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Macroeconomic Policy Instruments

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Beacon 12 Economics

on 17 February 2011

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Transcript of Macroeconomic Policy Instruments

Macroeconomic Policy Instruments Remember...

Marcoeconomic Policy OBJECTIVES

?..?.. Price Stability...
Full employment...
Balance of payments...
Economic growth... Demand-Side
Policies Supply-Side
Policies Policies that aim to influence an economy's AGGREGATE DEMAND.

* Stabilising level of output and employment or stabilising price level.

* Thus, focusing on the short-run position of the macroeconomy. Range of measures intended to have a direct impact on AGGREGATE SUPPLY.

* Intention is to affect AS in the long run. FISCAL POLICY MONETARY POLICY ...decisions made by the government on its expenditure, taxation and borrowing... ...the decisions made by government regarding monetary variables such as the money supply or the interest rate... * An increase in government expenditure will shift the AD curve to the right!

In response... the economy moves to a new EQUILIBRIUM - where price level will rise (P) and real output (y) will move closer to the full employment level (y*). If the government runs a budget deficit - remember, it may need to borrow money, which affects their debt position and possibly overall interest rates! Price Level Real Output This kind of policy is ONLY effective if the AD curve intersects the AS curve in the upward-sloping segment of AS!

If the economy is already at the full employment level of output (y*), then an increase in aggregate demand only results in higher price levels! =( Remember also... TAXATION!

* The key issue in fiscal policy is the BALANCE between government expenditure and revenue - because ultimately, this is what affects AD directly! GOVERNMENT BUDGET DEFICIT
[Decrease in the budget surplus]
... the balance between government expenditure and revenue ...
An INCREASE in the budget deficit moves the AD curve to the right!

Budget Deficit = Increase in expenditure OR decrase in taxation... INTEREST RATES
* At higher interest rates, firms undertake less investment expenditure and consumers less consumption expenditure.

* Remember, this may also raise exchange rates as overseas firms will purchase more pounds and invest more! Real Output Price Level * Now remember...
If the government feels that the economy is close to full employment, then this will push prices up without ANY resulting benefits in terms of output...

This means, that if the government INCREASES THE INTEREST RATE (a monetary policy instrument), this will lead to a FALL in AD - this will relieve the pressure on prices. THE MONETARY POLICY COMMITTEE
...body within the Bank of England responsible for the conduct of monetary policy... The MPC is responsible for setting interest rates in a way to keep inflation within 1 percentage point (either way) of the 2% target for CPI inflation... The BANK RATE is set by the MPC of the BANK OF ENGLAND in order to influence inflation - this rate is used by the commercial banks as their own base rate... Education & Training Flexibility of Markets Unemployment Benefits Promotion of Competition Incentive Effects ...encouraging workers to undertake education and training to improve productivity in the workforce... this includes potential workers too! This education and training can allow for workers to move easily between sectors and occupations, and switch into new activities when the structure of the economy is changing... ...providing training and education also allows for greater flexibility in labour markets - allowing workers to switch between economic activities... Limiting the power of trade unions is another strategy for improving market flexibility - by decreasing resistance to new working practices and avoiding the push to increase wages (or else employment will fall!) An important influence on labour supply is the level of unemployment benefit...

Too high = not enough participation in the workforce...

Reducing the unemployment benefit, may motivate individuals to join the workforce and therefore increase labour supply. It is good to promote competition!

If monopoly firms are faced with competition, they are forced to stay competitive and protect their market share - usually through keeping prices low (or reasonable) to compete! Also, increased competition may encourage a firm to improve productivity...

Lack of competition may produce complacency, in that firms and their workforce may not be as productive as they can be. Progressive taxation system...

Higher income = higher tax paid...

If this becomes too high, or inequality begins to show, workers will become less motivated to provide the extra productivity and effort in the workforce... HOW DO THESE CONFLICT? Fiscal Policy & Monetary Policy Because of the implications that fiscal policy may have for the interest rate, it is inevitable that fiscal and monetary policy may come into conflict! Fiscal Policy & Supply-Side Fiscal policy may have INFLATIONARY effects in the short-run and DEFLATIONARY effects in the long-run...

WHY...? Fiscal policy may also interact with supply-side policies...

For example - government may initially increase expenditure on education and training. This would have a short-run effect on aggregate demand... However, as we know, in the long-run, this education and training may raise worker productivity, which in turn will have the effect of shifting the AS curve! Because remember...

If the government increases expenditure (fiscal policy) it may end up operating at a DEFICIT... which means borrowing money... which means the possibility of rising interest rates (monetary policy)... Monetary Policy & The Exchange Rate Higher interest rates = less investment and consumption expenditure...

AND increased investment from overseas (increasing demand for pounds) = appreciation in the exchange rate = decrease in foreign demand for UK exports = reduced demand for domestic goods... all of these factors LOWER the level of aggregate demand, shifting the AD curve to the left! Of course, a reduction in interest rates would have the opposite effect! Monetary Policy & Supply-Side The overall aim of monetary policy is not simply to keep inflation low, but to encourage firms to invest in order to generate an increase in production capacity, by shifting the AS curve... The PROBLEM is that high interest rates may be needed at times in order to achieve the inflation target ... and high interest rates will tend to discourage investment! SO WHAT DOES ALL THIS MEAN...? Demand-side and supply-side policies have different objectives! Demand-side policies [fiscal and monetary] are aimed primarily at stabilising the economy. Supply-side policies are geared more towards promoting economic growth [influencing the position of the aggregate supply curve]. MONETARY POLICY involves the manipulation of monetary variables in order to influence AGGREGATE DEMAND in the economy! The prime instrument of MONETARY POLICY is the interest rate! Interest rates will effect consumer willingness to spend money... In the UK, monetary policy is conducted by the Bank of England, which has had independent responsibility for meeting the inflation target since 1997. It is hoped that by keeping inflation low, firms will remain confident and invest more - therefore increasing the productive capacity of the economy. HOWEVER, in the short run, high interest rates imposed to reduce inflation may discourage this investment... If government decreases taxes, they also decrease their revenue as a result! HOWEVER... effective stabilisation of the economy (using DEMAND-SIDE policies) may also have long-term effects on aggregate supply.
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