Unit 2 - The UK economy - performance and policies
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PEARSON (PEARSON)
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covers:
2.6.1 possible macroeconomic objectives
2.6.2 demand side policies
2.6.3 supply side policies
2.6...
264 conflicts and tradeoffs between objectives and policies
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PEARSON (PEARSON)
Economics A
Unit 2 - The UK economy - performance and policies
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2.6 Macroeconomic objectives and policies
Demand side policies- a deliberate manipulation by the government of aggregate demand in order to achieve
macroeconomic objectives
Monetary policy- involves the monetary instruments such as interest rates and the money supply (quantitative easing) to
influence one or more of the components of aggregate demand
Contractionary monetary policy- reduces the size of the money supply or raises the interest rate in order to reduce AD
Expansionary monetary policy- increases the size of the money supply, decreases the interest rate in order to increase AD
Interest rate- the cost of borrowing, reward for saving, return for lending
Base rate- set by the BOE. The rate at which the BOE will lend to the financial system and Influences the structure of all
other interest rates
Commercial bank rate- set by individual banks for their own products e.g. mortgages, loans. Vary from institution to
institution and are monitored for competitiveness with other banks in order to attract customers.
Inflation targeting- monetary policy regime in which a central bank has an explicit target inflation rate for the medium
term and announces this inflation target to the public
Symmetric inflation targeting- deviations of inflation below the target are to be treated with the same importance as
deviations above it
Interest rate transmission mechanism- changing the rate of interest sets off a chain of reactions in the economy, many of
which mean AD will shift- these processes are called transmission mechanisms
Quantitative easing- purchase of gilts and other illiquid assets as a means of making credit easier to access. A monetary
policy in which a central bank purchases government securities or other securities from the market in order to increase the
money supply
Fiscal policy- involves changes in the level or structure of government spending, borrowing and taxation aimed at
influencing one or more components of AD. Controlled by the UK government through the budget
Current government spending- government expenditure on day- to day running of public sector activities
Capital government spending- government expenditure on improving the productive capacity of the economy
Discretionary fiscal policy- involves deliberate one off changes in government spending and taxation with the intention of
influencing AD
Expansionary fiscal policy- the use of fiscal policy to stimulate AD, increasing levels of gov spending, increasing gov
borrowing and decreasing taxes- lower tax revenue
Contractionary fiscal policy- the use of fiscal policy to stimulate AD which involves decreasing gov spending, decreasing
gov borrowing and increasing taxes- higher tax rev
Moral hazard- taking excessive risk as you are insured or protective form failure. 3rd party bares the benefit of the cost of
someone else
Regulatory capture-when regulators of different industries act in favour of producers not consumers
,Government budget- comprised of gov spending and tax revenue
Balanced budget- where gov tax rev is = to government expenditure during a financial year
Budget surplus- where tax rev exceeds gov spending in a financial year
Budget deficit- where government spending exceeds tax rev in a financial year
Cyclical budget deficit- temporary budget position, related to business cycle. Deficit may occur during a recession, tax rev
fall and expenditure of u/e benefits increases- gov increase sending to stimulate the economy
Structural budget deficit- a budget which is either in a deficit or surplus due to an imbalance in the revenue and
expenditure of the government, it exists at every point in the business cycle. Doesn’t matter if a county is in a boom or
recession, country would still run a deficit
Direct taxes- a tax that is paid directly to the government by the individual tax payer. The tax liability cannot be passed
onto someone else e.g. income tax, corporation tax
Indirect taxes- a tax imposed on expenditure on goods and services. Paid by the retailer on behalf of the consumer
although can be transferred onto the consumer. E.g. VAT and excess duties
The laffer curve- representation of the relationship between rates of taxation and the hypothetical resulting levels of
government revenue. Up until the point T, as tax rates increase, gov tax rev increases. After point T people do not think
it’s worthwhile working and the lack of incentive to work leads to falling revenue. T is the optimum tax rate where the
gov can maximise rev
,Demand side policies:
- designed to manipulate consumer demand. Expansionary policy is aimed at increasing AD to bring about growth,
whilst contractionary policy attempts to decrease AD to control inflation.
Monetary policy instruments:
Interest rates in the UK, the Monetary Policy Committee (MPC) alters interest rates to control the supply of money. They
are independent from the government, and the nine members meet each month. Rates are used to help meet the
government target of price stability, since it alters the cost of borrowing and reward for saving.
The bank controls the base rate, which ultimately controls the interest rates across the economy. A reduction in the base
rate will lead to a rise in AD. This happens through a number of transmission mechanisms:
Expansionary monetary policy- the transmission mechanism (opposite for Contractionary) – use of i/r to influence AD
§ Cut in I/R will reduce the cost of borrowing. Cheaper for consumers to borrow. Disposable income increases allowing
them to spend on houses, cars- increases C shifting AD to the right from AD1 to AD2
§ Cut in I/R reduces the rate of return on savings. This reduces the incentive to save and increases the incentive to
spend or borrow to spend. Savings ratio will decrease, consumption increases shifting AD to the right from AD1 to
AD2
§ Reduces the monthly payments for those with tracker or variable mortgages. Monthly, these homeowners will
receive a boost to their disposable income; increase MPC thus boosting C shifting AD to the right from AD1 to AD2.
§ Higher consumption, due to lower borrowing, will mean that asset prices increase. This will lead to a positive wealth
effect.
§ Reduces the cost of borrowing for firms enabling them to reach their hurdle more easily. Increases MP to invest
increasing I in AD shifting AD to the right from AD1 to AD2
If relative UK interest rates fall, investors will move their money out of UK financial institutions in order to chase
better I/R. Lower interest rates reduce the incentive for investors to hold their money in British banks there’d be
hot money outflows from the UK increasing supply of the pound. A weak E/R makes exports cheaper and imports
dearer. Improvement in the trade balance reduce a CA deficit or move it to a surplus. As (X-M) is a component of
AD, shifting AD to the right from AD1 to AD2
§ Higher rates will increase the incentive for foreigners to hold their money in British banks as they can see a higher
rate of return. As a result, there will be increased demand for pounds and the value of the pound will rise . This means
that imports will be cheaper, and exports will be more expensive. This decreases net trade and therefore AD.
There are some problems with this method of demand management
§ The exchange rate may be affected so much that exports fall significantly and imports rise significantly, causing a
balance of trade deficit.
§ Banks might not pass the base rate onto consumers, which means that even if the central bank changes the interest
rate, it might not have the intended effect
§ Changes in interest rates take up to 2 years to have their full effect and small changes in interest rates may not
affect people’s decisions.
§ Sometimes, interest rates are so low that they cannot be decreased any further to stimulate demand
§ There are a range of different interest rates and not all of them are affected by the Bank of England base rate
§ A lack of confidence in the economy may mean that, no matter how low interest rates are, consumers and
businesses do not want to borrow or banks do not want to lend to them.
§ High interest rates over a long period of time will discourage investment and decrease LRAS.
,Expansionary monetary policy cons:
§ Demand pull inflation- as spare capacity is being exhausted more competition for resources and pressure is put on
existing FOP increasing the price of them. Puts upward pressure on price – DPI
§ I/R cannot fall below 0 (liquidity trap); Keynesian argument I/R after a given point loses their effectiveness when they
hit their lower bound. When they hit this economy enters liquidity trap. Consumers and businesses convert their illiquid
financial assets into cash to facilitate spending or investment, hoarding. If the central bank tries to cut I/R further
consumers already have lots of cash no need to borrow, won’t see increase in consumption, investment if I/R are
already low.
§ Large negative impact on savers. Wealth inequality with the poor struggling to find assets with a good return rich are
more likely to take a risk and search to find higher yielding assets
Expansionary monetary policy evaluation (opposite for Contractionary)
The initial level of economic activity. Economy is in large negative output gap- increase in AD = larger output and
decrease in U/E. Due to spare capacity, potentially no DPI pressures, not making exports less competitive and worsening
CA position
Consumer confidence- consumers need to be confident- low I/R incentive to borrow and spend. Low consumer confidence,
cutting I/R doesn’t guarantee spending
Business confidence- need to be confident in profitability and demand- reason to invest when I/R are low. When business
confidence is low it doesn’t guarantee more borrowing for investment.
§ AD is unlikely to increase if at all leaving the four key macroeconomic objectives of government unaltered.
The length of time lags for I/R (monetary policy) having an effect on the economy. 2 years for it to feed through and have
an impact on economy. A change in I/R- feeds through the transmission mechanism affecting house prices, commercial
bank I/R
Whether banks are willing to lend and willing to pass on the full rate cut. Banks in times of deep recession or crisis are
concerned with liquidity and profitability. Their willingness to take risks is low, reducing willingness to lend. Even if banks
are willing to lend- may only pass on a small percentage of the rate cut for consumers and firms and thus the positive AD
impact.
As AD increases due to expansionary monetary policy
§ Growth- actual growth increases from Y1 to Y2. With greater demand firms respond by increasing output
exhausting spare capacity; Y2 is closer to YFE output. This increase in output is an increase in real GDP, increase in
economic growth
§ Unemployment- decreases, labour= derived demand. Demand for goods and services is high, firms will need more
workers to produce extra output- reducing u/e
,Quantitative easing:
Asset purchases to increase the money supply: Quantitative Easing (QE)
§ Helps to stimulate economy when standard MP is no longer effective, not possible to lower interest rates further.
§ Inflationary effects since it increases the money supply, and it can reduce the value of the currency.
§ It can prevent the liquidity trap, where even low interest rates cannot stimulate AD.
§ Banks buy assets in the form of government bonds using the money they have created- used to buy bonds from
investors, which increases the amount of cash flowing in the financial system. This encourages more lending to
firms and individuals, cost of borrowing lower. The theory is that this encourages more investment, more
spending, and hopefully higher growth.
§ A possible effect of this is that there could be higher inflation. If inflation gets high, the Bank of England can reduce
the supply of money in the economy by selling their assets. This reduces the amount of spending in the economy.
Advantages:
§ Gives a central bank an extra tool of monetary policy besides changing interest rates
§ Increasing the size of the monetary base helps to lower the threat of price deflation. Without QE the fall in real GDP
would have been deeper and the rise in unemployment greater
§ Lower long term interest rates have kept business confidence higher and given the commercial banking system extra
deposits to use for lending
§ QE can lead to a depreciation of the exchange rate which helps to improve the price competitiveness of export
industries
Disadvantages:
§ May contribute to rising wealth inequality because of surging house prices and housing rents- worsens geographical
mobility
§ Increase in the monetary base might lead to inflationary pressure
§ Ultra low interest rates can distort the allocation of capital and also keep alive zombie companies (key criticism of
Hayekian/ Austrian school)
§ Low interest rates has reduced the annual incomes from pension funds making life tougher for those with savings and
who rely on their occupational pension
§ It had a large effect on the housing market by stimulating demand and leading to rapid price rises since 2013, helping
to worsen the issues of geographical mobility. It also led to rising share prices which increases inequality, since the
rich grow richer whilst the poor see none of the gains.
Bond price increase= yield
Process:
decrease
1. Electronic money on balance sheets
Bonds purchased –
2. Purchase bonds from a financial
demand increase thus
institution- increase price of bonds
price increases.
3. Yields of bonds fall
4. Financial institutions- increase Inverse relationship
cash/ liquidity between yield and price of
5. Banks increase lending theoretically bond. Bond yield = i/r rate
= more cash + cheaper credit on bond- bond yield
6. Low i/r – increase consumption decreases- i/r at com bank
+investment falls
7. Currency depreciates due to capital § Effect of QE on foreign exchange market:
outflows § Yield decreases- foreign currency Bond yield= coupon value/
depreciates market price of bond *100
,
, Fiscal policy: changes in government spending and taxation to influence aggregate demand in an economy
Governments spend money in the economy to:
§ Influence the level of economic activity
§ Correct market failures/ improve allocative efficiency
§ To reduce inequality and promote equity
Expansionary fiscal policy:
1. Government can reduce the marginal rate of income tax for those in lower income tax bands or increase the tax
free allowance. Increase AD, MPC increases
2. Governments can reduce the marginal rate of income tax on the rich. Increase disposable income which will be spent
in the economy increasing AD- multiplier effect
j h
3. Reduce level of regressive taxes such as VAT. Frees up more income for poor to spend AD increases
4. Governments can reduce the level of corporation tax. Increase retained profits- investment AD to AD1
5. Governments can boost spending on infrastructure, education, healthcare, wages. G is core component- significantly
increase AD- generates large multiplier effect- final GREATER increase in AD
As AD increases due to expansionary fiscal policy
§ Growth- actual growth increases from Y1 to Y2. With greater
demand firms respond by increasing output exhausting spare
capacity; Y2 is closer to YFE output. This increase in output is
an increase in real GDP, increase in economic growth
Unemployment- decreases, labour= derived demand. Demand for
goods and services is high, firms will need more workers to produce
extra output- reducing u/e
Expansionary fiscal policy and LRAS
1. Reducing level of corp tax- investment increase- quantity and quality of the capital stock in the economy shifting
LRAS1 to LRAS2
2. Governments can boost spending in the economy by spending on infrastructure; healthcare etc. increases the
quantity and quality of the capital stock. Investment in education and healthcare – increase the productivity of labour;
quality. Infrastructure- increase productive efficiency of the economy making it quicker, easier and cheaper to
transport goods and services nationally and internationally. Increase LRAS from LRAS1 to LRAS2
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