Macro Government Policies PDF

Macro Government Policies Macro Topic 3 FIS Grade 12 Government policies Demand side policies: Fiscal policy Monetary policy Supply side policies Government policies - Fiscal Policy Fiscal policy - where the government adjusts the economy by changing either government expenditure,...

Macro Government Policies Macro Topic 3 FIS Grade 12 Government policies Demand side policies: Fiscal policy Monetary policy Supply side policies Government policies - Fiscal Policy Fiscal policy - where the government adjusts the economy by changing either government expenditure, taxation or both. [Taxes include both direct taxes and corporate taxes] Expansionary fiscal policy - when the government intervenes in the economy and either decreases taxation, increases government expenditure or both. “Loose” policy Deflationary/Contractionary fiscal policy - when the government intervenes in the economy and either increases taxation, decreases government expenditure or both. “Tight” policy Expansionary fiscal policy is when the government intervenes in the economy and either decreases taxation, increases government expenditure or both. As AD= C+I+G+(X-M), an increase in government expenditure (G) and a decrease in tax (which will lead to an increase in real incomes and therefore consumption (C)) will increase aggregate demand. This will shift out the AD curve from AD to AD1, increasing price level from P to P1 and increasing output from Y to Y1. The overall effect on the economy will be higher prices and greater levels of output. Contractionary fiscal policy is when ….. Sample Paper 2 question - May 23 SL Expansionary Fiscal Policy - Sources of Revenue If the government decides to spend more than it earns in tax revenue (a budget deficit) it needs to be able to fund this spending. There are a variety of sources of revenue. Direct and indirect taxation Sale of goods and services from state-owned enterprises Sale of government assets They can also adjust their expenditures: Current expenditures Capital expenditures Transfer payments Expansionary Fiscal Policy - Sources of Revenue 2 Funding a budget deficit can be done in a variety of ways: Printing money - not a popular choice as this will most likely lead to inflation Borrowing from overseas - this is where the government borrows from international sources. This is successful if the stimulus to the economy is such that it leads to an increase in GDP and thus an increased capacity to pay. However, if the government spending “crowds out” private spending and does little to stimulate the economy then the subsequent loan repayments can be harder to pay. Borrowing domestically (open market operations) - this refers to when the government buys and sells bonds in the market. If the government chooses to raise funds to finance a budget deficit it may do so by selling bonds on the open market. ○ A bond is a security in which investors pay a premium today, earn interest over a period of say, five years, after which the original premium is repaid. ○ However this simply transfers money from the private banking sector (as investors are using their savings that would otherwise go to banks) to the public sector. EVALUATION: Some argue that these funds would be better off in the control of the private sector as the market mechanism will direct these funds into firms who are the most competitive, the most efficient, and the most profitable. The government intervening in the economy, simply distorts the allocation of funds available for investment. At the same time, as the private and public sector compete for funds, they will simply drive up the interest rate. In this way, the private sector is “crowded out” of the economy. Goals of fiscal policy Low and stable inflation Low unemployment Promote a stable economic environment for long-term growth Reduce business cycle fluctuations Equitable distribution of income External balance Close deflationary/recessionary and inflationary gaps Evaluating the Effectiveness of fiscal policy Constraints on fiscal policy ○ Political pressure ○ Time lags ○ Sustainable debt ○ Crowding out (HL) Strengths of fiscal policy ○ Targeting of specific economic sectors ○ Government spending effective in deep recession Automatic Stabilizers (HL) Strengths and limitations in promoting growth, low unemployment, and low and stable inflation rate Fiscal Policy Review video (8 mins) The Limits of Fiscal Policy video (7 mins) Keynesian Multiplier - HL Only (used to fill a deflationary gap) A multiplier is the ratio of change in the level of national income to an initial change in one or more injections into the circular flow model (I, G, C). It assumes… That the government is increasing expenditures or businesses are increasing investment That we are only looking at one instance, not a continuous flow That AD rises  Explain the multiplier effect of injections on national income Any injections are multiplied through the economy as people receive a share of the income and then spend a part of what they receive. Each injection back into the economy undergoes the cycle again, as extra spending on domestic goods and services is induced by the extra income earned.  Calculate the value of the multiplier Multiplier = 1 or 1 or 1 1-mpc mps + mpm + mrt mpw mpc is marginal propensity to consume mps is marginal propensity to save mpm is marginal propensity to import mrt is marginal rate of tax mpw is marginal propensity to withdraw For example… See also exercises on page 201 Accelerator Effect (HL) - Removed from this syllabus Due to depreciation (loss of value over time, equipment wears out), all capital equipment must be replaced over time, which requires investment. An accelerator is the relationship between the level of induced investment and the rate of change of national income. It explains the level of investment in society Induced investment the incentive to invest in new equipment to meet an increase in AD and increase capacity. It assumes ○ At full employment, to increase output, you need to invest. ○ Firms are working at full capacity and spending a constant amount on investment to maintain capital level ○ Firms want to maintain a fixed capital output ratio (Number of items produced: number of machinery - E.g. 20 000 toasters : 20 machines) Explain the accelerator effect of investment on national income: If incomes rise, AD will rise, so firms will increase investment to increase capacity The level of induced investment will be determined by the rate of change of national income Multiplier/Accelerator effect: Induced investment is subject to the multiplier which increases income farther and explains the upward momentum of the business cycle. Crowding Out (HL) Crowding out occurs when public sector spending replaces private sector spending. Reading Let’s say that the government wishes to stimulate the economy through increasing government expenditure on infrastructure e.g. Hong Kong wish to build a tunnel under Victoria Harbour. An increase in government expenditure (G) will shift out aggregate demand curve from AD to AD1, increasing price level from P to P1 and increasing output from Y to Y1 (diagram 1). However, in order to pay for the tunnel, the government may choose to obtain funds by borrowing domestically. The government may choose to sell bond, and thereby compete directly with the private sector for funds. This competition will simply drive up the interest rate from r to r1 (diagram 2). As the interest rate rises, other firms that would invest in other projects may find it too expensive to do so - and overall investment in the economy will fall. This decrease in investment (I) will shift back the aggregate demand curve from AD1 to AD2. The price level will fall from PL1 to PL2 and output will fall back from Y1 to Y2. Fiscal Policy and Crowding Out video (5 mins) When implementing expansionary fiscal policy, governments need to consider the extent to which crowding out will occur. Complete crowding out is extremely likely to occur if the private sector is willing to invest. For example, if the economy is expanding and there is a lot of producer and consumer confidence (upwards sloping section of the AS curve) then firms will be much more sensitive to changes in the interest rate. A higher interest rate might dissuade firms from investing - thereby reducing the effectiveness of fiscal policy and making crowding out more likely to occur. However, if the government stimulates the economy in times when the private sector is unlikely to invest anyway (such as during recessions - the horizontal section of the AS curve) then crowding out is less likely to occur. In this way the government is stimulating AD by injecting funds into the economy that were sitting idle elsewhere. In this case ‘crowding out’ will not occur. Note, also that the type of government spending matters. If investment is financed and many firms exist, growth will be different. LDCs need infrastructure and financing is mostly from foreign sources, which has less effect on interest rates but causes other problems. Investment comes from several sources and is highly influenced by the interest rate. If interest rates are high, then firms may prefer to put their profits into the bank to earn higher returns as savings rather than use them to invest. There is an inverse relationship between interest rates and the level of investment. Whether or not crowding out does occur and the extent to which it might occur is a subject of much debate. Keynesian economists say that it will not occur if the economy is producing at less than full employment. The new classical economists, who are opposed to the use of demand management policies, argue that crowding out is a significant problem of increased government spending. Automatic stabilizers (HL) Explain how factors including the progressive tax system and unemployment benefits, which are influenced by the level of economic activity and national income, automatically help stabilize short-term fluctuations. In macroeconomics, automatic stabilizers are features of the structure of modern government budgets, particularly income taxes and welfare spending, that act to dampen fluctuations in real GDP. The best-known automatic stabilizers are corporate and personal taxes, and transfer systems such as unemployment insurance and welfare. Automatic stabilizers are so called because they act to stabilize economic cycles and are automatically triggered without explicit government action. Policies or institutions (built into an economic system) that automatically tend to dampen economic cycle fluctuations in income, employment, etc., without direct government intervention. For example, in boom times, progressive income tax automatically reduces money supply as incomes and spendings rise. Government policies - Monetary Policy Monetary Policy is where the government adjusts the economy by changing the interest rate or the money supply. The interest rate refers to the price of money, and affects the decisions of firms to invest. A very important component of aggregate demand is investment (AD = C + I + G + (X - M)). Investment refers to the increase in the capital stock. Firms will choose to increase the capital stock when the price to do so is low. The price to increase the capital stock is the interest rate. It follows that at high rates of interest, firms will be less likely to invest, and the level of investment will fall. Low interest rates will encourage investment, and will lead to an increase in aggregate demand. However, monetary policy not only affects the demand side of the economy, but the supply side as well, and of course the exchange rate. An increase in the capital stock will increase the capacity of the economy to produce and will push out the aggregate supply curve. Goals of Monetary Policy Low and stable inflation rate ○ Inflation targeting refers to the practice of central banks using monetary policy to achieve a specific rate of inflation. This is pursued by many countries such as Canada, Finland, NZ, South Africa, and UK. Price stability will enhance consumer and business confidence in the economy. ○ Reading: Rate Cuts Needed to Defend Fed’s Inflation Target Low unemployment Reduce business cycle fluctuations Promote a stable economic environment for long-term growth External balance - the value of a country's export earnings being equal or approximately equal to the value of its import expenditure  Also known as ‘loose’ or ‘easy’ monetary Expansionary Monetary Policy policy. Expansionary Monetary Policy is where the government decreases the interest rate in order to stimulate the economy. They aim to boost economic activity by expanding the money supply. A decrease in the interest rate will make it cheaper for firms to invest (I) and thus push out the aggregate demand (AD = C + I + G + (X - M) curve from AD1 to AD2. This will increase the output from Y1 to Y2 and increase the price from P1 to P2. HOWEVER: This diagram is almost the same as the fiscal policy diagram, and this is complete acceptable for an IB paper 2 response. However, some textbooks will also indicate a double shift with an increase in AS as well - see next slide. This is useful for discussing pros/cons and evaluation of the different policies. This type of diagram would also be acceptable, but is unnecessary. As firms buy more investment goods, this will increase the capital stock and thereby increase the capacity of the economy to produce. This will shift out the aggregate supply curve from AS to AS1. Overall, output will rise from Y to Y1, but the effect on price level will be indeterminate. Why is price indeterminate? Because we cannot tell if the increase in capacity is proportionate to the increase in investment. Contractionary monetary policy is... Guardian article: ECB moves to promote growth (also known as ‘tight’ monetary policy) Advantages of expansionary monetary policy An increase in investment will increase the capital stock, thereby increasing the capacity of the economy to produce in the long run. In this way, an economy may be able to push out its physical limit. As investment increases, more and more labour is replaced by capital. This may free up labour resources which may be used elsewhere in the economy. Used to control inflation and manage the private sector Success/effectiveness of Monetary Policy The determinants of success are: Constraints on monetary policy, including ○ Limited scope of reducing interest rates, when close How accuracy were the inflation forecasts? to zero Were there time lags ○ Low consumer and business confidence Can we see the Interest Strengths of monetary policy, including elasticity of demand? ○ Incremental, flexible, easily reversible Are the effects equally ○ Short time lags shared? (usually not) Strengths and limitations in promoting Was the currency value impacted? (YES!) growth, low unemployment, and low and What are the inflation stable inflation rate expectations? How is Government debt? Example: In Japan, monetary policy When else is monetary policy not usable? is ineffective because they have deflation. From paper 3 (M18). NOTE: The increase in investment could be due to a change in interest rates, but this is not made clear. How the US Reserve Bank sets interest rates BBC Article Below see US interest rates since 1955: 2022 Real vs. Nominal Interest rates Interest rate is the price of money, expressed as a percentage, and represents the cost of borrowing money or the return for savers. Nominal interest rate - the actual rate that is agreed between a bank and the customer (i.e. the rate borrowers pay on their loans or the return savers receive on their cash deposits) Real interest rate - the impact of inflation on the return to savers and the cost of debts to borrowers. It is possible to have a negative real interest rate. Real interest rate = nominal interest rate - Inflation rate Example: If bank pays savers nominal interest rate of 2% but inflation is 1.5% then the real return is only 0.5%. Turkey’s Erdogan reportedly fired his central bank chief for refusing to slash interest rates The process of money creation by commercial banks (HL Only) One of the key functions of commercial banks is to bring together savers and borrowers in a process called credit creation (the process by which banks create money from the deposits of savers and borrowers). Interest rate charged to borrowers (e.g. 5%) must be greater than the return paid to savers (e.g. 1%) so that the bank earns a profit and safeguards the bank from the fall in real value of loans due to inflation. Borrowers rarely withdraw all their money so the bank may lend 90% of this in the form of loans, but this is regulated by the government and called the minimum reserve ratio (in this case it would be 10%). The process of money creation by commercial banks (HL Only) - continued Minimum reserve ratio = the lowest amount that commercial banks are required to keep as reserves in the central bank, thus limiting how much they can lend and how much credit they can create. Money multiplier = the formula used to calculate by how much an initial deposit (savings at a bank) increases the money supply. The formula is : Money multiplier = 1 ÷ Reserve ratio  Tools of monetary policy (HL only) Open market operations (OMO) - the buying and selling of government securities (a type of public sector debt) by a country's central bank to influence the interest rate ○ Includes sale of bonds - backed by government and so are regarded as safest/low risk investments ○ If the government needs the money supply to fall to slow inflation, they sell securities so it is seen as contractionary monetary policy as it withdraws money from the economy ○ If they need to increase the money supply and stimulate AD they purchase securities (expansionary monetary policy) Minimum reserve requirements (MRR) - see money creation section ○ Raising the MRR limits growth in money supply and lowers C and I => contractionary monetary policy ○ Reduce the MRR - expansionary monetary policy Tools of monetary policy (HL only) -2 Changes in the central bank minimum lending rate (MLR) also known as the base rate/discount rate/refinancing rate ○ Minimum lending rate - the official rate of interest charged by the central bank on loans to commercial banks. The central bank will not lend money below this rate. ○ It influences the interest rates charged on credit transactions, bank loans and mortgages. ○ Raising the MLR - contractionary monetary policy ○ Lowering the MLR - expansionary monetary policy Quantitative easing (QE) - a form of monetary policy that injects money directly into the economy increasing the monetary supply via the central bank purchasing corporate bonds. ○ Bonds are a form of government debt security - the institutions selling these bonds to the government, such as commercial banks or insurance companies then have ‘new’ money in their accounts or an increase in their liquidity (cash reserves) and this boosts the money supply and promotes lending. ○ A liquidity trap is when the MLR cannot be cut any further, which makes traditional expansionary monetary policy ineffective - a sign that banks are reluctant to lend and consumers are reluctant to borrow due to lack of confidence in the economy - so they use QE..  (HL only) Demand and supply of money - determination of equilibrium interest rates The interest rate can be described as the return for lenders of money or the price of borrowing money. The equilibrium interest rate is determined where demand for a supply of money intersect. Demand for money - desire to hold money rather than save it to finance consumption and current expenditure. The opportunity cost of holding money depends on the interest rates Supply of money - total money circulating including bank notes and coins, bank deposits, loans and credit. Increase in money supply decreases interest rates and vise versa. Vertical at Q1 because it is fixed by central bank at any one point in time. The price of money is the interest rate. Demand and supply of money - determination of equilibrium interest rates (HL only) What does the government consider when setting interest rates? The state of the economy The rate of growth of nominal wages Business confidence levels House prices The exchange rate Controlling the money supply is difficult - banks can create credit fairly easily and thus it is difficult to accurately control it. Government policies - Supply Side Policies Supply side policies are any government policies that improve the quantity or quality of the factors of production and allow an increase in the capacity of an economy to produce. They are designed to increase competition and therefore efficiency. If the productivity of an industry improves, then it will be able to produce more; with a given amount of resources, shifting the aggregate supply curve to the right from AS to AS1, increasing output from Y to Y1 and putting downward pressure on price from PL to PL1. All of the following policies are, in some way or another, trying to increase the level of competition in product markets or in labour markets. Goals of Supply-side policies Long-term growth by increasing the economy’s productive capacity Improving competition and efficiency Reducing labour costs and unemployment through labour market flexibility Reducing inflation to improve international competitiveness Increasing firms’ incentives to invest in innovation by reducing costs  Market based policies Supply Side Policy Tools 1. Removing labour market rigidities - this refers to removing the rigidities that may stop labour markets from moving into equilibrium. (Syllabus specifically identifies these ones) ○ Reduce the power of trade unions ○ Reduce unemployment benefits (Reduce welfare to increase the opportunity cost of being employed) ○ Remove/abolish minimum wage ○ Increase training programs for the unemployed ○ Increase employment agencies to help link unemployed with vacancies ○ Increase the time period to qualify for unemployment benefits e.g. you must be out of work for 6 weeks before you can collect benefits ○ Link welfare benefits to training ○ Change the minimum/maximum working age Supply Side Policy Tools - continued Market based policies 2. Incentive related policies: Encouraging firms to increase output and individuals to work ○ Personal income tax cuts ○ Cuts in business tax and capital gains tax (tax paid on the profit earned on a fixed asset when it is sold). Decrease profit tax. ○ Offer tax deductions on the purchase of capital goods 3. Policies to encourage competition: Privatisation - the transfer of ownership from the public sector to the private sector (i.e. sell off government assets). The privatisation of various large former state-run industries (telecommunication, electricity, water, steel, gas, rail, etc.) are designed to break up the state monopolies to create more competition. As these firms start to use the profit motive to make output decisions they have incentive to pursue the least cost method of production and in doing so become more efficient, pushing out aggregate supply.  Market based policies Supply Side Policy Tools - continued 4. Policies to encourage competition: Deregulation - removing government regulations regarding production decisions for industries e.g. safety standards on airlines. Deregulation means the opening up of markets to greater competition. E.g. allowing Easy Jet to enter the airline market. The discipline of increased competition should lead to greater cost efficiency from producers -- who are keen to hold onto their existing market share. 5. Policies to encourage competition: Trade liberalization - i.e. Commitment to free trade - many countries sign trade agreements brokered by the WTO. Trade creates competition and should be a catalyst for improvements in cost and lower prices for consumers. Supply Side Policy Tools - continued Market based policies 6. Policies to encourage competition: Anti-monopoly regulation - Laws that control or limit the restrictive practices and market power of dominant firms in an industry protect the interests of consumers against anti competitive behaviours or monopolies. Examples: investigations by agencies, price controls/price ceilings, regulations of mergers and takeovers 7. Measures to encourage small business start-ups. Government policy initiatives designed to stimulate new businesses may include: Business start-up grants Loan guarantee schemes Lower rates of corporation tax for small businesses Investment allowances and regional policy assistance for new business start-ups in some area Supply Side Policy Tools - continued Interventionist policies 8. Increased spending on Education and Training Government spending on education and training may improve workers human capital. They become better quality workers. Their productivity improves and so the LRAS curve shifts to the right, promoting growth in output and employment. 9. Improving quality, quantity and access to health care - this improves the lives and thus the productivity of workers 10. Research and development - the process of business activities to improve, introduce and innovate products, processes and procedures Supply Side Policy Tools - continued Interventionist policies 11. Provision of infrastructure - The physical and organisational structures and facilities of an economy that are necessary for the operations of society as a whole, including transportation networks, telecommunications, electricity grids, waste/sewage disposal systems. Providing/investing in infrastructure helps facilitate more efficient and productive output in a more cost efficient manner, attracting more investment from both domestic firms and multinational companies. 12. Industrial policies target specific key industries to promote economic growth and employment. Reading: pro market policies You first saw this when learning about Aggregate Supply. Market oriented vs. Interventionist Supply Side Policies (see P2 M18 Q1d) Analysis of supply side policies Demand-side effects of supply side policies Supply side effects of fiscal policies Effectiveness of supply-side policies ○ Constraints on supply-side policies Market based - equity issues, time lags, vested interests, environmental impact Interventionist - costs, time lags ○ Strengths of supply-side policies Market based - improved resource allocation, no burden on government budget Interventionist - direct support of sectors important for growth ○ Strengths and limitations in promoting growth, low unemployment and low/stable inflation rate When are Supply Side Policies most effective? What are the drawbacks of using supply side policies? Specific policy drawbacks? Market based policies? Interventionist policies? Resources Money as Debt (documentary - 45 mins) How long will interest rates stay low - Monetary Policy Barn Dance Fiscal Policy (video) Fiscal policy and the multiplier (video) Monetary Policy Part 1 (video) Monetary Policy Part 2 (video) Showing Economic Growth There is a difference between short term growth (actual growth on PPC model, role of AD in the AD/AS model) and long term growth (shifts in PPC production possibilities, role of LRAS in AD/AS model) Economic Growth and the PPC Production Possibilities Curve Economic Growth and the PPC Explain, using a PPC economic growth as an increase in actual output resulting from factors such as the utilisation of unemployed resources and increases in productive efficiency, leading to a movement of a point inside the PPC to a point closer to the PPC. Explain using a PPC diagram, economic growth as an increase in production possibilities caused by factors including increases in the quantity and quality of resources, leading to outward PPC shifts. Essential to achieving economic growth are increased investment and improved productivity. Economic Growth and the PPC Economic growth and the AD curve AD increases showing increases in real output Economic growth and the LRAS curve LRAS increases showing increases in full employment output What are the consequences of economic growth? Impact on living standards Impact on the environment Impact on income distribution e.g. Why the wealth gap has grown despite Economic growth HL Policy Questions (10 points) Macro goal: sustainable level of government (national) debt - HL ONLY - From Syllabus Measurement of government (national) debt as a percentage of GDP Relationship between budget deficit and government (national) debt Costs of high government (national) debt ○ Debt servicing costs ○ Credit ratings ○ Impacts on future taxation and government spending Measurement of government (national) debt The Debt to GDP ratio shows a country’s national debt as a percentage of their GDP (national income). Looking at nominal or absolute numbers makes it difficult to compare between countries or historically, so we need to compare the debt to the GDP. Visit here for some statistics: https://worldpopulationreview.com/cou ntry-rankings/debt-to-gdp-ratio-by-coun try From: https://worldpopulationreview.com/country-rankings/debt-to-gdp-ratio-by-country Relationship between budget deficit and government (national) debt There is a direct relationship between a budget deficit and government debt. Every time a government runs a budget deficit it adds to the national debt. Government debt is the accumulation of all the budget deficits of previous years. US Debt hits record: Should you worry? US Debt year by year compared to events and GDP (another version here) Costs of high government (national) debt 1. Debt servicing costs refer to the money that is required to cover the payment of interest and principal on a loan or other debt for a particular time period. Sometimes countries can only afford to pay back the interest, and the principal amount does not change, so the loan seems like it will never get paid off. 2. A credit rating is a measure of a borrower’s ability to repay a loan. A high credit rating means borrower has good credit history and is perceived to have a low level of risk. It depends on: Borrower’s previous credit record Amount the borrower needs Amount of existing loans The income of the borrower (i.e. real GDP of a country) Costs of high government (national) debt 2 3. Impacts on future taxation and government spending National debt that is not managed and repaid simply continues to increase, making it even more challenging to pay off. The likely impact of this is austerity measures (cutbacks in fiscal spending in order to repay the debt + increases in taxes). Example: Spain and Greece during the financial crisis in 2008 New York Times: German Government Slashes Spending, Except on the Military (from July 2023) - pdf version What are some real-world examples of policies? (Assignment on Canvas)