate permits, since this can result in the economy overheating with inflation and balance of payments problems arising. They also try to prevent AD rising more slowly than the trend growth rate, since this would mean a negative output gap developing with unemployed resources. In other words, governments seek to avoid economic cycles.

 

Policies to improve the balance of payments

There are several policy instruments a government can use to improve its balance of payments position.

Short run

Exchange rate adjustment.

A country may want to reduce the exchange rate if it believes that its current level is too high and as result is causing its products to be uncompetitive against rival countries` products. A lower Exchange rate will cause export prices to fall and import prices to rise. To succeed in increasing export revenue and reducing import expenditure, it is important that demand for exports and imports is price elastic, that other countries do not devalue and do not increase any import restriction.

Deflationary demand management

To discourage expenditure on imports, a government may adopt deflationary fiscal and monetary policy instruments. Higher tax, lower government spending and/or higher interest rates may reduce domestic spending. The risk is that a reduction in spending may cause aggregate output to fall and unemployment to rise.

Import restrictions

A country may seek to reduce expenditure on imports by imposing import restrictions including tariffs (tax on imports) and quotas (a limit on imports). However, these measures may inflationary side-effects. For instance, imposing 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 and prices low.

Long run

The most appropriate approach to long-run solutions would be to implement supply-side policies. How successful supply side policies are depends on the appropriateness of the policies.

Current account surplus

A disequilibrium may also arise because of a current account surplus. A government may seek to reduce or eliminate a surplus in order avoid inflationary pressure and to raise the amount of imports it can enjoy. To reduce it a government may seek to raise the value of its currency, introduce reflationary fiscal policy and monetary instruments and/or reduce imports restricitons.

 

Effectiveness of fiscal policy

 

Advantages

Number of taxes and forms of government spending adjust automatically to offset fluctuations in real GDP.

Some forms of government spending and taxation, including cuts in corporation tax and training grants, have the potential to increase both AD and AS.

 

Disadvantages

It takes time for government spending and tax to affect the economy and it takes time to recognise the need for a change in policy and at which base to change.

There is an time lag between introducing fiscal policy instruments and that instrument having an impact on the economy.

Number of government spending is inflexible (e.g. difficult to cut spending on health care and pensions).

Need to be based on accurate information (e.g. radio predict recession might lead to a change in expectations)

Households and firms may react in unexpected ways (e.g. cut in income taxes may not lead to higher consumption and investment if households and firms lack confidence).

May have an adverse effect on incentives and other macroeconomic objectives. (e.g. rise increase in state benefits may discourage some people from working).

Can be offset by changes in the economic activity in other countries.

 

Effectiveness of monetary policy

 

Disadvantages

Can be difficult to control the policy instruments (e.g. keep inflation in check by controlling the money supply)

The use of interest by MPC may be overestimating the prospects of inflation and so keeping the interest rate too high and limiting economic growth.

Take time for interest rate to work through the economy.

The interest rate may not change the AD s much as expected (e.g. if people are optimistic about the future, they may not reduce spending even after a rise in the interest rate).

A central bank’s ability to change its interest rate may be limited by the need for it to remain in line with other countries` interest rates (noticeable difference may cause inflow or outflow of hot money flows, which can disrupt financial markets).

When interest rates falls to very low levels, a further cut is likely to be ineffective in stimulating economic activity.

If interest rates is low when inflation is low and stable, it may not have big effect on the economy to change the interest if there is an increase in inflation.

Tend to be more concentrated on certain groups (e.g. rise in interest rate will hit firms that export a high proportion of their output more than it will affect other firms).

May have undesirable side-effects. A rise in the exchange rate, designed to reduce inflationary pressures, may worsen the balance of payments position.

 

The effectiveness of supply-side policies

Economists agree that if the supply-side performance of the economy can be improved, it may be easier for a government to achieve its objectives. However, increasing the productive potential on its own will not be sufficient in raising economic performance if there is a lack of AD.

Some supply-side policies take a relatively long time to have an effect, they can be exoensive to operate and there is no guarantee that they will work.

 

Possible conflicts between policy objectives

 

The objectives of economic growth and low unemployment may benefit from expansionary demand-side policy measures. In contrast, such measures may make it more difficult for a government to achieve low inflation and a satisfactory balance of payments position.

MPC may face a conflict when setting the interest rate because it may want to raise interest rate to reduce inflationary pressure but be concerned about the effects such a move will have on the exchange rate and so on the balance of paymenst and employment.

 

Advantages that may be gained from international trade

International trade involves the exchange of goods and services across national borders. These are the benefits from international trade:

lower prices and high quantity because of high competition

greater variety of products

high competition leads to firms accessing larger markets in which to sell their products and buy raw materials.

There are some challenges with international trade as well. Competition from other countries and access to their markets result in some industries contracting and some expanding. This requires the shifting of resources, which can be unsettling and may be difficult to achieve due to, for example, occupational immobility of labour (difficulty in moving from one type of job to another).

What also happens in international trade is that some countries put restrictions on the exports of certain products if they become in short supply.

 

Methods of protection

 

International free trade occurs when there are no restrictions imposed on the movement of goods and services into and out of countries. In contrast protectionism results in the deliberate restriction of the free movement of goods and services between countries and economic blocks. A government engage in protectionism when it introduces measures to protect its own industries from competition from the industries of other countries.

 

Tariffs.

Tariffs are taxes on imported products.

Quotas.

This is a limit of supply of a good or service.

Voluntary export restraint.

Voluntary export restraint (VER) is a limit placed on imports from a country with the agreement of that country’s government.

Foreign exchange restrictions.

Governments may seek to reduce imports by limiting the amount of foreign exchange made available to those wishing to buy imported goods and services or to invest or to travel abroad.

Embargoes.

An embargo is a ban on the export or import of a product and/or a ban on trade with a particular country.

Red tape.

Time-delaying procedures may be used to discourage imports.

Other measures.

Two additional measures are quality standards and government purchasing policies. Quality standards may be set high and complex requirements may be put in place with the intention of raising the costs of foreign firms seeking to export to the country. A government may also try to reduce imports by favouring domestic firms when it places orders.