Macro Economics Policies

Macro economic policies What does it mean if there is a government budget deficit?

Budget deficit or surplus • When government expenditures exceed government tax revenues in a given year, the government is running a budget deficit for that year. • When government expenditures are less than tax revenues in a given year, the government is running a budget surplus for that year.

• Monetary policy involves changing the interest rate and influencing the money supply. • Fiscal policy involves the government changing tax rates and levels of government spending to influence aggregate demand in the economy.

They are both used to pursue policies of higher economic growth or controlling inflation.

Monetary Policy Monetary policy is usually carried out by the Central Bank / Monetary authorities and involves: • Setting base interest rates (e.g. Bank of England in UK and Federal Reserve in US) • Influencing the supply of money.

How Monetary Policy Works •

The Central Bank may have an inflation target of 2%. If they feel inflation is going to go above the inflation target, due to economic growth being too quick, then they will increase interest rates. • Higher interest rates increase borrowing costs and reduce consumer spending and investment, leading to lower aggregate demand and lower inflation. • If the economy went into recession, the Central Bank would cut interest rates.

Fiscal Policy Fiscal Policy is carried out by the government and involves changing: • •

Level of government spending Levels of taxation

Expansionary fiscal policy is defined as an increase in government expenditures and/or a decrease in taxes that causes the government's budget deficit to increase. Contractionary fiscal policy is defined as a decrease in government expenditures and/or an increase in taxes that causes the government's budget deficit to decrease.

Example of Expansionary Fiscal Policy • In a recession, the government may decide to increase borrowing and spend more on infrastructure spending. • The idea is that this increase in government spending creates an injection of money into the economy and helps to create jobs. • There may also be a multiplier effect, where the initial injection into the economy causes a further round of higher spending. • This increase in aggregate demand can help the economy to get out of recession.

• If the government felt inflation was a problem, they could pursue contractionary (deflationary) fiscal policy (higher tax and lower govt. spending) to reduce the rate of economic growth. • Multiplier effect – the amount by which an increase in spending produces an increase in total spending in the economy

• Supply Side economics is the branch of economics that considers how to improve the productive capacity of the economy. • Supply Side Policies are government attempts to increase productivity and shift Aggregate Supply (AS) to the right. • Q) Discuss with a partner what these supply side policies could be.

Supply Side Policies Most supply side policies aim to enable the free market to work more efficiently by reducing govt interference. Privatisation. • This involves selling state owned assets to the private sector. It is argued that the private sector is more efficient in running business because they have a profit motive to reduce costs and develop better services.

Deregulation • This involves reducing barriers to entry in order to make the market more competitive. For example BT used to be a Monopoly but now telecommunications is quite competitive.

Reducing Income Taxes. • It is argued that lower taxes (income and corporation) increase the incentives for people to work harder, leading to more output. Increased education and training • Better education can improve labour productivity and increase AS. • Often there is under-provision of education in a free market. Therefore the govt may need to subsidise suitable education and training schemes. • However govt intervention will cost money, requiring higher taxes, It will take time to have effect and govt may subsidise the wrong types of training Reducing the power of Trades Unions This should: • a) increase efficiency of firms e.g. less time lost to strikes

Reducing State Welfare Benefits • This may encourage unemployed to take jobs. It cannot be reduced TOO MUCH! Can you think of why? Providing better information about jobs • This may also help reduce frictional unemployment

Lower Tariff barriers this will increase trade Removing unnecessary red tape and bureaucracy which add to a firms costs Improving Transport and infrastructure. • Due to market failure this is likely to need govt intervention to improve transport and reduce congestion. This will help reduce firms costs.

Benefits of Supply Side Policies 1. Lower Inflation • Shifting AS to the right will cause a lower price level. By making the economy more efficient supply side policies will help reduce cost push inflation.

2. Lower Unemployment • Supply side policies can help reduce structural, frictional and real wage unemployment and therefore help reduce the natural rate of unemployment.

3. Improved economic growth • Supply side policies will increase the sustainable rate of economic growth by increasing AS.

4. Improved trade and Balance of Payments. • By making firms more productive and competitive they will be able to export more. This is important in light of the increased competition from S.E. Asia.

What policies could be used to decrease unemployment?

Policies for Reducing Unemployment There are two main strategies for reducing unemployment • Demand side policies (fiscal and monetary) to reduce demand-deficient unemployment (unemployment caused by recession) • Supply side policies to reduce structural unemployment

Demand Side Policies • Demand side policies are important when there is a recession and rise in cyclical unemployment. (e.g. after 1991 recession and after 2008 recession)

Policies for Reducing Unemployment Fiscal Policy • Fiscal policy can decrease unemployment by helping to increase aggregate demand and the rate of economic growth. The government will need to pursue expansionary fiscal policy • - this involves cutting taxes and increasing government spending. Lower taxes increase disposable income (e.g. VAT cut to 15% in 2008) and therefore help to increase consumption, leading to higher aggregate demand (AD). • With an increase in AD, there will be an increase in Real GDP (as long as there is spare capacity in the economy.) If firms produce more, there will be an increase in demand for workers and therefore lower demand-deficient unemployment. Also, with higher aggregate demand and strong economic growth, fewer firms will go bankrupt meaning fewer job losses.

Impact of Higher AD on Economy

However, • 1. It depends on other components of AD. e.g. if confidence is low, cutting taxes may not increase consumer spending because people prefer to save. Also, people may not spend tax cuts, if they will soon be reversed. • 2. Fiscal policy may have time lags. E.g. a decision to increase government spending may take a long time to have an effect on increasing AD. • 3. If the economy is close to full capacity an increase in AD will only cause inflation. Expansionary fiscal policy will only reduce unemployment if there is an output gap. • 4. Expansionary fiscal policy will require higher government borrowing – this may not be possible for countries with high levels of debt. • 5. In the long run expansionary fiscal policy may cause crowding out. Crowding out refers to when government must finance its spending with taxes, leaving businesses with less money and effectively "crowding them out." They have less to spend and therefore AD doesn’t increase.

Monetary Policy • Monetary policy would involve cutting interest rates. Lower rates decrease the cost of borrowing and encourage people to spend and invest. This increases AD and should also help to increase GDP and reduce demand deficient unemployment. • Also lower interest rates will reduce exchange rate and make exports more competitive. • In some cases, lower interest rates may be ineffective in boosting demand.

Evaluation • Similar problems to fiscal policy. e.g. it depends on other components of AD. • Lower interest rates may not help boost spending, if banks are still reluctant to lend. • Demand side policies can help to reduce demand deficient unemployment e.g. in a recession. However, they cannot reduce supply side unemployment. Therefore, their effectiveness depends on the type of unemployment that occurs.

Supply Side Policies for Reducing Unemployment Supply side policies deal with more microeconomic issues. They don’t aim to boost overall Aggregate Demand, but seek to overcome imperfections in the labour market and reduce unemployment caused by supply side factors. Supply side unemployment includes: • • Frictional • • Structural • • Classical (real wage)

• What kind of supply side policies could be used to reduce unemployment?

Supply Side Policies for Reducing Unemployment

Education and Training. The aim is to give the long term unemployed new skills which enable them to find jobs in developing industries.

. Employment Subsidies. Firms could be given tax breaks or subsidies for taking on long term unemployed. This helps give them new confidence and on the job training.

Improve Labour Market Flexibility and Deregulation It is argued that higher structural rates of unemployment in Europe is due to restrictive labour markets which discourages firms from employing workers in the first place.

Stricter Benefit requirements. Governments could take a more proactive role in making the unemployed accept a job or risk losing benefits. After a certain time period the government could guarantee some kind of public sector job (e.g. cleaning streets). This could significantly reduce unemployment.

Improved Geographical Mobility. Often unemployment is more concentrated in certain regions. To overcome this geographical unemployment, the government could give tax breaks to firms who set up in depressed areas.

Evaluate the policies that could help to reduce unemployment.