Edexcel Economics (A) A-level Theme 2: The UK Economy - Performance and Policies 2.6 Macroeconomic Objectives and Policies

Transcription

1 Edexcel Ecnmics (A) A-level Theme 2: The UK Ecnmy - Perfrmance and Plicies 2.6 Macrecnmic Objectives and Plicies Summary Ntes

2 2.6.1 Pssible macrecnmic bjectives The gvernment has fur main macrecnmic bjectives. These aim t prvide macr stability. Ecnmic grwth: In the UK, the lng run trend f ecnmic grwth is abut 2.5%. Gvernments aim t have sustainable ecnmic grwth fr the lng run. In emerging markets and develping ecnmies, gvernments might aim t increase ecnmic develpment befre ecnmic grwth, which will imprve living standards, increase life expectancy and imprve literacy rates. Lw unemplyment: Gvernments aim t have as near t full emplyment as pssible. They accunt fr frictinal unemplyment by aiming fr an unemplyment rate f arund 3%. The labur frce shuld als be emplyed in prductive wrk. Lw and stable rate f inflatin: In the UK, the gvernment inflatin target is 2%, measured with CPI. This aims t prvide price stability fr firms and cnsumers, and will help them make decisins fr the lng run. If the inflatin rate falls 1% utside this target, the Gvernr f the Bank f England has t write a letter t the Chancellr f the Exchequer t explain why this happened and what the Bank intends t d abut it Balance f payments equilibrium n current accunt: Gvernments aim fr the current accunt t be satisfactry, s there is nt a large deficit. This is usually near t equilibrium. A balance f payments equilibrium n the current accunt means the cuntry can sustainably finance the current accunt, which is imprtant fr lng term grwth. Additinally, the gvernment might have the fllwing macrecnmic bjectives.

3 Balanced gvernment budget: This ensures the gvernment keeps cntrl f state brrwing, s the natinal debt des nt escalate. This allws gvernments t brrw cheaply in the future shuld they need t, and makes repayment easier. Prtectin f the envirnment: This aims t prvide lng run envirnmental stability. It ensures resurces used are nt explited, such as il and natural gas, and that they are used sustainably, s future generatins can access them t. Mrever, it means there is nt excessive pllutin. Greater incme equality: Incme and wealth shuld be distributed equitably, s the gap between the rich and pr is nt extreme. It is generally assciated with a fairer sciety.

4 2.6.2 Demand-side plicies Demand-side plicies are plicies designed t increase cnsumer demand, s that ttal prductin in the ecnmy increases. The distinctin between mnetary and fiscal plicy: Mnetary plicy is used by the gvernment t cntrl the mney flw f the ecnmy. This is dne with interest rates and quantitative easing. This is cnducted by the Bank f England, which is independent frm the gvernment. Fiscal plicy uses gvernment spending and revenues frm taxatin t influence AD. This is cnducted by the gvernment. Mnetary plicy instruments: Interest rates In the UK, the Mnetary Plicy Cmmittee (MPC) alters interest rates t cntrl the supply f mney. They are independent frm the gvernment, and the nine members meet each mnth t discuss what the rate f interest shuld be. Interest rates are used t help meet the gvernment target f price stability, since it alters the cst f brrwing and reward fr saving. The bank cntrls the base rate, which ultimately cntrls the interest rates acrss the ecnmy. A reductin in the base rate will lead t a rise in AD. This happens thrugh a number f transmissin mechanisms: Cnsumptin and investment increase due t lwer csts f brrwing Higher cnsumptin, due t lwer brrwing, will mean that asset prices increase. This will lead t a psitive wealth effect. Saving becmes less attractive, as a lwer rate f return is ffered, s cnsumptin and investment bth increase. Mrtgage interest repayments are lwer and s therefre cnsumers have mre incme left t spend, which als increases cnsumptin. Lwer interest rates reduce the incentive fr investrs t hld their mney in British banks, s demand fr the pund will fall. The pund will be weaker, s exprts will be cheaper and imprts mre expensive. Net trade will therefre increase.

5 Asset purchases t increase the mney supply: Quantitative Easing (QE) This is used by banks t help t stimulate the ecnmy when standard mnetary plicy is n lnger effective. This has inflatinary effects since it increases the mney supply, and it can reduce the value f the currency. QE is usually used where inflatin is lw and it is nt pssible t lwer interest rates further. QE is a methd t pump mney directly int the ecnmy. It has been used by the Eurpean Central Bank t help stimulate the ecnmy. Since the interest rates are already very lw, it is nt pssible t lwer them much mre. The bank bught assets in the frm f gvernment bnds using the mney they have created. This is then used t buy bnds frm investrs, which increases the amunt f cash flwing in the financial system. This encurages mre lending t firms and individuals, since it makes the cst f brrwing lwer. The thery is that this encurages mre investment, mre spending, and hpefully higher grwth. A pssible effect f this is that there culd be higher inflatin. If inflatin gets high, the Bank f England can reduce the supply f mney in the ecnmy by selling their assets. This reduces the amunt f spending in the ecnmy. Limitatins f mnetary plicy: Banks might nt pass the base rate nt cnsumers, which means that even if the central bank changes the interest rate, it might nt have the intended effect. Even if the cst f brrwing is lw, cnsumers might be unable t brrw because banks are unwilling t lend. After the 2008 financial crisis, banks became mre risk averse. Interest rates will be mre effective at stimulating spending and investment when cnsumer and firm cnfidence is high. If cnsumers think the ecnmy is still risky, they are less likely t spend, even if interest rates are lw.

6 Fiscal plicy instruments: Gvernment spending and taxatin Gvernments can change the amunt f spending and taxatin t stimulate the ecnmy. The gvernment culd influence the size f the circular flw by changing the gvernment budget, and spending and taxes can be targeted in areas which need stimulating. Fiscal plicy aims t stimulate ecnmic grwth and stabilise the ecnmy. In the UK, the gvernment spends mst f their budget n pensins and welfare benefits, fllwed by health and educatin. Incme tax is the biggest surce f tax revenue in the UK. Expansinary fiscal plicy This aims t increase AD. Gvernments increase spending r reduce taxes t d this. It leads t a wrsening f the gvernment budget deficit, and it may mean gvernments have t brrw mre t finance this.

7 Deflatinary fiscal plicy This aims t decrease AD. Gvernments cut spending r raise taxes, which reduces cnsumer spending. It leads t an imprvement f the gvernment budget deficit. The gvernment budget (fiscal) surplus and deficit: A gvernment has a budget deficit when expenditure exceeds tax receipts in a financial year. A gvernment has a budget surplus when tax receipts exceed expenditure. Direct and indirect taxes: Direct taxes are impsed n incme and are paid directly t the gvernment frm the tax payer. Examples include incme tax, crpratin tax, NICs and inheritance tax. Cnsumers and firms are respnsible fr paying the whle tax t the gvernment. Indirect taxes are impsed n expenditure n gds and services, and they increase prductin csts fr prducers. This increases market price and demand cntracts.

8 Limitatins f fiscal plicy: Gvernments might have imperfect infrmatin abut the ecnmy. It culd lead t inefficient spending. There is a significant time lag invlved with emplying fiscal plicy. It culd take mnths r years t have an effect. If the gvernment brrws frm the private sectr, there are fewer funds available fr the private sectr, which culd lead t crwding ut. The bigger the size f the multiplier, the bigger the effect n AD and the mre effective the plicy. If interest rates are high, fiscal plicy might nt be effective fr increasing demand. If the gvernment spends t much, there culd be difficulties paying back the debt, which culd make it difficult t brrw in the future. Demand-side plicies in the Great Depressin and the Glbal Financial Crisis f 2008: The Great Depressin The Great Depressin initiated in 1929, and by 1933 real GDP had fallen by 30% and the unemplyment rate increased t 25%. In the 75 years prir t this, ecnmic declines lasted abut 2 years; The Great Depressin lasted ver a decade. Keynes shifted macrecnmic thught frm a fcus n AS t AD. Keynesian ecnmists emphasis the use f demand-side plicies t clse gaps between actual and ptential utput. Causes: It was set ff by the Wall Street Crash f 1929 This led t a huge lss in cnsumer and business cnfidence, decreasing cnsumptin and investment The 1920s had been a perid f unsustainable bm and the banking system was unstable; the gvernment allwed the banks t crash The USA had intrduced prtectinism whilst the UK was cmmitted t the gld standard, where its currency was fixed t gld and was vervalued.

9 Respnses in the UK: The gvernment thught balancing the budget was essential s they cut public sectr wages and unemplyment benefits and raised incme tax Interest rates were high t help maintain the pund, which came under attack frm speculatrs Eventually, they left the gld standard and cut interest rates. Respnses in the USA: Rsevelt's New Deal used public sectr investment, wrk schemes fr the unemplyed and fiscal stimulus t increase AD and bring abut a recvery Sme argue that nt enugh spending was undertaken fr it t be effective; it was the war which eventually ended the Depressin They als tried t increase the mney supply, but it is unclear hw effective this was. The Glbal Financial Crisis The Glbal Financial Crisis is smetimes called The Great Recessin, and it refers t the decline in wrld GDP in Causes: Befre the crash, asset prices were high and rising, and there was a bm in ecnmic demand. There were risky bank lans and mrtgages, especially in the US where gvernment securities were backed by subprime mrtgages. This means the brrwers had pr credit histries, and after huse prices crashed in the US in 2006, several hmewners defaulted n their mrtgages in Banks had lst huge funds, and required assistance frm the gvernment in the frm f bailuts. Plicy respnses in the UK and USA: Bth gvernments were frced t natinalise banks and building scieties. They guaranteed savers their mney in rder t prevent the chas f a cllapsed system. They used expansinary mnetary plicies, including recrd lw interest rates and quantitative easing. The UK cut VAT frm 17.5% t 15% and saw a huge increase in gvernment brrwing. The USA used mre expansinary fiscal plicy, and this is perhaps why it recvered faster. In 2010, the UK priritised reducing Natinal Debt but the USA did nt make this decisin until Synptic pint: Any gvernment plicy decisin will als have micrecnmic impacts, fr example firms may see higher pst tax prfits and have mre t invest which culd increase efficiency.

10 2.6.3 Supply-side plicies Supply-side plicies aim t imprve the lng run prductive ptential f the ecnmy. The distinctin between market-based and interventinist plicies: Market-based plicies limit the interventin f the gvernment and allw the free market t eliminate imbalances. The frces f supply and demand are used. Interventinist plicies rely n the gvernment intervening in the market. Market-based plicies: T increase incentives - Reducing incme and crpratin tax t encurage spending and investment. - Reducing benefits t increase the pprtunity cst f being ut f wrk T prmte cmpetitin - By deregulating r privatising the public sectr, firms can cmpete in a cmpetitive market, which shuld als help imprve ecnmic efficiency. T refrm the labur market - Reducing the NMW (r ablishing it altgether) will allw free market frces t allcate wages and the labur market shuld clears. - Reducing trade unin pwer makes emplying wrkers less restrictive and it increases the mbility f labur. This makes the labur market mre efficient. Interventinist plicies: T prmte cmpetitin - A stricter gvernment cmpetitin plicy culd help reduce the mnply pwer f sme firms and ensure smaller firms can cmpete, t. T refrm the labur market - Gvernments culd try and imprve the gegraphical mbility f labur by subsidising the relcatin f wrkers and imprving the availability f jb vacancy infrmatin. T imprve skills and quality f the labur frce

11 - The gvernment culd subsidise training. This als lwers csts fr firms, since they will have t train fewer wrkers. - They may spend mre n educatin, such as university, s wrkers will be mre skilled and efficient. - Spending mre n healthcare helps imprve the quality f the labur frce, and cntributes twards higher prductivity. - This may help t reduce ccupatinal immbility. T imprve infrastructure - Gvernments culd spend mre n infrastructure, such as imprving rads and schls. AD/AS diagrams: Bth diagrams shw the effects f emplying a supply-side plicy. The LRAS curve shifts t the right, t shw the increase in the prductive ptential f the ecnmy. In ther wrds, the maximum utput f the ecnmy at full emplyment has increased. This leads t a fall in the average price level, frm P1 t P2, and an increase in natinal utput, frm Y1 t Y2. The first diagram is the Keynesian LRAS curve, and the secnd is the Classical LRAS curve.

12 Strengths and weaknesses f supply-side plicies: Supply-side plicies are the nly plicies which can deal with structural unemplyment, because the labur market can be directly imprved with educatin and training. Demand-side plicies are better at dealing with cyclical unemplyment, since they can reduce the size f a negative utput gap and shift the AD curve t the right. There are significant time lags assciated with supply-side plicies and nt all plicies will be successful. Market-based supply-side plicies, such as reducing the rate f tax, culd lead t a mre unequal distributin f wealth. There may be negative impacts n the gvernment budget due t higher gvernment expenditure r lwer taxes. Plicies may impact AD befre they impact AS and s they culd have inflatinary effects. If there is a lt f spare capacity in the ecnmy, then supply side plicies will have n impact. On the Keynesian curve, if the ecnmy is prducing n the elastic part f the curve, there will be n change in utput fllwing the plicy.

13 Synptic pint: Sme f these plicies are aimed at slving micrecnmic issues, fr example under-perfrming mnplies, in rder t imprve a macrecnmic cncept. If the ecnmy is nt successful at a micrecnmic level, it will be unable t meet macrecnmic bjectives.

14 2.6.4 Cnflicts and trade-ffs between bjectives and plicies Ptential cnflicts and trade-ffs between the macrecnmic bjectives: Ecnmic grwth vs inflatin: A grwing ecnmy is likely t experience inflatinary pressures n the average price level. This is especially true when there is a psitive utput gap and AD increases faster than AS. Ecnmic grwth vs the current accunt: During perids f ecnmic grwth, cnsumers have high levels f spending. In the UK, cnsumers have a high marginal prpensity t imprt, s there is likely t be mre spending n imprts. This leads t a wrsening f the current accunt deficit. Hwever, exprt-led grwth, such as that f China and Germany, means a cuntry can run a current accunt surplus and have high levels f ecnmic grwth. Ecnmic grwth vs the gvernment budget deficit: Reducing a budget deficit requires less expenditure and mre tax revenue. This wuld lead t a fall in AD, hwever, and as a result there will be less ecnmic grwth. Ecnmic grwth vs the envirnment: High rates f ecnmic grwth are likely t result in high levels f negative externalities, such as pllutin and the usage f nn-renewable resurces. This is because f mre manufacturing, which is assciated with higher levels f carbn dixide emissins. Unemplyment vs inflatin: In the shrt run, there is a trade-ff between the level f unemplyment and the inflatin rate. This is illustrated with a Phillips curve. As ecnmic grwth increases, unemplyment falls due t mre jbs being created. Hwever, this causes wages t increase, which can lead t mre cnsumer spending and an increase in the average price level.

15 The extent f this trade ff can be limited if supply side plicies are used t reduce structural unemplyment, which will nt increase average wages. Ptential plicy cnflicts and trade-ffs: This ccurs when ne macrecnmic plicy has a larger impact than anther, which cnflicts with the ther plicy r reduces its effectiveness. Every plicy is likely t have unintended cnsequences; these are sme examples: Envirnment vs cmpetitiveness: If green taxes are implemented, such as carbn taxes, r if there are minimum prices n pllutin permits, the cmpetitiveness f dmestic firms culd be cmprmised. This is because they are limited in their prductin. Fiscal vs mnetary plicy: Expansinary fiscal plicies invlve mre gvernment brrwing, which culd cause interest rates and the inflatin rate t rise. Interest rate vs inequality: The lw interest rate culd affect the distributin f incme. Savers nly receive a small return n their savings. Synptic pint: Sme micrecnmic plicies culd have adverse macrecnmic impacts and vice versa, fr example indirect taxes t fix market failure culd reduce cmpetitiveness and decrease SRAS.