The Macro Economy
Economic Objectives
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Low Unemployment
High but sustainable economic growth
Low and stable inflation (target is 2%)
Balanced balance of payments
Government Objectives
The role of the government
is to provide a stable
environment in which
business can flourish. It
aims to provide the highest
possible trend rate of
growth.
Government and the cycle – too high growth rates
are rarely sustainable. Current governments have
taken to trying to dampen down the extremes of the
cycle so that recessions are not as deep or recoveries as
sharp as they have been in the past.
AD / AS Analysis
• This gives us a model of how
the economy works and how
output and employment is
determined.
• Demand may not be at an
optimum level. Governments
may use monetary and fiscal
policy to influence the level
of AD
• Long run growth is
determined by AS
A combination of policies can be used
to achieve objectives
• DEMAND SIDE POLICIES – about changing the
level of aggregate demand (spending)
• Monetary Policy – the use of interest rates and
control of the money supply to achieve
macroeconomic objectives
• Fiscal Policy – the use taxation and government
spending to achieve macroeconomic objectives
• SUPPLY SIDE POLICIES – about increasing the
economies capacity to produce goods and
services
Tackling Unemployment
• Increase aggregate demand in the economy.
More demand = more spending = more
output = more employment (lower
unemployment)
• Expansionary fiscal and monetary policy
• Supply Side Policies
• Eg education and training to help peopl gain
employment
Economy Overheating – Inflation
above target
• Contractionary Monetary Policy – increase
interest rates – more incentive to save – people
pay more back on mortgages – demand in the
economy falls – inflationary pressures reduced
• Contractionary Fiscal Policy (budget surplus?)–
tax up – gov spending down – lower aggregate
demand – inflationary pressures reduced
• Supply Side Policies – allow demand to grow
without increasing prices by increasing
economies productive potential
Economy in Recession or Slowdown –
growth low or negative
• Expansionary Monetary Policy
• Expansionary Fiscal Policy
• Supply Side Policies
• HOWEVER – evaluate!!!!
• Eg expansionary monetary policy to increase
growth may lead to inflation rising above
target
Macro Economic Policy
Fiscal Policy
• Is the use of government spending and
taxation to achieve economic objectives
Fiscal Policy
• Expansionary (Reflationary) Fiscal Policy – if the
economy is in a slowdown, or recession, the
government may cut taxes and increase
government spending, in order to increase
aggregate demand (spending) in the economy.
• Contractionary (Deflationary) Fiscal Policy – If
the economy is overheating, with too much
inflation, the government may increase taxes and
reduce government spending, in order to reduce
aggregate demand (spending) in the economy.
You need to be able to explain.
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Example
A cut in direct taxation such as income tax.
Will increase people’s disposable income.
As a result there will be more aggregate demand and
spending in the economy
Therefore businesses will produce more in response to
higher demand
As a result GDP will be higher (economic growth)
More people will be needed to produce higher output
(lower unemployment)
However there may be an upward pressure on prices
(demand pull inflation)
Fiscal Policy – Key Concepts
• Budget Deficit – is where the government spends more
than it takes in revenue from taxation and other
sources. An expansionary fiscal policy may involve
deliberately running a budget deficit so as to increase
total demand in the economy. This may be done if the
economy is growing slowly or in a recession
• Budget Surplus – is where the government spends less
than it takes in revenue from taxation and other
sources. A contractionary fiscal policy may involve
deliberately running a budget surplus so as to reduce
total demand in the economy. This may be done if the
economy is overheating and inflation is rising
Tax and Spend – Key Terms
• Tax – a compulsory payment to the government
• Direct Tax – a tax on income and wealth paid directly to the government
• Indirect Tax – a tax on spending. Often defined as a tax on goods and services.
We pay this indirectly through the price of something
• Progressive Tax – Takes a greater proportion of income from higher incomes
• Regressive Tax – Takes a greater proportion of incomes from lower incomes
• Proportional Tax – Takes the same proportion of income from all income levels
Government Spending & Business
The impact will depend upon what the government spends its
money on
• Increases in spending may create more demand in the
economy
• Spending may be targeted in order to support certain
areas – eg car scrappage scheme
• Spending on roads, buildings etc may support
construction industry
• The multiplier effect – this is where an injection of
spending creates more spending than the initial
amount spent. (can be regional or national)
The Multiplier Effect
• Where an injection of spending in the economy
leads to more spending than the initial amount
spend. Eg
• Government builds school – incomes of builders
etc rises – these people are able to spend more –
increased spending represents income for other
business – these businesses may increase output
and employ more people as their income rises – a
lot of this extra income will be spent generating
more income for other businesses etc
Economic Effects of Changes in Direct
Taxation
• Direct Taxes such as income tax help to reduce
inequalities in income as they are progressive
• High Direct Taxes may harm incentives. Income tax
may deter workers from working longer, seeking
promotion or moving to higher paid jobs.
• Unemployment Trap – taxes such as income tax may
even deter people from working at all if their income
after tax is not much higher than income from benefits
when not working
• High Direct Taxes may discourage entrepreneurship
and even lead to business locating in another country
Economic Effects of Changes in
Indirect Taxation
• Choice – Taxpayers have a choice as they only pay the
tax if they purchase the commodity on which the tax is
raised
• Indirect Taxes affect the pattern of demand –
consumers will reduce the consumption of goods and
services with the highest taxes on them. This can lead
to less output and employment in those industries
• Indirect taxes tend to be regressive – poorer people
pay a higher proportion of their income in tax
• Indirect taxes – can be used to discourage the
consumption of demerit goods or goods with high
external costs such as cigarettes, alcohol and petrol
Tax!
• The impact of any tax cut on spending will depend
upon the Marginal Propensity to Consume (MPC).
This is the proportion of any extra income that will
be spent. Mine is likely to be lower than yours!
• The government is currently spending more than it
takes in taxation – it is borrowing and it can’t do this
for ever
• Robin Hood Economics – Tax from rich and give to the
poor is likely to create the most spending in the short
term.
Evaluating the Effects of Fiscal Policy
• Imprecise Tool - Affects demand and spending
BUT – difficult to judge and estimate the impact
any decision might have (eg size of multipliers)
• Side Effects of Policy – Expansionary may add to
inflationary pressures. Contractionary may lead
to slower growth and rising unemployment
• May Conflict with Other Objectives – eg
government would be reluctant to undertake an
expansionary fiscal policy at present as it is trying
to cut the budget deficit
The Importance of the Budget Deficit
• In recent years the UK government has faced a difficult trade off in its
objectives for demand management:
• On the one hand – the economy has been operating at well below full
capacity as a result of the recent recession. This would suggest a need for
an expansionary fiscal policy to boost aggregate demand in the economy
• On the other hand – we have a large budget deficit and national debt as a
percentage of GDP has risen to levels not seen since the end of WW2. this
would suggest a need for a contractionary fiscal policy
• Why does the deficit matter?
• A high proportion of government revenue is being used to pay the interest
on the national debt
• The debt imposes a burden on future generations
• If we do not tackle the deficit it could affect the UK’s credit rating. If our
credit rating falls we may have to pay higher interest on the debt.
Monetary Policy
The use of interest rates and the
supply of money to achieve
Macro Economic objectives. The
Bank of England is responsible
for monetary policy in the UK
and is tasked with keeping
inflation at 2% (+ or – 1%)
Interest Rate Policy
• Expansionary Monetary Policy – if the economy
is in a slowdown, or recession, and inflation is
below target the Bank of England may cut
interest rates in order to increase total demand
and spending in the economy.
• Contractionary Monetary Policy – If the economy
is overheating, with too much inflation, the Bank
of England may increase interest rates in order to
reduce total demand and spending in the
economy.
How does interest rate policy work?
• A rise in interest rates
• Makes saving more rewarding so consumers may
spend less
• Makes borrowing more expensive so consumers
may spend less on credit
• Makes borrowing more expensive for firms so
investment expenditure falls
• Means many people have higher mortgage
repayments so their disposable income falls and
they have less to spend
Evaluating the Effects of Monetary
Policy
• Time Lags – The MPC meets monthly so it can
react quickly to changes in the economy. It is also
quicker to react than fiscal policy BUT – it still
takes time for the full impact of interest changes
to affect the economy
• Exchange Rate Effects – Changes in interest rates
can also affect the exchange rate and so can
impact upon the Balance of Payments
• Policy Conflicts – higher interest rates now to
combat inflation could send us back into
recession
Supply Side Policies
• Policies that increase the ability
of the economy to supply more
goods and services
• If successful, this means that
when demand rises in the
economy, this will lead to a
greater GDP (economic growth)
without inflation being a
problem
Supply Side Policies Examples
• Education and Training - make workforce more productive and flexible –
human capital
• Reducing Direct Taxes – on lower income earners increases the incentive
to work – on higher income earners may increase incentive to work hard
or work in the UK rather than somewhere else
• Reducing Benefits – Increases incentive to work
• Encouraging Enterprise – through tax relief, grants and subsidies – new
business should lead to more output and more growth
• Encouraging new technology and innovation – capital allowances to
encourage investment and R&D – Helps to increase productive capacity of
the economy
• Reducing Monopoly Power – monopolies restrict output and increase
prices. Reducing monopoly power helps increase total supply in the
economy
• Reduce Union Power – as these act as monopolies in the labour market
Evaluating the Effects of Supply Side
Policies
• Long Term – often take a long time to put into
effect and to have an impact
• Controversial – may face resistance from
some groups in the economy – eg trade
unions will oppose policies to limit their
powers. Reducing benefits may hurt
vulnerable groups in society.
Tradeoffs
It is difficult to achieve all objectives all of the time
Comparing Policies
MPC meet
monthly
Quite
Flexible
but….
Eg – changes
in education
may take years
to be effective
Monetary
Demand can
be affected
fairly quickly
by policy
changes
Demand Side
Policy
Fiscal
Changes made
annually in
budget
Not Flexible
enough to
react to
changes in the
economy in the
short term
Supply Side
Long Term
Possible Questions
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Assess the likely effects on UK Inflation of rising energy bills (10 marks)
Assess the likely effects of rising energy bills on the UK Economy (12 marks)
To what extent does Britain’s budget deficit make it difficult for the UK government
to follow the energy policy it would like (10 marks)
Assess the economic case for subsidising windfarms – evidence D (12 marks)
Assess the extent to which subsidising windfarms creates economic benefits (12
marks)
Assess the case for the UK government paying cold weather payments to
vulnerable people (10 marks)
Analyse two reasons why of those in debt on their energy bills, 41% owe more
than they did 12 months ago - evidence H (8 marks)
Assess the potential impact of rising levels of energy bill debt on the UK economy
(12 marks)
Assess the potential impact of disruptions to Norwegian gas supplies for the UK
Economy (10 marks)
Assess the extent to which energy security is important to the UK economy (10
marks)