Macroeconomic Policies

Macroeconomic Policies
Monetary Policy
Monetary Policy
Attempts to influence the level of economic activity
(the amount of buying and selling in the economy)
through changes to the amount of money in
circulation and the price of money short-term
interest rates.
Interest rates the key area of Monetary Policy
Monetary Policy
Short-term interest rates set by the Monetary Policy
Committee (MPC) of the Bank of England
Meets for 2 days each month
to decide on rates
The official rate is the rate at which the Bank of
England will lend to the financial system and
influences the structure of all other interest rates
Monetary Policy
Monetary Policy
Basis of Monetary Policy is that there is a long run
relationship between the amount of money and
inflation
Demand for Money the amount people wish to
hold as cash as opposed to other assets
The Supply of Money the amount
of money in circulation in the economy
The Classical Quantity Theory
of Money:
MV = PY
(where M = the money stock, V = velocity of
circulation, P = price level and Y = level of
national income
More formally:
Monetary Policy
Monetary Policy
M
d
= k PY where:
P is the price level
Y is the level of real national income
M
d
is demand for money for transactions purposes
K = proportion of national income held as transactions
balances
In equilibrium M
d
= M
s
So: P = 1/kY x M
A rise in Ms will lead to a proportional rise in P
Monetary Policy
Supply of Money:
Narrow Money notes and coins
in circulation
Broad Money Notes and coins plus money held
in bank and building society accounts
A rise in either (ceteris paribus) might signal
a rise in aggregate demand (AD)

Monetary Policy
The Interest Rate Transmission Mechanism
The process by which a change in interest rates
feeds through to AD

The Interest Rate Transmission
Mechanism 1
Interest
Rates
Borrowing
Individuals
Credit
Loans
Consumption
Firms
New
Loans
Investment
Existing Loans
Costs Employment Margins
Consumption
The Interest Rate Transmission
Mechanism 2
Interest
Rates
Mortgages
Existing
New
Consumption
Investment
Disposable
Income
Property
Equity
Demand
for New
Housing
Savings Consumption
The Interest Rate Transmission
Mechanism 3 External sector
Interest
Rates
Exchange
Rates
Appreciation
Mp
Xp
Dm
Dx
Depreciation
Mp
Xp
Dm
Dx
Balance of
Payments
Supply Side Policy
Supply Side Policy
Intention is to shift the aggregate supply curve to the
right, increasing the long term productive capacity
of the economy
Tend to be long-term policies
Arguments about how effective they are e.g.
lowering taxes increases incentives, reducing
welfare dependency increases the urge
to find work
Supply Side Policy
Inflation
Real National Income
AS
Yf
AS1
Yf2
AD
2.3%
2.0%
Supply side
policies can help
to push the AS
curve to the right
increasing the
capacity of the
economy from Yf
to Yf2
Increases in
long-term
capacity can help
the economy to
grow without
undue pressure
on inflation.
Supply Side Policies
Policies aim to influence productivity and
efficiency of the economy
Key feature open up markets and de-
regulate to improve efficiency in the working
of markets and the allocation of resources
Supply Side Policy
Main areas of policy:
Labour Market reduce impediments to free market, reduce
bureaucracy and red tape flexible labour markets
Reduce power of trade unions legislation of the eighties still
has an impact in this respect
Short term contracts
Flexible working arrangements
Hiring and firing
Contracts, terms and conditions, pay
Criticism of such policies is that they put the needs of
employers above those of workers which can lead to
exploitation


Supply Side Policy
Tax and Welfare Reform:
More stringent benefit regime
Tax reform to encourage people
to work
Improving access to training
and education
NREGS
Supply Side Policy
Education and Training:
Reform of 14 19 education
Modern Apprenticeships
National Qualifications framework coherent set
of qualifications
Expansion of vocational qualifications
Expansion of university access
Supply Side Policy
Incentives and technology:
Tax reform to encourage incentives
and entrepreneurial spirit
Incentives to develop new technology investment
Drive to embracing knowledge driven economy
Regional policies to encourage enterprise, investment,
location, expansion

Fiscal Policy
Fiscal Policy
Influencing the level of economic activity
though manipulation of government income
and expenditure
Associated with Keynesian Demand
Management Policies
Now seen in wider terms:
Fiscal Policy
Influence Aggregate Demand
Tax regime influences consumption (C) and
investment (I)
Government Spending (G)
Influences key economic objectives
Acts as an automatic stabiliser
BUT:
Fiscal Policy
Also used to influence non-economic
objectives and provide framework for supply
side policy
e.g. education and health, poverty reduction,
welfare reform, investment, regional policies,
promotion of enterprise, etc.
Government Income
Tax Revenue
Sale of Government Services e.g.
prescriptions, passports, etc.
Borrowing
Fiscal Policy
Need to remember subtleties in use of fiscal policy
Adjustment of income tax allowances rather than rates of income
tax
Extending or amending range of goods covered by VAT
Changing the rules under which tax has to be paid married
persons allowances, inheritance taxes, stamp duties, etc.
Abolishment of certain tax allowances MIRAS (Mortgage
Income Relief At Source)
Accusations of stealth taxes much of it is a tinkering with the
tax system to achieve certain aims mostly non-economic
(governments these days, for example, rarely increase taxes to
dampen down the economy)
Government Expenditure
Social Security
Law and Order
Emergency Services
Health
Education
Defence
Foreign Aid
Environment
Agriculture
Industry
Transport
Regions
Culture, Media and
Sport
The Golden Rule!
Fiscal policy framework
The Government's fiscal policy framework is based on
the five key principles set out in the Code for fiscal
stability - transparency, stability, responsibility, fairness
and efficiency.

The Code requires the Government to state both its
objectives and the rules through which fiscal policy will
be operated. The Government's fiscal policy objectives
are:

The Golden Rule!
over the medium term, to ensure sound public
finances and that spending and taxation impact
fairly within and between generations; and

over the short term, to support monetary policy and,
in particular, to allow the automatic stabilisers to
help smooth the path of the economy.
The Golden Rule!
These objectives are implemented through two fiscal
rules, against which the performance of fiscal policy can
be judged. The fiscal rules are:

the golden rule: over the economic cycle, the
Government will borrow only to invest and not to fund
current spending; and

the sustainable investment rule: public sector net debt
as a proportion of GDP will be held over the economic
cycle at a stable and prudent level. Other things being
equal, net debt will be maintained below 40 per cent of
GDP over the economic cycle.
The Golden Rule!
The fiscal rules ensure sound public finances in the medium
term while allowing flexibility in two key respects:
the rules are set over the economic cycle. This allows the
fiscal balances to vary between years in line with the cyclical
position of the economy, permitting the automatic stabilisers
to operate freely to help smooth the path of the economy in
the face of variations in demand; and

the rules work together to promote capital investment while
ensuring sustainable public finances in the long term. The
golden rule requires the current budget to be in balance or
surplus over the cycle, allowing the Government to borrow
only to fund capital spending. The sustainable investment
rule ensures that borrowing is maintained at a prudent level.
To meet the sustainable investment rule with confidence, net
debt will be maintained below 40 per cent of GDP in each
and every year of the current economic cycle.
Fiscal Policy In Action
Inflation
Real National Income
AS
AD
2.0%
U=5%
Assume an
initial
equilibrium
position with a
level of
National
Income giving
an
unemployment
rate of 5% (U
= 5%)
If government
reduces taxes
(remember the
subtleties) and
or increases
spending, it will
have various
effects:
AD=C+I+G+(X-M)
Apart from G, C
and I are also
likely to be
affected directly or
indirectly by the
policy change.
AD 1
AD therefore
shifts to the
right to AD1
2.5%
U=3%
The rise in AD leads to
an increase in real
national income,
ceteris paribus,
unemployment would
fall to 3% but at a cost
of higher inflation
Fiscal Policy In Action
Fiscal Policy influences AD in the short term but can
be used to affect AS in the long run depending on
the nature of the policy.
MULTIPLIER
The MULTIPLIER is the amount by
which a $1 change in autonomous
spending changes the equilibrium level
of output.

The greater the propensity to consume,
the higher the multiplier.

The Government Sector
Govt purchases and govt transfer payments
act like increases in autonomous spending in
their effects on the equilibrium level of income.

A proportional income tax has the same effect
on the equilibrium level of income as a
reduction in the propensity to consume.

A proportional income tax thus reduces the
multiplier.
The Budget
The budget surplus is the excess of govt
receipts over expenditures. When the govt is
spending more than it receives, the budget is
in deficit.


The size of the budget surplus ( or deficit) is
affected by the governments fiscal policy
variables - govt purchases, transfer
payments and tax rates.

The Budget
The actual budget surplus is also affected by
changes in tax collection and transfers from
movements in, the level of income that occur
because of changes in private autonomous
spending.

The full - employment (high employment) budget
surplus is used as a measure of the active use of
fiscal policy.

The full employment surplus measures the budget
surplus that would exist if output were at its
potential full - employment level.