The National Economy

Fiscal policy looks at how government spend their money and how they control their taxes.

There are 2 types of fiscal policy:

Contractionary fiscal policy: Where the government reduce spending and / or when they make taxes higher, they try to increase its PSBR( public sector borrowing requirement) to fund the tax drops they also do this to reduce its surplus on its budget for the fiscal year.

Expansionary fiscal policy: Where the government cut taxes or increase government spending. They will increase the amount the government borrows to fund the expenditure.

Monetary policy is the use of interest rates, money supply and exchange rates to influence economic growth and inflation

Interest rates – are the cost of borrowing money

Exchange rates – the value of one currency in terms of another

Money supply – the amount of money in circulation in an economy

Supply side policies are policies that improve the supply-side of the economy increasing its efficiency and thereby resulting in economic growth

Supply side policies can act in the product and labour markets

Government expenditure covers all spending by the public sector

The government spends money on many things including:

Education

Defence

Welfare benefits

Healthcare

Infrastructure

Police

As well as gaining revenue through taxation the government can also finance their spending through borrowing

The public sector net cash requirement (PSNCR) measures the annual borrowing requirement of the government in an economy

Direct taxes are taxes of income and expenditure

e.g. income tax, corporation tax (levied on company profits).

Indirect taxes are taxes such as VAT (value added tax), changes in this type of tax has a rapid effect on the level of economic activity.

e.g. an increase in VAT will cut consumption

Taxation influences the AD curve because:

An increase in taxation will decrease the level of consumption in the economy

An increase in taxation will increase the level of government spending in the economy

A decrease in taxation will increase the level of consumption in the economy

A decrease in taxation can decrease the level of government expenditure in the economy

The impact of a change in government expenditure depends on the size of the multiplier

Governments can utilise fiscal policy to control the level of AD in the economy

There can be problems with this due to:

Time lags

The size of the multiplier

Fiscal crowding out

Peoples reaction to cuts / rises in taxation

Fiscal policy can be used to increase the productive capacity of the economy

This is because government expenditure can be used to:

Increase the skill levels of workers

Provide economic incentives to firms

Increase factor mobility

The Bank of England are responsible for setting interest rates in the UK

The Bank sets the rate after analysing macroeconomic trends and risks associated with inflation

Since 1997 the UK government has used interest rates to control the level of inflation in the economy (at a level of 1.5-3.5% - target = 2.5%)

If the Bank believes the level of AD is rising too quickly potentially causing cost push inflation they will decide to raise interest rates

Changes to interest rates influence many things in the economy:

Housing prices and housing market – if interest rates rise the cost of mortgages increases therefore reducing demand for housing in theory (this has not occurred recently in the UK)

Disposable income of house owners – if interest rates rise the real disposable income of home owners falls as they have larger mortgage payments (variable rate only)

Credit demand – if interest rates rise the amount of credit sales should decrease as it becomes more expensive

Investment – if interest rates rise they lead to a decrease in the level of investment

Exchange rates – An increase in interest rates may lead to an appreciation of UK currency making exports less attractive

Interest rates are used to control inflation as when interest rates are increased consumption decreases as peoples real incomes are eroded by mortgage payments and credit payments and the opportunity cost of spending has increased

By controlling interest rates the government aims to keep inflation at a low level

Changes in the UK’s interest rates will lead to changes in the exchange value of the pound.

If interest rates rise the value of the pound will rise so the pound will now buy more US dollars, Japanese Yen, Euros etc.

If interest rates fall the value of the pound will fall so the pound will now buy less US dollars, Japanese Yen, Euros etc

A fall in the exchange rate reduces the price of exports and increases the price of imports

Domestic demand will be stimulated and more people will buy exports as they are cheaper

This will create a deficit on the current account of the balance of payments

As consumption will increase it will increase AD which will increase the level of output in the economy and more it towards full employment

Trade union reforms

Increased expenditure on training and education

Changes in taxation

Changes to welfare system

Privatisation

Deregulation Free trade

Incentives for small businesses

Supply side policies cause economic growth as they cause the LRAS to shift outwards, increasing the potential output of the economy

If the economy is operating near full potential increases in aggregate demand can cause cost push inflation, by the LRAS curve shifting outwards this inflationary pressure is reduced

As supply side policies can cause the LRAS to shift outwards they can lead to a fall in unemployment levels

Many supply side policies concentrate on the labour market and increase skills for workers which help reduce structural unemployment in the economy

As the LRAS shifts outwards businesses will have lower average costs as productivity has increased

Lower costs mean that businesses are able to compete more internationally therefore making the balance of payments more healthy

Aggregate demand measures the total expenditure in the economy as a whole

It is calculated using the following formula: AD = C + I + G + (X-M)

C = consumption

I = investment

G = government expenditure

X = exports

M = imports

Aggregate supply shows the total amount supplied in the economy as a whole at each price level

In the short term aggregate supply slopes upwards

The determinants of AD are C, I, G, X and M

C represents the consumption expenditure of the economy as a whole

There are a number of factors that influence the level of C including:

Tax rates

Inflation

Wage increases

Interest rates

Credit

Wealth : Shares, Property, Savings, Bonds

A change in the level of AD can cause influence the level of national income

If an economy is operating below its potential level then a shift in AD causes national income to rise in the short term

The impact of the change in AD depends on how close the economy is to full capacity

LRAS is determined by the productive resources available in the economy and the productivity of the factors of production (land, labour and capital)

In the long run the assumption is that supply is not dependent on the level of prices in the economy therefore the LRAS is vertical

The curve slopes from left to right because it is based on the following assumptions :

- Bank of England sets short term interest rates

- A rise in inflation is matched by a rise in interest rates

- An increase in interest rates increases the cost of borrowing

In the short run where the AD and AS curves interact is the level of national income

If the price level changes this is represented by movements along the AD / AS curves

Any change in the components of AD (C,I, G, (X-M) cause the curve to shift

Economic growth is represented by a rightwards shift in the LRAS curve