Macro-Retake Notes PDF

Macro- measures of economic performance Macro economic objectives: T rade I nflation G rowth E mployment R e-distribution of income S tability Other possible objectives: Stable government finances The circular flow of income: GDP methods: Output=Income=Expen...

Macro- measures of economic performance Macro economic objectives: T rade I nflation G rowth E mployment R e-distribution of income S tability Other possible objectives: Stable government finances The circular flow of income: GDP methods: Output=Income=Expenditure Aggregate Demand AD = C + I + G + (X-M) Why there might be extensions and contractions on the AD graph 1. The wealth effect (c) as the price level decreases, the purchasing power of people increases 2. The trade effect (X-M) as price level decrease exports become more competitive and imports become less competitive - If exports are higher in demand revenue will increase, increasing X - M will be less as domestic goods would be cheaper 3. Interest effect (C,I and (X-M)): as price level decreases interest rates can be kept lower in the economy as most central banks will adopt interest rate policy to meet an inflation target. - People will consume more - People will invest more - Reduced the value of the exchange rate so exports are higher Why there might be shifts on the AD graph - Nothing to do with changes in the price level  Determinants of consumption Marginal propensity to consume Reasons consumption could either increase or decrease independent of price level: 1. Level of real disposable income (income tax) - increases the marginal propensity to consume 2. Interest rates - cost of borrowing falls, rate of return on savings fall - increases marginal propensity to consume/ Availability of credit - banks are not willing to lend 3. Consumer confidence - Job prospects - Level of unemployment (low) 4. Asset prices - the wealthier people feel, the more likely they are to spend money 5. Household indebtedness Determinants of Savings, i.e less consumption Reasons savings could either increase or decrease independent of price level: 1. Level of real disposable income - when incomes rise consumption increases as well as savings 2. Higher interest rates means more savings ( higher rate on return) 3. Level of consumer confidence -this can be caused by changes in house prices, unemployment rate, inflation etc. 4. Range/Trustworthiness of financial institutions - in developing countries banks may be corrupt and unofficial so people might be reluctant to save + education - people are not educated on the benefits of using a bank 5. TAX incentives e.g ISAs - Individual saving accounts that aqre tax-free 6. Age structure of the population - middle aged individual is more likely to save for their children and for their retire Determinants of Investment Reasons Investment could either increase or decrease independent of price level: Definition of investment in economics : when firms spend money on Capital goods to increase their productive capacity 1. Interest rates - when interest rates are low firms have more incentive to borrow and invest + the hurdle (the required rate of return that firms need for investment projects to go ahead) if interest rates are low reaching the hurdle becomes easier 2. Business confidence: - Expected profit - Expected demand in the economy Marginal propensity to invest will be higher to meet future demands 3. Corporation tax - if corporation tax is low, businesses will have more retained profit to then invest - retained profit - the amount of a business's net income that is kept within its accounts, rather than paid out to shareholders 4. Spare capacity - if businesses have a lot of spare capacity there is no need to buy more machinery, therefore no need to invest 5. Level of Competition + Level of Technology - strong competition means firms will try to invest more to reach the level of efficiency other businesses are at 6. Price of Capital machinery - The accelerator effect: when there is an increase in the rate of real GDP in an economy, which then encourages further investment ( as they want to ensure they can handle higher demand) Determinants of Government spending What can governments spend their money on: 1. Current Spending e.g maintenance of public services and payment of public sector wages 2. Capital spending e.g infrastructure projects 3. Welfare spending e.g benefits and pensions - These would all shift AD to the right 4. Debt interest payments Budget deficit : G>T - when government spending is greater than tax in a fiscal year Budget surplus : G tax revenue in a year Structural budget deficit: Budget deficit when the economy is at full employment Cyclical budget deficit: Budget deficit in a recession National debt: the total shock of gov. Debt over time Running a budget deficit/ increasing in national debt implies there must be increases in government spending/ low taxation Pros Cons 1) Higher growth, Lower 1) Deterioration of government Unemployment finances - burden on future 2) Benefits of government spending ( generations education, healthcare, 2) Inflation conflict infrastructure, public services) 3) Current account deficit conflict 3) Redistribution of Income 4) Crowding out effect - could crowd 4) Incentives of Tax cuts - an out the private sector + increase incentive for greater demand for loanable funds entrepreneurship, more 5) X-inefficiency immigration, the incentive to be more productive 5) Crowding in - promote more private sector investment Evaluations: 1) State of government finances - if the government has high budget deficits and high debt the cons will outweigh the pros 2) SRun + LRun impacts 3) Stage of the economic cycle in recession pros, in a boom it is a time to mend government finances 4) Specific policy used 5) consumer/business confidence 6) Role of the automatic stabilizers - if they are already strong more policies are not needed  Budget surplus/ national debt Budget surplus: tax revenue > government spending Structural budget surplus: budget surplus at full employment Cyclical budget surplus: budget surplus in a boom National debt: total stack of gov. Debt over time Running a budget surplus/ bad national debt implies less government spending and higher taxation Pros Cons 1) Confidence in government 1) Demand side shock - reducing AD finances - translates to improved can cause lower growth, higher credit ratings on government unemployment, and lower living bonds- governments can borrow standards and fund public services 2) Micro and macro impacts - 2) Flexibility with fiscal policy - education e.g. larger class sizes, emergency funding of healthcare e.g. longer wait times, expansionary fiscal policy, public and infrastructure. services, etc. 3) Long-run returns of higher 3) Less crowding out - won't be as government spending and lower much pressure on borrowing - taxation lower interest rates / 4) Incentives distortion of higher x-inefficiency - less wasteful taxation - lower incentives to spending work, entrepreneurship and 4) Lower inflation and current higher emigration - increase in account deficit corporation tax means lower incentives for businesses to invest 5) Risk of income inequality Evaluation: 1) Is it necessary? 2) Debt/GDP rising? 3) Policy used 4) stage of the economic cycle  Monetary policy Changes to interest rates, the money supply, and the exchange rate by the central bank to influence AD Expansionary monetary policy ( policies Contractionary monetary policy ( policies to increase AD) to decrease AD) 1) Increase inflation (central bank 1) Reduce inflation (central bank mandate) mandate) 2) Increase growth 2) Prevent asset/ credit bubbles 3) Reduce unemployment 3) Reduce excess debt + promote saving 4) Reduce current account deficit Expansionary Monetary Policy Transmission Mechanism: 1) Lower credit card interest, saving, and mortgage rates- increase consumption 2) Lower rates on business loans - increase investment 3) Weaker exchange rate - boost in net exports Expansionary monetary policy - lower interest rates Cons: 1) Demand-pull inflation 2) Current account deficit 3) Liquidity trap - interest rates will lose their effectiveness when they hit their lower bound 4) Negative impact on savers 5) Time lags Evaluation: 1) Size of the output gap 2) Consumer confidence - job prospects 3) Business confidence - confident in expectations about demand a profitability for their business 4) Banks' willingness to lend/pass on the full cut 5) Size of the rate cut - needs to be big so that consumers can borrow more easily  Contractionary monetary policy - higher interest rates Pros Cons 1) Decreases demand-pull inflation - - Shocks: however, if there is cost-push 1) Lower Growth inflation higher interest rates 2) Higher unemployment would be ineffective 2) Discourage Household/ corporate 3) Impact on the indebted - more debt - encourages only the expensive to pay loans, individuals who need to borrow bankruptcy - homelessness, (more sustainable) business bankruptcy - rising 3) Encourage saving - pensioners, unemployment the unemployed, and the retired 4) Reduces investment will benefit - safety net for 5) Worsening CA deficit via exchange households rate strengthening - high interest 4) More affordable housing - rates - hot money inflow - increasing cost of mortgages you increasing demand for the pound - call cool down demand for housing increasing the exchange rate - - reducing the rate of growth for imports become cheaper housing prices - improves social mobility + standards of living 5) Reduce CA deficit 6) Flexibility for expansionary monetary policy Supply-side policies Policies designed to increase the economy's productive capacity, shifting LRAS to the right. 3 main reasons why the LRAS curve may shift to the right: 1) Increase the quantity of factors of production 2) Increase the quality of factors of production 3) Increase productive efficiency Interventionist SSPs: 1) Gov. spending on education/ training 2) Gov. Spending on infrastructure 3) Subsidies to firms to promote investment Market-based SSPs: Tax reform: 1) Lower-income tax - an incentive for those outside the labor force to enter - increases the quantity of labor, also increases productivity 2) Lower Corporation tax - more retained profits for investment purposes Labor market reform: 1) Reduce benefits 2) Reduce min wages 3) Reduce trade union power Competition policy: 1) Privatization 2) Deregulation 3) Trade liberalisation Cons/ Evaluation: 1) There is no guarantee of success - subsidies, gov spending, etc. 2) Cost 3) Time Lags 4) Negative stakeholder impacts - environment, worker safety, consumer safety - laws taken away can have some negative effects on society 5) Output gap - if the economy is in a recession SSPs are going to be useless 6) Need for targeted SSPs Policies to increase growth Short-run growth: Expansionary fiscal ( increases in government spending or reductions in tax) /monetary policy ( cut in interest rates or quantative easing) e.g Evaluation: 1) Conflict of objectives- demand pull inflation if output gap is small 2) Gov.finances 3) Consumer/business confidence e.g in a recession the effect of theser policies will be limited 4) Time lag Long run growth - if economy is functioning with full employment: Supply side policies - interventionist or market based Evaluation: 1) No guarantee of success 2) Interventionist policies can be very costly 3) Time lag 4) Market based polisices can have negative stakeholder impacts Type of growth needs to be strong, sustained, sustainable.  Policies to reduce unemployment: Cyclical unemployment - occurs in a recession when AD is very low Expansionary fiscal/monetary policy to achieve economic growth problems : Current account deficit from the sucking in of improts as more households gain money to spend Real wage unemployment - when wages in the labour market are forced above the equilibrium 1) Reduce minium wages 2) Reduce the power of the trade unions Evaluation: i) impact on workers and their living standards ii) income inequality Structural unemployment- Immobility of labour ( occupational and geographical ): Interventionist SSPs: 1) Government spending on education 2) Subsidies for in work training 3) Government spending on infrastructure 4) Grants or low cost housing Market based SSPs 1) Reduce benefits 2) Deregulate hiring / firing laws - employees will have an incentive to hire the low skilled workers and train them as they know that can just fire them later if they dont meet their needs frictional unemplyment - workers that are between jobs Interventionist SSPs: 1) More and better resources for job centers 2) Subsidies to private job agencies 3) Government spending on infrastructure Market based SSPs: 1) Reduce benefits Evaluation for both - No guarantee - Cost - Stakeholder impacts  Policies to reduce inflation Demand pull inflation: Contractionary Monetary/ fiscal policy Evaluation: 1) Conflict of objectives - lower economic growth and higher unemployment 2) Impact of investment - puts off firms from investing, lower productivity, worsening of the competitiveness of the economy 3) Impadt on the indebted 4) Strong exchange rate - current account deficit Cost push inflation ( often short term causes e.g weak exchange rates or high production costs) : 1) Implement/ reduce inflation target 2) Reduce VAT / subsidies to firms - significant cost to the government - bad idea 3) Intervene in foreign exchange markets to strengthen the exchange rate - imports cheaper - reduces costs of production High long term inflation rates - lack of spare capacity: Supply side policies e.g interventionist or market based SSPs Evaluation: 1) No guarantee of success 2) Cost 3) Time lags END EVALUTATION POINTS: - Hard to know what type of inflation, cost push inflation cannot be controlled , low and stable inflation 2% is good  Macro policy tradeoffs/conflicts Expansionary fiscal and monetary policy Good: higher economic growth, lower unemployment, lower income inequality Bad: higher inflation, Current account position, government finances, income inequality - the nature of growth, capital intensive, one sector dominant, poorer quality jobs, + if it is uneven ( south of UK compared to the north) , environment - air pollution - transportation. Evaluation: 1) Size of the output gap 2) Nature of growth 3) Specific policy used 4) Classical view of compatible objectives Contractionary policies: Good: Low inflation, good current account position, good government finances, low income inequality, good for the environment Bad: Slow growth, high unemployment, low labor productivity Evaluations: 1) Laffer curve concerns if direct taxes go up - less incentive to work , 2) policy used Supply side policies: Good: higher growth, lower unemployment, low inflation, good current account position Evaluation: 1) Output gap size - in a recession we cant use supply-side policies we need demand-side policies 2) Government finances 3) Income inequality/living standards 4) Environment