Chapter 1 - Economic Policy PDF

## S7ECOEN - Chapter 1 - Economic policy The main macroeconomic goals of governments usually are: * A stable and sustainable rate of economic growth. * A low level of unemployment. * A low and stable rate of inflation. * A favourable balance of payments position. * A fair distribution of income a...

## S7ECOEN - Chapter 1 - Economic policy The main macroeconomic goals of governments usually are: * A stable and sustainable rate of economic growth. * A low level of unemployment. * A low and stable rate of inflation. * A favourable balance of payments position. * A fair distribution of income and wealth. While trying to achieve these goals, governments should also focus on ensuring the availability and quality of public services and infrastructure while maintaining the national budget and the national debt under control. Most economic policies can be divided into two groups, **demand-side policies**, which influence aggregate demand, and **supply-side policies**, which influence aggregate supply. ### Aggregate Demand Aggregate demand (AD) is the total demand for goods and services over a given period of time at a given price level throughout an economy. There is a negative relationship between the average price level and the real output demanded in an economy which translates into a downward sloping AD curve. A change in the average level of prices will therefore result in a movement along the AD curve. While the vertical axis of the graph measures the average price level (inflation), the horizontal axis measures real national output (economic growth) as well as employment as any increase in real output is likely to require more labour. * **AD = Aggregate demand** * **C = Consumption**. Household expenditure on final goods and services. * **I = Investment**. Capital stock added to the economy. Investments made by companies, including inventory investment and capital expenditure on assets such as industrial buildings or machinery. In order to avoid double counting, financial investments, such as buying bonds or shares, are not considered as investment, but as saving. * **G = Government spending**. Government current expenditure on goods and services, such as salaries of public servants or school textbooks, and government capital expenditure on investments, such as roads or hospitals. Transfer payments, such as unemployment benefits, child allowance payments, pensions, or subsidies to producers, are not included in this category as they are not the result of an increase in output. * **(X - M) = Net exports**, which is equal to total exports minus total imports. * **X = Exports**. Revenue from domestic goods and services bought by foreigners. * **M = Imports**. Domestic expenditure on goods and services from foreign producers. ### Demand-side Policies Demand-side policies are policies aimed at increasing or decreasing an economy's AD by changing its components (consumption, investment, government spending, exports, and imports). Demand-side policies can either be: * **Expansionary**, in which case they aim to stimulate expenditure in an economy, which should lead to an increase in real output, higher employment, and a raise in inflation. This increase in AD would be translated into a shift in the AD curve to the right. * **Contractionary**, in which case they aim to reduce expenditure in an economy, which should lead to a decrease in real output, lower employment, and a fall in inflation. This decrease in AD would be translated into a shift in the AD curve to the left. Demand side policies therefore usually involve a trade-off. If economic growth and employment are increased, inflation also tends to increase, and vice versa. ### Fiscal policy and Monetary Policy Demand-side policies can be classified into **fiscal policy** and **monetary policy**. * **Fiscal policy** involves government spending or tax policy. * **Direct taxes**, such as household income taxes or corporate taxes, are imposed upon individuals and companies, while **indirect taxes**, such as value-added tax (VAT) on goods and services, are imposed upon transactions. * Examples of *expansionary fiscal policy* include: * Increasing government spending on investment projects such as new roads or schools. This should increase AD while improving infrastructure and public services at the same time. An increase in government spending might also have a multiplier effect on the economy, further increasing AD. * Governments could also increase *transfer payments*, such as unemployment benefits, leading to more disposable income for individuals to spend on consumption which should result in an increase in AD. * Lowering *corporate taxes* should lead to more after-tax profits that companies could either spend on investment or distribute to their shareholders in the form of dividends, increasing their disposable income to spend on consumption. Both possibilities should result in an increase in AD. * Lowering *income taxes* should lead to more disposable income for individuals to spend on consumption resulting in an increase in AD. * Lowering *indirect taxes* should result in lower prices for consumers. This should lead to an increase in real disposable income for individuals to spend on consumption resulting in an increase in AD. * **Monetary policy** is the policy adopted by the monetary authority regarding the interest rate or the money supply of an economy. The *monetary transmission mechanism* refers to the process by which monetary policy decisions affect the economy. The main monetary policy instruments available to central banks include: * **Interest rates**. By changing its interest rates, the central bank will influence the level of lending and saving in the economy as commercial banks tend to adapt their interest rates accordingly. Lower interest rates should lead to an increase in AD as it becomes cheaper to borrow money for consumption and investment. Savings should also decrease as there is less incentive to save which should further increase consumption. While central banks can reduce their deposit interest rates below 0%, there is a risk that commercial banks begin to charge depositors leading to a potential decrease in the money available for loans as a large number of people simultaneously decide to withdraw their money. * **Reserve requirements**. By changing the reserve requirement, which is the minimum amount of all deposits that commercial banks must keep as reserves in their vaults or in their account at the central bank, the central bank can influence an economy's money supply. A lower minimum reserve requirement would mean that commercial banks would be able to lend more money for consumption and investment leading to an increase in AD. This would however also make commercial banks more vulnerable in case of bank runs, which occur when a large number of people simultaneously decide to withdraw their money due to concerns about a bank's solvency. * **Open market operations (OMO)** occur when central banks either buy government bonds to expand the money supply or sell government bonds to contract the money supply. The central bank does not buy bonds directly from governments, which would violate the statutes of the ECB, but from commercial banks. By buying government bonds the central bank increases the economy's money supply and the funds that commercial banks have available to lend, which tends to reduce interest rates, leading to an increase in AD as savings decrease and borrowing money for consumption and investment becomes cheaper. * **Quantitative easing (QE)** is an expansion of the open market operations of a central bank. Instead of just buying government bonds, quantitative easing is about purchasing large volumes of different financial assets, such as corporate bonds or mortgage-backed securities, in order to expand the economy's money supply and stimulate lending, consumption, and investment, leading to an increase in AD. Quantitative easing is an unconventional form of monetary policy usually used when standard monetary policies have become ineffective, for example if interest rates are already near 0%. *Quantitative tightening (QT)*, which is the opposite of quantitative easing, occurs when central banks sell the financial assets that they hold to contract the money supply in the economy, leading to a decrease in AD. * **Forward guidance** refers to the communication from a central bank to the public about its future monetary policy intentions, based on its assessment of the economic situation, to prevent surprises that might disrupt the markets and to maintain business and consumer confidence. * An *expansionary (or loose) monetary policy* occurs when a central bank uses its tools to increases AD by increasing the money supply and lowering interest rates. A *contractionary (or tight) monetary policy* is the opposite of a loose monetary policy. * In most industrialised countries the central bank is an independent body from the government with the primary responsibility of maintaining a low and stable rate of inflation in the economy. The *European Central Bank (ECB)* is the monetary authority that oversees monetary policy in the euro area (or eurozone) and the *Federal Reserve System* (also simply known as the Fed) is the central bank of the USA. Nations within the euro area have ceded their monetary sovereignty to the ECB, whose principal objective, acting as an independent entity like most central banks, is price stability in the euro area with an inflation target of 2%. ### Aggregate Supply Aggregate supply (AS) is the total amount of goods and services produced by all industries in an economy over a given period of time at a given price level. ### Supply-side policies Supply-side policies are policies aimed at increasing an economy's AS by improving its overall productive capacity. This can be done by increasing the quantity or the quality (productivity) of its factors of production. While the effects of demand-side policies might felt rather quickly, there is usually a long delay between the implementation of supply-side policies and their effects. Graphically, supply-side policies would therefore be translated into a shift in the *long run aggregate supply (LRAS)* curve to the right. There are two schools of thought concerning the shape of the LRAS curve leading to debate about the best type of economic policy to be followed by governments: the *new-classical* (or *monetarist*) view and the *Keynesian* view. * **The new-classical** (or **monetarist**) view describes the LRAS as *inelastic* at *full employment level of output*, which is the maximum level of production an economy can sustain in the long run using all of its factors of production. The LRAS is vertical because a free-market economy is assumed to be efficient in the long run (all prices and costs are fully adjusted given sufficient time) and operating at full capacity at any given price level. This view therefore asserts that in the long run any change in AD would only lead to a change in the average price level and will not lead to a change in real output or employment. New-classical economists therefore argue that real output and employment may only be increased by adopting *supply-side policies* to shift the LRAS to the right. This would also lead to reduced inflationary pressure, as the average price level would fall. * **The Keynesian view** describes the LRAS as having three possible phases: * At low levels of economic activity, the LRAS will be perfectly elastic (horizontal) since there is spare capacity in the economy, such as unemployed labour and underutilised capital. An increase in AD should therefore lead to an increase in real output and employment without inflationary pressure as unused factors of production can be used without incurring higher average costs. * As the economy approaches its maximum output (Yf), the LRAS will become upward sloping as the spare capacity diminishes and producers will have to bid for increasingly scarce factors of production to increase output. An increase in AD should therefore lead to an increase in real output and employment with inflationary pressure as the price level rises to compensate for the higher costs of production. * When the economy reaches maximum output (Yf), the LRAS is perfectly inelastic (vertical) as it becomes impossible to increase output any further since all factors of production are fully employed. This phase corresponds to the LRAS of new-classical economists. Keynesian economists agree that any change in AD at this phase would only lead to a change in the average price level and that the economy's output can only be influenced by changes in the quantity or the quality of its factors of production. ### Interventionist supply-side policies Interventionist supply-side policies involve government intervention aimed at increasing an economy's potential output by increasing the quantity or the quality of its factors of production. * **Investment in infrastructure**. Improvements in transport infrastructure should for example lead to cheaper and faster transportation of goods and people, increasing the productive potential of the economy. Telecommunication infrastructure ensuring fast, stable, and widely available Internet access could be another example. * **Provide subsidies and tax incentives to promote innovation**. Providing companies, public research facilities or universities with incentives to invest in research and development (R&D) of new improved production processes should increase productivity. * **Improvements in education and training**. Improving education and providing companies with incentives to do on-the-job training should lead to an increase in labour productivity as workers improve their skills and flexibility. This would also improve occupational labour mobility, which refers to the ability of workers to change job types. ### Market-based supply-side policies Market-based supply-side policies focus on allowing markets to operate more freely, with minimal government intervention, in order to increase an economy's potential output by increasing the quantity or the quality of its factors of production: * **Reduction in corporate taxes**. If businesses are able to keep more of their profits, then they will have more money available for investment. Lower corporate taxes could also motivate potential entrepreneurs to set up new businesses. * **Reduction in household income taxes**. This could incentivise the economically inactive population to join the labour force and people currently working to work more. * **Reduction in unemployment benefits**. This could provide unemployed workers with a greater incentive to take on available jobs. * **Deregulation**. Reductions in bureaucracy and excessive regulations could reduce costs for companies and encourage investment. Such regulations could include environmental laws, health and safety regulations, or labour market regulations. Deregulating labour markets and granting less power to trade unions (associations of workers formed to protect their rights and interests. Also known as labour unions.) would give companies more freedom in terms of wages, hiring, firing or work hours leading to an increase in labour market flexibility. This could for example lead to a decrease in the number of strikes, make it easier for companies to replace unproductive workers and cheaper to hire new workers. * **Policies to increase competition**. Promoting competition, preventing anti-competitive behaviour or opening state-run monopolies to competition through privatisation could increase productivity as companies become under constant pressure to operate more efficiently. With reference to international trade, policies that make a country more open to international trade (trade liberalisation) are also likely to improve the efficiency of domestic firms. The increase in AS caused by supply-side policies should result in economic growth, lower unemployment, and reduced inflationary pressure. Supply-side policies should also lead to increased exports and therefore improvements in the balance of trade by making firms more productive and competitive on a global scale. Furthermore, several supply-side policies, such as investment in infrastructure, improvements in education, or reductions in direct taxes, have both a demand-side and a supply-side implication, leading to both an increase in the economy's AD and LRAS. ### Disadvantages of Supply-side Policies There are however also some disadvantages to supply-side policies. * While the effects of demand-side policies may be felt quite quickly, it can take quite a long time before the effects of most supply-side policies, such as improvements in infrastructure and education, are seen in the economy. * They can be quite costly to implement and therefore the extent to which they can be provided may be limited by budget constraints as each item of spending in a government budget involves an opportunity cost. * They can also have a negative effect on income distribution and the socio-economic well-being of certain individuals. Corporate tax cuts, reduced unemployment benefits and deregulation of labour markets might for example all contribute to economic inequality and a possible reduction in living standards for unemployed people, low-income households or unionised workers. * Deregulation might lead to negative consequences on the environment if environmental regulations are relaxed, a reduction in worker safety if health and safety regulations are relaxed, and a worsening in working conditions and job security if labour market regulations are changed. * They will also often be strongly resisted by various interest groups such as monopolies or trade unions as they might reduce their power. Supply-side policies are therefore often quite unpopular and hard to implement. * Finally, supply-side policies on their own are not enough to achieve economic growth if the level of AD is not high enough to ensure that the productive capacity of an economy is actually put to use. ### Government budget and national debt When we refer to *government* (or *public*) *spending*, we are speaking about the total spending by all levels of government in an economy, including the national government, regional governments, and local governments. Broadly speaking, these are the main categories of public spending: * **Capital expenditure** includes any spending that adds to the capital stock of the economy, such as the spending on the upgrading of roads or the building of schools and hospitals. * **Current expenditure** tends to be on-going spending such as the payment of wages to public sector employees or the purchases of textbooks in schools. * **Transfer payments** include any benefits paid to people in the economy for which no goods or services are produced in return. These include payments such as unemployment benefits, child benefits, disability payments, and pensions. Governments receive their income (or revenue) from different sources: * **Taxes**. These include the payment of income and wealth taxes by households, corporate taxes imposed on firms' profits, indirect taxes paid on expenditure on goods and services, and tariffs paid on the purchase of imported products. * **Profits**. Governments also earn money from the profits of government-owned (nationalised) businesses or if they sell government-owned businesses. * **Rent**. Income can also be earned when governments rent out government-owned buildings or land. Each year governments issue their *national budgets*, where they lay out their expected revenues and spending for the coming year. If they earn more than they spend it is called a *budget surplus*. If they spend more than they earn it is called a *budget deficit*. If revenues are equal to spending, then it is a *balanced budget*. To finance a *budget deficit* the government will have to borrow money, either from the households and firms within the country or by borrowing from abroad. The government does this by *selling government bonds*. People buy the bonds as a form of saving; they lend money to the government and are eventually paid back, along with extra payment which is the interest paid by the government. When a government runs a deficit in one year this is added to the total *national debt* (also known as *government debt*, *public debt*, or *sovereign debt*) accumulated by the government. Therefore, in any given budget, the government has to allocate some money to paying back the loans and the interest on the loans taken in the past. As debt increases, a greater part of the national budget must be spent on servicing debt repayments. This may mean higher tax payments and also involves an *opportunity cost* in terms of reduced government spending on other things, such as healthcare, education or infrastructure. Governments can use several policies to reduce budget deficits: * **Increase taxes**. The first obvious way to reduce a budget deficit is to increase tax rates. Contractionary fiscal policy will however cause AD to decrease, leading to lower economic growth and a higher rate of unemployment. This can eventually lead to a higher budget deficit as governments tend to get less tax revenue in periods of economic downturn. From a political standpoint, higher taxes are also highly unpopular and might lead to social unrest. Another reason why these tax rate increases can be quite ineffective in reducing the budget deficits for eurozone member states is that these nations can't simultaneously pursue a loosening of their monetary policy as they have ceded their monetary sovereignty to the ECB. * **Decrease government spending**. The second obvious way to reduce a budget deficit is to reduce public spending. This usually means less money spent on infrastructure and public services and, like tax increases, this could also lead to lower economic growth and a higher rate of unemployment as AD decreases. During the European debt crisis that started at the end of 2009, many European countries, including Ireland, Greece, Portugal, and Spain, cut government spending in order to try and reduce their budget deficits. However, these spending cuts contributed to a decline in economic growth, leading to lower tax revenues and rising debt-to-GDP ratios for these countries. Cutting public sector investment will have a big adverse effect on AD and the supply side of the economy. Cutting pension spending by making people work longer is however a solution that shouldn't greatly reduce AD and may simultaneously lead to an increase in the economy's productive capacity. There is therefore a temptation for governments to increase the legal retirement age as this can reduce public spending with less impact on economic growth. * **Economic growth**. An effective way to reduce the budget deficit as a percentage of GDP is to promote economic growth. If the economy grows, then tax revenue will increase without raising tax rates. With economic growth, firms pay more corporate tax, workers pay more income tax, and consumers pay more VAT. Economic growth is the least painful way to reduce a budget deficit because tax rates don't need to be raised and government spending doesn't need to be cut. * **Bailout**. A *bailout* can be defined as an act of providing financial assistance to a failing economy or business to save it from collapse. In some circumstances, countries can be eligible for a bailout from international organisations, such as the *International Monetary Fund (IMF)* or the *European Stability Mechanism (ESM)*. A bailout may reassure investors and give the country valuable time to deal with its budget deficit. Bailouts however usually come with strict austerity measures. Austerity refers to policies that aim to reduce budget deficits through tax increases, government spending cuts, or a combination of both, in order to facilitate the repayment of public debts. * **Default**. *Sovereign default* is defined as a failure in the repayment of a county's public debts. Sometimes countries have got to the stage where it has become impossible to manage their budget deficit. Therefore, they may have no choice but not to pay, or only partially pay, their debts. Sovereign countries are generally not subject to normal bankruptcy laws and may therefore be able to default without legal consequences. The defaulting country and the creditor are thus more likely to renegotiate the length of the loan, the principal payments, or the interest rate. Countries are however usually very hesitant to default on their debts, since doing so destroys the savings of investors, including domestic ones, and will lead to a loss of confidence in the government, making borrowing funds in the future very difficult and expensive. To reduce budget deficits, governments are likely to use a combination of policies. A key factor is the timing of these policies. It is much harder to reduce the deficit if the country is already in recession because contractionary fiscal policy tends to worsen the economic situation leading to lower tax revenues. The most sensible way to reduce budget deficits is often to achieve economic growth while maintaining a sustainable level of taxes, government spending, and national debt. Clamping down on tax evasion and wasteful or corrupt public spending is also often crucial in reducing budget deficits. The *Stability and Growth Pact (SGP)* is a set of rules designed to ensure that countries in the EU pursue sound public finances and coordinate their fiscal policies. To ensure that fiscal discipline is maintained, the SGP requires each EU Member State to limit government deficits to 3% of GDP and public debt levels to 60% of GDP. If the public debt is above this level, it should decline each year with a satisfactory pace towards a lower level. If a Member State does not comply with both the deficit limit and the debt limit imposed by the SGP, and corrective actions continue to remain absent after multiple warnings from the European Commission, the country can ultimately be issued economic sanctions. While the main goal of the SGP is to maintain economic and financial stability in the EU, it also limits the freedom of Member States over their fiscal policy as both tax cuts and expenditure increases tend to worsen government deficits.