Lecture 12: Macroeconomic Policy

1. Lecture 12: Macroeconomic Policy

2. Fiscal Policy Fiscal policy seeks to control aggregate demand by altering the balance between government spending and taxation The purpose of fiscal policy correcting a fundamental disequilibrium fine tuning to influence aggregate supply

3. Fiscal Policy • Government finances, the terminology • budget deficits and surpluses • general government • the whole public sector • public-sector net borrowing • public-sector net cash requirement

4. QThe public-sector net cash requirement (PSNCR) is defined as: the amount central government has to borrow in a given year. the national debt. the increase in government securities issued in a given year. the excess of public-sector spending over public-sector receipts in a given year. the budget deficit in a given year.

5. Fiscal Policy Government finances, the terminology budget deficits and surpluses financing a deficit general government the whole public sector PSNCR the national debt and public-sector debt

6. QIf investment exceeds saving by £10m and there is a current balance of payments surplus of £30m, then for the economy to be in equilibrium there must be a: budget deficit of £40m. budget surplus of £40m. budget deficit of £20m. budget surplus of £20m. budget balance.

7. Fiscal Policy • Factors determining the effectiveness of fiscal policy • accuracy of forecasting • effect on J and W • effect of changes in J and W on national income • timing of the effects • effects on the various macro objectives

8. Fiscal Policy • Discretionary policy • problems of forecasting the magnitude of the effects • effects of changes in government expenditure • crowding out • effects of changes in taxes • size of the multiplier and accelerator effects • random shocks • problems of timing and time lags • various time lags • policy may be destabilising

9. Fiscal policy: stabilising or destabilising? Path (a): no intervention 3 4 Real national income 3 2 4 2 1 1 O Time

10. Fiscal policy: stabilising or destabilising? Path (b): policy stabilises Path (a): no intervention 3 4 Real national income 3 2 4 2 1 1 O Time

11. Fiscal policy: stabilising or destabilising? Path (c): policy destabilises Path (a): no intervention Path (b): policy stabilises 3 4 Real national income 3 2 4 2 1 1 O Time

12. QCrowding out is defined as: increased public expenditure replacing private-sector expenditure. increased taxes pushing up interest rates. when there are insufficient tax revenues to finance increased government expenditure. the difficulty some people find in paying their taxes. that part of public expenditure financed from borrowing.

13. Fiscal Policy • Fiscal rules • constraints on fiscal policy • the EU Stability and Growth Pact • current EU targets • UK Labour government's 'Golden Rule’

14. Fiscal Policy • Fiscal rules • constraints on fiscal policy • the EU Stability and Growth Pact • current EU targets • UK Labour government’s ‘Golden Rule’ • the UK Fiscal Compact • Coalition government’s ‘Fiscal Mandate’

15. Monetary Policy • The significance of monetary policy • the use of monetary policy • varieties of monetary policy • The policy setting • the goals of the policy • monetary rules or discretionary policy? • relationship between the government and the central bank • degree of central bank independence

16. Monetary Policy • Medium- and long-term policy • control of banks’ liquidity ratio • restricting size of public-sector deficits • Issues with medium- and long-term monetary control • the effects of automatic fiscal stabilisers • the desire to cut taxes • difficulty in cutting government expenditure

17. Monetary Policy • Alternative approaches to short-term control • controlling money supply • controlling interest rates • credit rationing

18. The demand for and supply of money MS r1 L Q1 Rate of interest O Money

19. The demand for and supply of money MS' r2 Q2 MS Rate of interest r1 L O Q1 Money

20. Monetary Policy • Techniques to control money supply • open-market operations • reduced central bank lending to banks • funding • variable minimum reserve ratios • Difficulties in controlling money supply • what to control? • ways in which banks can resist attempts to restrict the growth in the money supply • demand-determined money supply

21. QWhich one of the following would NOT be a cause of growth in the money supply? The central bank sells fewer securities to the banking sector. The central bank takes measures to reduce the exchange rate. Public-sector borrowing is financed by selling Treasury bills to the banking sector. The central bank imposes a statutory reserve ratio on banks that is higher than their current reserve ratio. The government operates an expansionary fiscal policy and the central bank maintains interest rates at their current level.

22. Monetary Policy • Techniques to control interest rates • announcing changes in interest rates (e.g. by MPC) • backing this up through operations in the repo market • Effectiveness of controlling interest rates • inelastic demand for loans • problem of possibly high interest rates • reasons for an inelastic demand for loans

23. An inelastic demand for loans Assume that the authorities want to reduce the demand for money to Q2. Rate of interest r1 Demand for loans O Q1 Q2 Loans

24. An inelastic demand for loans r2 A large rise in the rate of interest (to r2) will be necessary. Rate of interest r1 Demand for loans O Q1 Q2 Loans

25. Monetary Policy Effectiveness of controlling interest rates inelastic demand for loans problem of possibly high interest rates reasons for an inelastic demand for loans • unstable demand for money • problem of changing expectations • speculation • possible conflict between domestic goals and exchange-rate goals

26. Monetary Policy • Using monetary policy • difficult to achieve precise control of aggregate demand • problem of time lags • weak when pulling against expectations • problem of liquidity trap • Use of interest rates to meet inflation target • impact on expectations

27. Demand-side Policy • Attitudes towards demand management • combination of fiscal and monetary policies • type and flexibility of rules • Case for rules and policy frameworks • political behaviour • seeking re-election or courting popularity • loss of credibility • time lags • initial under- and then over-correction • help to reduce inflationary expectations • create a stable environment for investment andeconomic growth

28. Demand-side Policy • Case for discretion • can cause severe fluctuations in interest rates and can cause greater instability • which rule to choose? • rules may conflict • rules may become unsuitable • fine tuning can be improved by better forecasting and quicker action

29. QWhich one of the following would reduce the case for using a fixed inflation target and increase the case for using discretionary policy? Time lags become longer between policies being implemented and their full effects being felt. Targets have an increasing impact on expectations. The world economy becomes more stable. Inflation becomes less likely to diverge from its target. Cost-push pressures increase.

30. Demand-side Policy • Constrained discretion in the UK • fiscal policy • 'golden rule' • but some flexibility • monetary policy • target of 2% CPI inflation set by government • MPC adjusts interest rates to meet this 2% target based on projections two years hence

31. Demand-side Policy • Constrained discretion in the UK • fiscal policy • 'golden rule' • but some flexibility • monetary policy • target of 2% CPI inflation set by government • MPC adjusts interest rates to meet this 2% target based on projections two years hence • benefits of transparency • benefits for expectations

32. Demand-side Policy • Response to credit crunch • fiscal policy • golden and sustainable investment rules suspended • monetary policy • interest rates cut to virtually zero

33. Demand-side Policy • Response to credit crunch • fiscal policy • golden and sustainable investment rules suspended • monetary policy • interest rates cut to virtually zero • pump liquidity and capital into banking system • quantitative easing • Fiscal consolidation of Coalition government • fiscal mandate • Cyclically adjusted current budget balance by 2015/16

34. Q To take account of the fact that achieving the target rate of inflation may nevertheless still be consistent with fluctuations in national income, some economists have advocated following a ‘Taylor rule’. This means that: national output is targeted rather than inflation. the central bank will reduce interest rates if inflation is above target, for fear of an impending recession. real national income and inflation will, as a result, vary inversely. the amount that interest rates rise when inflation rises depends on the relative weights attached to divergences of inflation and real national income from their respective targets. inflation is less likely to diverge from its target.

35. Supply-side Policy • The use of supply-side policies • increase potential output • increase long-run rate of economic growth • Increase employment • reduce price pressures • Market-orientated supply-side policies • reducing government expenditure • tax cuts • importance of incentives • labour supply • capital expenditure

36. Supply-side Policy • Market-orientated supply-side policies (cont.) • reducing the power of labour • reducing welfare • policies to encourage competition • privatisation • deregulation • introducing market relationships into public sector • the Private Finance Initiative (PFI) • free trade and capital movements

37. QWhich of the following could be classified as market-orientated supply-side policy? Building more motorways. Investment grants for private firms. A reduction in corporation tax. Government-funded workplace training schemes. Urban regenerations schemes.

38. Supply-side Policy • Interventionist supply-side policy • failure of the market to provide adequate training, R&D and investment • training and education • infrastructure and capital projects • help to firms • nationalisation • direct provision • funding research and development • assistance to small firms • regional and urban policy • advice and persuasion • information

39. Q Although governments in most industrialised countries do not engage in national economic planning, virtually all intervene selectively in order to bring supply-side improvements. True False

40. The end… (kind of!) Any Questions?