Transcript The Main Instruments Of Government Macroeconomic Policy

The Main Instruments Of
Government Macroeconomic Policy
Content
• Fiscal Policy
– Government expenditure
– Taxation
– Influence on AD / AS
• Monetary Policy
– Interest rates
– Money supply
– Exchange rates
• Supply side policies
• .
What is fiscal policy
• Fiscal policy looks at how government spend their money and how
they control their taxes.
• There are 2 types of fiscal policy:
• Contractionary fiscal policy: Where the government reduce
spending and / or when they make taxes higher, they try to increase
its PSBR( public sector borrowing requirement) to fund the tax drops
they also do this to reduce its surplus on its budget for the fiscal year.
• Expansionary fiscal policy: Where the government cut taxes or
increase government spending. They will increase the amount the
government borrows to fund the expenditure.
Government Expenditure
• Government expenditure covers all spending by the public
sector
• The government spends money on many things including:
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Education
Defence
Welfare benefits
Healthcare
Infrastructure
Police
Government Borrowing
• As well as gaining revenue through taxation the
government can also finance their spending through
borrowing
• The public sector net cash requirement (PSNCR)
measures the annual borrowing requirement of the
government in an economy
Direct & indirect taxes
• Direct taxes are taxes of income and expenditure
e.g. income tax, corporation tax (levied on company
profits).
• Indirect taxes are taxes such as VAT (value added
tax), changes in this type of tax has a rapid effect on
the level of economic activity. E.g. an increase in
VAT will cut consumption
Fiscal Policy and AD
• Taxation influences the AD curve because:
– An increase in taxation will decrease the level of consumption in
the economy
– An increase in taxation will increase the level of government
spending in the economy
– A decrease in taxation will increase the level of consumption in
the economy
– A decrease in taxation can decrease the level of government
expenditure in the economy
• The impact of a change in government expenditure
depends on the size of the multiplier
Fiscal Policy and AD
• Governments can utilise fiscal policy to control the
level of AD in the economy
• There can be problems with this due to:
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Time lags
The size of the multiplier
Fiscal crowding out
Peoples reaction to cuts / rises in taxation
Fiscal Policy and AS
• Fiscal policy can be used to increase the productive
capacity of the economy
• This is because government expenditure can be
used to:
– Increase the skill levels of workers
– Provide economic incentives to firms
– Increase factor mobility
Monetary Policy
• Monetary policy is the use of interest rates, money
supply and exchange rates to influence economic
growth and inflation
• Interest rates – are the cost of borrowing money
• Exchange rates – the value of one currency in
terms of another
• Money supply – the amount of money in circulation
in an economy
Interest Rates
• The Bank of England are responsible for setting interest
rates in the UK
• The Bank sets the rate after analysing macroeconomic
trends and risks associated with inflation
• Since 1997 the UK government has used interest rates to
control the level of inflation in the economy (at a level of
1.5-3.5% - target = 2.5%)
• If the Bank believes the level of AD is rising too quickly
potentially causing cost push inflation they will decide to
raise interest rates
Interest Rates and The Economy
• Changes to interest rates influence many things in
the economy:
– Housing prices and housing market – if interest rates
rise the cost of mortgages increases therefore reducing
demand for housing in theory (this has not occurred
recently in the UK)
– Disposable income of house owners – if interest rates
rise the real disposable income of home owners falls as
they have larger mortgage payments (variable rate only)
Interest Rates and The Economy
• Credit demand – if interest rates rise the amount of
credit sales should decrease as it becomes more
expensive
• Investment – if interest rates rise they lead to a
decrease in the level of investment
• Exchange rates – An increase in interest rates may
lead to an appreciation of UK currency making
exports less attractive
Interest rates and Inflation
• Interest rates are used to control inflation as when
interest rates are increased consumption decreases
as peoples real incomes are eroded by mortgage
payments and credit payments and the opportunity
cost of spending has increased
• By controlling interest rates the government aims to
keep inflation at a low level
Interest and Exchange Rates
• Changes in the UK’s interest rates will lead to changes in
the exchange value of the pound.
• If interest rates rise the value of the pound will rise so the
pound will now buy more US dollars, Japanese Yen, Euros
etc.
• If interest rates fall the value of the pound will fall so the
pound will now buy less US dollars, Japanese Yen, Euros
etc
Exchange rates
• A fall in the exchange rate reduces the price of
exports and increases the price of imports
• Domestic demand will be stimulated and more
people will buy exports as they are cheaper
• This will create a deficit on the current account of
the balance of payments
• As consumption will increase it will increase AD
which will increase the level of output in the
economy and more it towards full employment
Supply Side Policies
• Supply side policies are policies that improve the
supply-side of the economy increasing its efficiency
and thereby resulting in economic growth
• Supply side policies can act in the product and
labour markets
Supply side policies
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Trade union reforms
Increased expenditure on training and education
Changes in taxation
Changes to welfare system
Privatisation
Deregulation
Free trade
Incentives for small businesses
Supply side policies
• Supply side policies cause economic growth as they
cause the LRAS to shift outwards increasing the
potential output of the economy
• If the economy is operating near full potential
increases in aggregate demand can cause cost
push inflation, by the LRAS curve shifting outwards
this inflationary pressure is reduced
Supply side policies
• As supply side policies can cause the LRAS to shift
outwards they can lead to a fall in unemployment
levels
• Many supply side policies concentrate on the labour
market and increase skills for workers which help
reduce structural unemployment in the economy
Supply Side Policies
• As the LRAS shifts outwards businesses will have
lower average costs as productivity has increased
• Lower costs mean that businesses are able to
compete more internationally therefore making the
balance of payments more healthy
Summary
• Fiscal Policy is the use of government expenditure and taxation to
influence the level of inflation / economic growth
• Government expenditure covers all things the public sector spends
money on
• Taxation earns revenue for the government either directly through
income taxes or indirectly through VAT
• Monetary Policy is the control of the economy through interest rates,
money supply and exchange rates
• The bank of England set the rate of interest in the UK
• The government uses interest rates to control the rate of inflation
around its target of 2.5%
• Supply side policies aim to increase productivity in the economy
therefore stimulating economic growth