Government Policies : Instrument & Objectives

Transcription

1 Fiscal Policy Topic 10: Government Policies : Instrument & Objectives Influencing the level of economic activity though manipulation of government income and expenditure Associated with Keynesian Demand Management Policies Now seen in wider terms: Fiscal Policy Fiscal Policy Influence Aggregate Demand Tax regime influences consumption (C) and investment (I) Government Spending (G) Influences key economic objectives Acts as an automatic stabiliser BUT: Also used to influence non-economic objectives and provide framework for supply side policy e.g. education and health, poverty reduction, welfare reform, investment, regional policies, promotion of enterprise, etc. 1

2 expenditure Government Fiscal Policy Taxes Fiscal policy is when national government makes decisions on taxation and spending to influence the level of production and employment. Increasing the autonomous spending, G, increases Y e by multiplier. If Y e too low, can increase G to combat unemployment If Y e too high, can decrease G to combat inflation What about taxes? G I C 0 Y e 45 o C+I+G C+I C income/ production What is the purpose of governmentimposed taxes? To raise government revenues. To restrict production of a product. What is an excise tax? A per-unit tax that s independent of the price of the product. Taxes How Taxes on Buyers (& sellers) Affect Market Outcomes Who pays the tax on a good? The buyer or the seller? How is the burden of a tax divided between buyer and seller? When the government levies a tax on a good, the equilibrium quantity of the good falls. The size of the market for that good shrinks, shifting either the demand or supply curve. Tax incidence: The study of who bears the burden of taxation. Taxes discourage market activity. When a good is taxed, the quantity sold is smaller. Buyers and sellers share the tax burden. 2

3 A Tax on Buyers A Tax on Sellers Price of Ice- Cream Cone Price of Ice- Cream Cone S 2 Price buyers pay Price without tax Price sellers receive $3.30 $3.00 $2.80 Tax ($0.50) Equilibrium with tax S 1 Equilibrium without tax A tax on buyers shifts the demand curve downward by size of the tax ($0.50). Price buyers pay $3.30 Price without $3.00 tax $2.80 Price sellers receive Tax ($0.50) Equilibrium with tax S 1 A tax on sellers shifts the supply curve upward by an amount of the tax ($0.50). Equilibrium without tax D 1 D 1 D Quantity of Ice- Cream Cone Quantity of Ice- Cream Cone Case Study: The Burden of Payroll Tax A Payroll Tax Example: Employment Insurance. A payroll tax places a wedge between the wage the workers receive and the wage the firm pays. Wage Wage firms pay Wage without tax Wage workers receive Tax wedge Labour supply Labour demand Murugan Chapter Purushothaman 6: Page (PEC 4123 ECONOMIC ENVIRONMENT FOR BUSINESS) 0 Quantity of Labour 3

4 Government Expenditure Public Sector Spending Social Security Law and Order Emergency Services Health Education Defence Foreign Aid Environment Agriculture Industry Transport Regions Culture, Media and Sport The Public Sector that part of business activity that is organised and controlled by the government or its agencies on behalf of the nation as a whole The public sector comprises: Public Sector Central Government Parliament Government Departments education, defence, etc. Devolved Governments Other public funds - Foreign exchange reserves Local Government Public Corporations Post Office Monetary Policy Attempts to influence the level of economic activity (the amount of buying and selling in the economy) through changes to the amount of money in circulation and the price of money short-term interest rates. Interest rates the key area of Monetary Policy 4

5 Monetary Policy Monetary Policy Short-term interest rates set by the Monetary Policy Committee (MPC) of the Central Bank of Malaysia (BNM) Meets for 2 days each month (every fortnight) to decide on rates The official rate is the rate at which the Central Bank of Malaysia (BNM) will lend to the financial system and influences the structure of all other interest rates Monetary Policy Monetary Policy Basis of Monetary Policy is that there is a long run relationship between the amount of money and inflation Demand for Money the amount people wish to hold as cash as opposed to other assets The Supply of Money the amount of money in circulation in the economy The Classical Quantity Theory of Money: MV = PY (where M = the money stock, V = velocity of circulation, P = price level and Y = level of national income More formally: 5

6 Monetary Policy Monetary Policy M d = k PY where: P is the price level Y is the level of real national income M d is demand for money for transactions purposes K = proportion of national income held as transactions balances In equilibrium M d = M s So: P = 1/kY x M A rise in Ms will lead to a proportional rise in P Supply of Money: Narrow Money notes and coins in circulation (M0) Broad Money Notes and coins plus money held in bank and building society accounts (M4) A rise in either (ceteris paribus) might signal a rise in aggregate demand (AD) Monetary Policy Aggregate Demand The Interest Rate Transmission Mechanism The process by which a change in interest rates feeds through to AD The sum of all expenditure in the economy over a period of time Macro concept WHOLE economy Formula: AD = C+I+G+(X-M) C= Consumption Spending I = Investment Spending G = Government Spending (X-M) = difference between spending on imports and receipts from exports (Balance of Payments) 6

7 Aggregate Demand Curve Aggregate Demand Curve Shows the overall level of spending at different price levels Note Inflation used for the vertical axis follows from new thinking on the derivation of AD curves from the likes of David University of California Assumes Central Banks do not target the money supply but short term interest rates Why does it slope down from left to right? Assume Central Bank of Malaysia (BNM) sets short term interest rates Assume a rise in the price level will be met by a rise in interest rates Any increase in interest rates will raise the cost of borrowing: Consumption spending will fall Investment will fall International competitiveness will decrease exports fall, imports rise Therefore a rise in the price level leads to lower levels of aggregate demand Aggregate Demand Curve Aggregate Demand Curve The AD diagram: Inflation on the vertical axis assume an initial target rate of 2.0% (as measured by the CPI) Real GDP or Real National Income or Real Output on the vertical axis (shown by the initial Y) Inflation 3.0% 2.0% This At The a lower higher level of level rate output of will inflation National At an be inflation associated (3.0%) Income level with rising requires of 2%, a interest particular the fewer AD rates units level mean of curve labour of that gives C, a I level and (X-M) unemployment of output all have of Y1 rises which negative to 7% we shown effects will by call on U = = AD 7% 5% NY falls to Y2 AD Y2 U = 7% Y1 U = 5% Real National Income 7

8 Inflation 2.0% Aggregate Demand Curve Shifts in the Aggregate Demand Curve Y1 U = 5% Any exogenous factor causing C, I or G to rise, or a trade surplus causes a shift to the right in AD This would cause a rise in national income (economic growth) and lead to a fall in unemployment (U = 2%) (and vice versa) Y2 U = 2% Shifts in AD will be caused by changes in factors affecting C, I, G and (X-M) (exogenous factors) e.g. increasing income tax rates affect consumption AD AD2 Real National Income Aggregate Supply: Capacity of the Economy Costs of Production Technology Education and Training Incentives Tax regime Capital stock Productivity Labour Market Aggregate Supply Aggregate Supply Inflation Economy starts to overheat AS Between Y1 and Yf, The This Yf increases An represents output shape shape in of capacity level the Full of AS are Y1 curve Employment possible would is suggest but important the Output nearer the in determining reflects at the this economy point is a gets the working to Yf, outcome Keynesian economy the below more full problems in is capacity the working view are to economy full experienced and capacity there would with and acquiring be of resources the AS to boost curve. cannot widespread produce any production (production more. bottlenecks) unemployment. especially labour skills shortages. Inflation AS1 AS2 Increases in capacity can occur as a result of a shift in AS (akin to a shift outwards of the Production Possibility Frontier) (PPF) Y1 Yf Real National Income Yf1 Yf2 Real National Income 8

9 Aggregate Supply Aggregate Supply Inflation Short SRAS run assumes aggregate costs such supply as (SRAS) overall assumes wage firms rate remain only able to increase output at SRAS 1 fixed, changes higher costs (e.g. in such costs overtime payments) cause a shift in SRAS thereby SRAS pushing curve up (exogenous price level shocks input costs) SRAS 2 Inflation LRAS This is because they Classical believe that in the economists long run, there will be assume no unemployment the long of resources because run aggregate markets will clear, supply thus whatever curve the (LRAS) rate of inflation, is vertical firms (perfectly will supply the maximum capacity of inelastic). the economy. Real National Income Yf Real National Income Aggregate Supply Putting AD & AS together Inflation AS For our analysis, we will assume the AS curve looks like this! Inflation 2.5% AS A shift in the AD In curve this to situation, AD1 as a the economy result of a would change be in operating any or all of at the less than factors capacity, affecting there AD would be increase unemployment growth, reduce and the unemployment economy might but at be a cost growing of higher only slowly. inflation (a trade-off) 2.0% AD 1 AD Real National Income Y1 Y2 Yf Real National Income 9

10 Putting AD & AS together Putting AD & AS together Inflation 3.5% 2.5% 2.0% AS Further increases in AD would lead to successively smaller increases in growth and employment at the cost of ever higher inflation. AD2 AD1 Inflation 2.0% AS AS1 Sustained growth (not to be confused with sustainable economic growth) occurs when AS and AD rise at similar rates national income can rise without effects on inflation Y1 Y2 Yf Y3 AD Real National Income Y1 Y2 AD2 AD Real National Income Types of Unemployment Types of Unemployment Frictional Unemployment: Unemployment caused when people move from job to job and claim benefit in the meantime The quality of the information available for job seekers is crucial to the extent of the seriousness of frictional unemployment Structural Unemployment: Unemployment caused as a result of the decline of industries and the inability of former employees to move into jobs being created in new industries 10

11 Types of Unemployment Types of Unemployment Seasonal Unemployment: Unemployment caused because of the seasonal nature of employment tourism, skiing, cricketers, beach lifeguards, etc. Demand Deficient: Caused by a general lack of demand in the economy this type of unemployment may be widespread across a range of industries and sectors Keynes saw unemployment as primarily a lack of demand in the economy which could be influenced by the government Types of Unemployment Unemployment Technological Unemployment: Unemployment caused when developments in technology replace human effort e.g in manufacturing, administration etc. Short run and long run unemployment: Classical theory short run unemployment is a temporary phenomenon; wages will fall and the labour market will move back into equilibrium Long run unemployment will be voluntary 11

12 Unemployment The Balance of Payment Keynesian Unemployment: Unemployment in the long run may remain stubbornly high because of imperfections in the market sticky wages A record of the trade between the UK and the rest of the world. Trade in goods Trade in services Income flows = Current Account Transfer of funds and sale of assets and liabilities = Capital Account The Balance of Payment The rate at which one currency can be exchanged for another e.g. 1 = $ = 1.50 Important in trade The UK Balance of Payments on Current Account Source: ONS ( (Crown copyright material is reproduced with the permission of the Controller of HMSO and the Queen's Printer for Scotland.) 12

13 Converting currencies: To convert into (e.g.) $ Multiply the sterling amount by the $ rate To convert $ into - divide by the $ rate: e.g. To convert 5.70 to $ at a rate of 1 = $1.90, multiply 5.70 x 1.90 = $10.83 To convert $3.45 to at the same rate, divide 3.45 by 1.90 = 1.82 Determinants of Exchange Rates: Exchange rates are determined by the demand for and the supply of currencies on the foreign exchange market The demand and supply of currencies is in turn determined by: Relative interest rates The demand for imports (D ) The demand for exports (S ) Investment opportunities Speculative sentiments Global trading patterns Changes in relative inflation rates Appreciation of the exchange rate: A rise in the value of in relation to other currencies each buys more of the other currency e.g. 1 = $ = $1.91 UK exports appear to be more expensive ( Xp) Imports to the UK appear to be cheaper ( Mp) 13

14 Depreciation of the Exchange Rate A fall in the value of the in relation to other currencies - each buys less of the foreign currency e.g. 1 = = 1.45 UK exports appear to be cheaper ( Xp) Imports to the UK appear more expensive ( Mp) A depreciation in exchange rate should lead to a rise in D for exports, a fall in demand for imports the balance of payments should improve An appreciation of the exchange rate should lead to a fall in demand for exports and a rise in demand for imports the balance of payments should get worse BUT The volumes and the actual amount of income and expenditure will depend on the relative price elasticity of demand for imports and exports. $ per S The Assume rise in Investing an in demand initial exchange creates a shortage the UK would rate of 1 in = the relationship now $1.85. be There more between attractive are rumours demand that the UK is for and demand supply going to for increase the price would (exchange rise interest rates rate) would rise Shortage D 1 D Q1 Q3 Q2 Quantity on ForEx Markets 14

15 Floating Exchange Rates: Price determined only by demand and supply of the currency no government intervention Fixed Exchange Rates: The value of a currency fixed in relation to an anchor currency not allowed to fluctuate Dirty Floating or Managed Exchange Rate: rate influenced by government via central bank around a preferred rate Purchasing Power Parity (PPP) The relationship between the exchange rate and the price level in different countries. The price of in the foreign currency = Foreign Country price level/uk price level The exchange rate would be a proper reflection of the purchasing power in each country if the relative values bought the same amount of goods in each country. E.g. If the price of a pint of Stella in the UK was 3.00 and in Europe 4.50, the exchange rate between the two countries should be 1 = 1.50 If any lower than this value, the would be undervalued and if any higher, the would be overvalued. Economic Growth : Benefits Increases in economic growth should enable more of everything to be produced Increases possibility of providing consumer goods for all More consumer goods, etc. could be equated with an increase in living standards Wealth generated may eventually trickle down to those who are poor by means of income distribution taxes and benefits, etc. 15

16 Economic Growth : Benefits Improvement in Welfare Improved standards of living associated with increase in the availability of luxury goods: TVs Fridges and freezers Swimming pools, etc. In addition: Infrastructure roads, rail, energy, water, communication networks Health and education provision All associated with a decent standard of living. Welfare associated with well-being: Welfare is improved by the provision of support services for those not necessarily able to help themselves often on the margins of society. Welfare includes: Pensions Benefits sickness, disability, etc. Support maternity, holidays, Housing Infrastructure homes for the elderly Such welfare provision often funded through income redistribution - taxes Welfare Providing support for the elderly, homeless, orphaned and disadvantaged is something only wealthy countries can afford to any great extent. Costs Economic growth can bring with it costs: Not all income distributed equally Wealth often in the hands of a few Trickle down does not always seem to work in practice Corruption may reduce redistribution effects Growth funded in part by spending on weapons which do not benefit the population as a whole 16

17 Costs Environmental Impact Environmental problems Expansion and growth brings with it the problems of pollution often developing countries do not have the infrastructure to cope with the waste generated nor the legislation or regulation to influence those who produce it. Negative Externalities Pollution dumping of hazardous waste Environmental degradation over farming reduces productivity of the soil, deforestation, damage to eco-systems and reduction in biodiversity Non-renewable resources finite resources Opportunity Cost of Growth Opportunity Cost of Growth Resource allocation Consumer Goods? Capital Goods? Necessity of generating growth through allocating resources to the sources of growth capital goods Makes population poorer as fewer consumer goods initially available often these consumer goods represent the basic essentials of life Capital Goods K2 K1 Gain C2 Sacrifice C1 Any Production attempt to Possibility increase the Frontier: basis for wealth generation by producing more capital goods Assume initial output levels of C1 consumer that need to be used for such wealth goods and K1 capital goods where C1 generation will mean a reduction in the barely represents the essentials of life in a number of consumer goods available (the developing country clean water, food, opportunity cost). Such a reduction can be shelter, etc. very damaging to a country already suffering a lack of basic essentials. Opportunity cost of K2 K1 capital goods is C1 C2 consumer goods sacrificed. Consumer Goods 17

18 The Economics of Financial Intermediation In a world of perfect financial markets there would be no need for financial intermediaries (middlemen) in the process of lending and/or borrowing Costless transactions Securities can be purchased in any denomination Perfect information about the quality of financial instruments The Economics of Financial Intermediation Reasons for Financial Intermediation Transaction costs Cost of bringing lender/borrower together Reduced when financial intermediation is used Relevant to smaller lenders/borrowers Portfolio Diversification Spread investments over larger number of securities and reduce risk exposure Option not available to small investors with limited funds Mutual Funds pooling of funds from many investors and purchase a portfolio of many different securities The Economics of Financial Intermediation The Economics of Financial Intermediation Reasons for Financial Intermediation (Cont.) Gathering of Information Intermediaries are efficient at obtaining information, evaluating credit risks, and are specialists in production of information Asymmetric Information Buyers/sellers not equally informed about product Can be difficult to determine credit worthiness, mainly for consumers and small businesses Reasons for Financial Intermediation (Cont.) Asymmetric Information (Cont.) Borrower knows more than lender about borrower s future performance Borrowers may understate risk Asymmetric information is much less of a problem for large businesses more publicly available information 18

19 The Economics of Financial Intermediation Reasons for Financial Intermediation (Cont.) Adverse Selection Related to information about a business before a financial transaction is consummated Occurs when an individual or group who is most likely to cause an undesirable outcome are also the most likely to engage in a market Small businesses tend to represent themselves as high quality The Economics of Financial Intermediation Reasons for Financial Intermediation (Cont.) Adverse Selection (Cont.) Banks know some are good and some are bad, how to decide Charge too high an interest, good credit companies look elsewhere leaves just bad credit risk companies Charge too low interest, have more losses to bad companies than profits on good companies Market failure Banker may decide not to lend money to any small businesses The Economics of Financial Intermediation Reasons for Financial Intermediation (Cont.) Moral Hazard Occurs after a transaction is consummated One party acts in a way contrary to the wishes of the other party Arises if it is difficult or costly to monitor each other s activities Taking risks works to owners advantage, prompting owners to make riskier decisions than normal Owner may hit the jackpot, however, bank is not better off From owner s perspective, a moderate loss is same as huge loss limited liability The Economics of Financial Intermediation Summary of role of financial intermediaries in flow of information (Figure 11.1) Case 1 Funds flow from savers/lenders through financial intermediaries (banks) to borrowers/spenders The financial intermediary issues nontraded contracts to the borrowers Primarily in the form of bank loans held to maturity Banks monitor borrower behavior over life of loan 19

20 The Economics of Financial Intermediation Summary of role of financial intermediaries in flow of information (Figure 11.1) Case 2 Funds flow from the financial intermediaries to financial markets who lend to borrowers/spenders In this case, the lending takes the form of traded contracts between the financial market and borrowers An example of this case would be money market mutual funds The Economics of Financial Intermediation Summary of role of financial intermediaries in flow of information (Figure 11.1) Case 3 In this case, funds flow directly through financial markets to borrowers/spenders in the form of traded contracts Financial intermediaries are not involved in this transaction Purchase of stocks/bonds by individuals in financial markets 20