Chapter 6

What are the three main economic policies that governments use to influence economic activity and to achieve their macroeconomic policy?

·fiscal policy ·monetary policy ·supply-side policy

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What does fiscal policy cover?

the taxation and spending decisions of a government

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What is the key aim of fiscal policy?

·increase AD ·the government can do this through increasing its own spending and/or by reducing taxes

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What is reflationary fiscal policy?

·rises in government spending and cuts in taxes designed to increase AD

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What is deflationary fiscal policy?

·Measures that reduce AD (cuts in government spending and/or rises in taxes)

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What is reflationary fiscal policy also known as?

·expansionary fiscal policy ·loose fiscal policy

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What is deflationary fiscal policy also known as?

·contractionary fiscal policy ·tight fiscal policy

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What can the government change?

·tax rates ·the types of tax it imposes ·what it taxes ·the composition, amount and timing of government spending

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Other than influencing the level of AD, why may changes in government spending and taxation be implemented?

·encouraging the consumption of meter goods ·discouraging the consumption of demerit goods ·altering the distribution of income ·altering incentives and simplifying the system

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What does acting counter-cyclically mean?

·the government is seeking to create greater economic stability by offsetting changes in private sector spending (e.g. a government may try to increase AD if private sector demand is low)

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How does a government achieve greater economic stability?

·by using discretionary fiscal policy or allowing automatic stabilisers to operate

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When is discretionary fiscal policy used?

·when a government actively influences AD by changing its expenditure or taxes

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What are automatic stabilisers?

·forms of government spinning and taxation that change automatically to dampen down economic fluctuations without any deliberate change in government policy

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What will the government receive when real GDP rises and why? What will this lead to?

·more income tax revenue ·because more people will be employed and some people will be earning higher wages ·the fall in government spending and rise in tax revenue will reduce the growth in AD and may help to prevent inflation

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What is the golden fiscal policy rule and what does it mean?

·over the economic cycle the government should not borrow to pay for investment spending ·this means it has to pay for finance its current spending out of taxation and not borrow to fund current spending

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What is the other fiscal policy rule?

·the sustainable investment rule ·requires the government to keep public sect debt over the economic cycle at a 'stable and prudent level'

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What is income tax?

·a direct and progressive tax ·(as a person's income rises, both the amount and percentage that a person pays in tax rises)

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What is VAT?

·value added tax ·an indirect and largely regressive tax ·imposed on the sale of goods and services at different rates

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What are the types of taxes?

·income tax ·VAT ·excise duty ·capital gains tax ·corporation tax ·inheritance tax

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What is excise duty?

·an indirect tax imposed on specific products ·e.g alcohol, tobacco and petrol

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What is capital gains tax?

·a tax on the increase in the value on items such as shares, second homes and painting ·'increase in the value on' means the difference between purchase and selling price

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What is inheritance tax?

·a tax on transfers of wealth above a certain amount

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What is corporation tax?

·a tax on the profit of firms

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What sections can government spending be divided into?

·capital expenditure ·current spending ·transfer payments ·debt interest payments ·

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What is capital expenditure spent on?

·infrastructure ·e.g. hospitals, schools, roads

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What is current spending used for?

·the running of public services ·e.g. teachers' pay & the purchase of medicines to be used in the NHS

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What are transfer payments?

·money transferred from taxpayers to recipients of benefits e.g. pensioners & the unemployed

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What are debt interest payments?

· payments made to the holders of government debt

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What are the five most important individual areas of government spending in the UK recently?

·social protection ·health ·education ·defence ·debt interest

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What is spending on social protection influenced by?

·benefit rates ·the level of economic activity ·(it rises during periods of increasing unemployment and falls during periods off falling unemployment)

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What is expenditure on health and education influenced by?

·government priorities ·government policies ·changes in the age composition of population ·expectations in relation to the range and quality of health care treatment ·advances in technology

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What is spending on defence influenced by?

·present military involvement

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What are debt interest payments affected by?

·the level of government debt ·the rate of interest

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What does the budget position show and when does a balanced budget occur?

·shows the relationship between government spending and tax revenue ·occurs when government spending and tax revenue are equal

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When does a budget deficit arise and how is it solved?

·when government spending exceeds tax revenue ·government will have to borrow to finance some of its spending

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When does a budget surplus occur and what does it allow?

·when tax revenue is higher greater than government spending ·government will be able to repay some of its debt

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What is the effect of a recession likely to be on tax revenue?

·tax revenue is likely to fall & government spending on benefits is likely to rise

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What does it suggest if a budget deficit occurs where there is a high level of economic activity?

·may suggest there is something wrong the structure of government spending and taxation

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What are fiscal policy and monetary policy sometimes referred to as?

·demand-side policies

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What do monetary policy instruments or measures include?

·rate of interest ·money supply ·exchange rate

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What is the main monetary policy instrument currently being used in the UK?

·the rate of interest

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What effect does a higher interest rate tend to have?

·tends to reduce consumption and lower firms' investment ·likely to encourage foreigners to place more money into UK financial institutions which will push up the value of the pound due to the rise in demand for pounds

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What effect does a higher exchange rate have?

·will make exports more expensive and imports cheaper ·likely to decrease AD by reducing consumption, investment and net exports

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How may changes in the money supply be used to influence AD?

·an increase in the money supply is likely to increase AD

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How may a central bank seek to influence the value of the currency?

·by changing the interest rate and/or by dealing in the foreign exchange market ·lower the interest rate or sell pounds to reduce the exchange rate

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How will a rise in the money supply, by increasing the amount that banks have to lend, affect the interest rate?

·reduces the interest rate

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What is raising the rate of interest and/or buying foreign currency to raise the interest rate an example of?

·deflationary or contractionary monetary policy

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What does a reflationary or expansionary monetary policy aim to do?

·seeks to stimulate a growth in AD

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If successful, what effect will supply-side policies have?

·increase productive potential ·help prevent inflation ·reduce structural & frictional unemployment ·improve the country's trade position

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What are examples of supply-side policies?

·education & training ·government assistance to new firms ·reduction in direct taxes ·national minimum wage (NMW) ·reduction in unemployment benefit ·reduction in other benefits ·reduction in trade union power ·privatisation ·deregulation ·

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How does education and training work as a supply-side policy?

·government investment in it can get firms to increase their training, which should raise the occupational mobility of labour & labour productivity ·if output per worker hour increases, potential output of economy will rise (shift right of AS curve)

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How may a government help new firms?

·providing grants ·changing a low rate of corporation tax

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What effect is a reduction in direct taxes likely to have?

·increased AD & AS ·lower direct taxes increases incentives to firms, workers & potential workers ·firms may have money available to invest, which could lead to a rise in the productive capacity of the economy

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What could be a counterargument to a reduction in direct taxes?

·lower income tax rates may encourage some workers to take more leisure time because they can gain the same disposable income by working fewer hours

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What is determinant of the NMW being a supply-side policy?

·whether it encourages people to enter the labour force or whether it reduces the efficiency of the labour market

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How might a reduction in unemployment benefit reduce unemployment?

·widen the gap between income from employment & the benefit ·force some of unemployed to seek work more actively & accept unemployment at lower wages ·greater use made of labour force ·reduce negative output gap & move output closer to full capacity

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How might a reduction in unemployment benefit increase unemployment?

·if the unemployment is of a cyclical nature, there will be no jobs available ·cutting their benefits will reduce consumption ·will lower AD & cause firms to cut back their output ·cutting benefits is likely to widen income inequality

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How might a reduction in trade union power increase the efficiency of labour markets?

·if trade unions reduce unemployment by pushing wage rates above the equilibrium level & encouraging workers to engage in restrictive parties ·reducing power will increase labour productivity & reduce the cost of employing labour

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How may trade unions help labour markets work efficiently?

·may act as a counter-balance to the market imperfection of every powerful employers ·may reduce firms' costs by acting as a communication channel between employers & workers on issues ·reducing trade union power may raise firms' costs & unemployment

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How might privatisation increase AS?

·private sector are subject to the discipline of the market & so can make better decisions ·provide products at competitive prices or they will go out of business

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What is deregulation?

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

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How might unemployment be reduced if the economy is operating below its productive capacity?

·by increases in Ad ·expansionary and/or monetary policy can be used to create jobs

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How might a government, using fiscal policy, raise its AD?

·increase its spending and/or cut tax rates ·increases in the money supply or interest rates (e.g. fall in the interest rates and/or an increase in the money supply should stimulate investment)

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What may a negative side-effect of a rise in AD be?

·a rise in the price level if the economy moves close to full employment

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What negative side-effects may a higher level of spending to reduce unemployment bring about?

·may increase any existing deficit on the current account of the BoP as UK residents buy more imported goods

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What are the two types of policies used to reduce unemployment?

·demand-side policies ·supply-side policies

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How will economic stability and low inflation make low unemployment more likely?

·by encouraging investment and maintaining or increasing international competitiveness

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What factors determine unemployment even when AD is high?

·time people spend finding a job is influenced by quality of info abut job vacancies ·many long-term unemployed lack qualifications, have poor communication skills & are geographically immobile ·unemployment trap

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How can supply-side policies be used to reduce levels of unemployment when the level of AD is high?

·can be implemented to increase economic incentives & the quality of labour services offered to the unemployed

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What supply-side policies could be introduced to reduce unemployment?

·quality & quantity of information available to the unemployed about job vacancies could be increased ·improved education & training & provision of work experience may raise skill levels

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How may supplied-side policies enable more lone parents to work?

·greater provision of low-cost child-care

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How may supplied-side policies facilitate the employment of more disable workers?

·legislation & subsidising of special equipment & adaptation of buildings

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How may supply-side policies increase the economic incentive to work?

·by widening the gap between the income received from working and the income received in benefits ·e.g. through a reduction in income tax rates

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How will be unemployment be solved if it is the result of both a lack of aggregate demand and supply-side problems?

·a combination of expansionary demand-side and supply-side policies will be needed

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Have fiscal and monetary policy been used to directly influence unemployment?

·no, they have been used to promote economic growth & to achieve the target rate of inflation

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What two types of policies can be used to reduce inflation?

·cost-push inflation ·demand-pull inflation

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How can the government directly control wages in the public sector and what are the disadvantages of this?

·by restricting increases in government spending allocated to the pay of public sector workers ·may create inflexibility in the labour market as firms will be limited in how much they can offer to attract new workers

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How can the government restrict wage rises in both the public and private sector and what does this seek to do?

·by introducing an incomes policy ·e.g. placing a limit on wage increases per year ·seeks to reduce inflation without causing unemployment

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How may the government try to lower firms' costs and what is the advantage of this?

·by reducing corporation tax ·may stimulate investment

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Why may a government introduce subsides and what are the effects of this?

·so firms can cover rising costs without needing to increase prices ·if some of subsidy is spent on investment, may reduce costs in the long run ·a dander of firms becoming reliant on subsidies & not trying to keep costs down

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What may a government use to reduce demand-pull inflation and why?

·deflationary fiscal and/or monetary policy instruments ·they aim to reduce inflation by decreasing AD ·e.g. raising income tax could reduce people's disposable income & their ability to spend

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What is the main instrument used to reduce demand-pull inflation and why?

·the interest rate ·a higher interest rate is likely to reduce AD by reducing consumption, investment & net exports

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How is inflation targeting useful?

·lowering chance of demand-pull & cost-push inflation by reducing expectations of inflation ·if people are convinced that a central bank has determination, experience & ability to meet its target, they will act in a way that doesn't cause inflation

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If inflation targeting is useful in keeping inflation low and stable then what effect does this have?

·then the interest rate can also be low, which in turn is likely to encourage investment & economic growth

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In the long run, how is a government likely to seek to reduce the possibility of inflationary pressure?

·by increasing AS ·if the productive capacity of the economy grows in line with AD, with increases in AD being matched with increases in AS, then the economy can grow without the price level rising

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What type of approach is using supply-side policies to ensure the quality & quantity of resources rise to supply more products and why?

·long-run approach ·it takes time to have an impact of productive capacity

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Why would increases in output in the short run occur and how could they be stimulated?

·due to increases in AD if the economy was producing below full capacity ·by expansionary fiscal or monetary policy

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Can fiscal and monetary policy instruments only increase AS?

·some policies have the potential to increase both AD and AS e.g. lower rate of interest will increase both

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In the long run, what is the only way for increases in the country's output to be achieved?

·if the productive capacity of the economy increases ·therefore the quality and/or quantity of resources has to increase

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What is the extent to which supply side policies increase the productive capacity of the economy influenced by?

·the appropriateness & quality of the investment

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What do the short-run measures of improving a governments' balance of payments position tend to focus on?

·demand

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What do the long-run measures of improving a governments' balance of payments position tend to focus on?

·improving the supply-side of the economy

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In the short run, what are the three main ways a government may try to raise export revenue and/ or reduce import expenditure in order to correct a current account deficit?

·causing a fall in the exchange rate ·reducing demand for all products whatever their source ·specifically reducing demand for imports

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When and how may a country seek to reduce the exchange rate and what is this known as?

·'exchange rate adjustment' ·when it believes the current level is too high & is causing its products to be uncompetitive against rival countries products ·central bank may try by selling its own currency and/ or reducing the interest rate

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Why may a government adopt deflationary fiscal & monetary policy instruments and what is this called?

·'deflationary demand management' ·to discourage expenditure on imports

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Under 'deflationary demand management', how may domestic spending be reduced but what is the risk?

·higher taxation ·lower government spending higher interest rates ·risk that resulting reduction in spending may cause aggregate output to fall & unemployment to rise

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How may a government seek to reduce expenditure on imports and what is this called?

·'import restrictions' ·imposing import restrictions including tariffs & quotas

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What may be the negative side-effects of import restrictions?

·inflationary side-effects e.g. tariffs will increase price of some imports & so reduce competitive pressure on domestic firms to keep costs & prices low ·restrictions run risk of provoking retaliation (countries increase restriction on each other)

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When is it necessary to use supply-side policies to solve a deficit?

·if it arises from a lack of quality competitiveness, low labour productivity or high inflation

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What does the successfulness of supply-side policies depend upon?

·the appropriateness of the policies e.g training in the right areas

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When does revaluation of a currency occur?

·when its value is adjusted

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What is devaluation of a currency?

·when the exchange rate is forced down, possibly due to it becoming overvalue over time because a country may find that at the existing exchange rate it is difficult for exporters to compete with cheaper or better quality products from abroad

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How would devaluation occur?

·The Central Bank would be instructed to increase of the current to international markets & would lead to a decrease in price & devaluation

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What are the potential drawbacks of fiscal policy?

·changes in gov spending & tax rates take time to recognise the need for change in policy & gather info ·takes time to draw up & implement new tax codes & gov spending plans ·time lag between introducing fiscal policy instrument & it having effect

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Is government spending flexible?

·some forms are inflexible ·e.g. it is difficult to cut spending on health & pensions

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When do fiscal policy instruments work effectively?

·when they are based on accurate information ·

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How may households & firms cause fiscal policy instruments to not work?

·they may react in way that the government does not expect them to ·e.g. if they lack confidence, a cut in taxes may not lead to higher expenditure

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How can a central bank seek to influence the exchange rate (Monetary Policy)?

·by buying or selling currency ·by changing the interest rate

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What is the main monetary policy instrument currently being used in the UK and why?

·rate of interest ·to influence short-run economic activity

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