1) Demand side policies, which include:
1.1) Fiscal policies, and
1.2) Monetary policies
2) Supply side polices.
1.1 Fiscal Policies: The nature of fiscal policies is to influence the AD. There are two main types of fiscal policies: Discretionary fiscal policies and Automatic stabilisers.
The Discretionary fiscal policies include:
1) A change in government spending, which includes:
1.1) Capital Expenditure (EG hospitals; roads; schools etc), this is influenced by government policies and for example changes in the composition of the population
1.2) Current Spending: all expenditures for running public services. (EG teachers, drugs for NHS or police officers) This is primarily effected by the level of wages.
1.3) Transfer payments: This is for transferring money from taxpayers to recipients. (EG money from working people to unemployed or pensioned)
1.4) Debt interest payments, this is primarily affected by the rate of interest.
2) A change in taxes, which includes:
2.1) Progressive tax, also: direct tax. (EG Income tax) Progressive means that the rich pay more on the taxes than the poor do.
2.2) Regressive tax, also: indirect tax. (EG VAT) Regressive means that the rich pay relatively less than the poor do. (Nominally the same)
The automatic stabilisers are a change in government spending by EG the social protection. (Paying to people who don’t have jobs) The more unemployed there are, the more the payments will be. (G up, ceteris paribus, AD up)
The fiscal policies do have some advantages and disadvantages.
The main advantages include:
- Offset fluctuations in GDP.
- Potential to increase both AS and AD (EG corporation tax cuts)
The main disadvantages include:
- Tax cuts have take some time to have an effect; because of this time lag the policies might work against the economy. (EG when economy is heading into a boom and AD is being stimulated this might lead to inflationary pressure)
- Might not work because firms and household might react in unexpected ways( Cut in income tax leading to more savings instead of consumption and investments; primarily because of a lack of confidence)
- Might not work because the size of the multiplier was estimated wrongly
-Might not work because other countries might have different fiscal policies resulting in less efficient fiscal policies in this country)
- Might clash with other macro-economic objectives. (EG a rise in income tax might discourage people from working or a rise in tax which was meant to reduce inflation might result in a too big cut of AD causing real GDP to fall causing unemployment. En visa versa: While stimulating AD to reduce unemployment price levels may go up as well increasing inflationary pressures.)
1.2 Monetary policies, there are three main monetary ‘tools’ for the government:
1) Rate of interest
When the government increases the rate of interest:
-The exchange rate will go up (because other people start putting their money on British banks and therefore the demand for the GBP will increase), this will result in cheap imports and dear exports. Therefore the Net exports will be reduced.
-The investments will fall because corporations will have to pay more interest on debts.
- Consumption will fall because consumers will borrow less.
- Since in AD=C+I+G+(X-M); C falls, I falls and (X-M) falls.. AD will fall.
2) Money supply.
When the government increases the money supply:
- Banks will lean more money; causing an increasing in consumption and a decrease in the rate of interest. (The supply for the pound has increased so the price will fall)
- A falling rate of interest and an increasing consumption will cause the AD to increase.
3) Exchange rate.
When the government lowers the exchange rate:
- It will increase the balance of trade ( (X-M) will increase)
-Increases economic activity. (More cheap for foreign investors to come and start businesses)
There are however some disadvantages to applying monetary policy:
- The market fluctuations have a big influence in the exchange rate; making it hard for governments to intervene in this market.
- Time lags ( Changes in the ‘tools’ take time to get to work; the rate of interest is estimated to take 2 years before the full effects are experienced)
- It’s hard to estimate in what extend AD will change when applying those tools.
- Ability to change interest rates isn’t that big because they have to stay within a certain boundary from other countries interest rates to prevent massive money flows.
- The use of these tools might have side effects. (EG the increase of the ex. Rate meant to reduce inflation might also worsen the balance of payments.
2) Supply side policies: policies primarily focused on influencing the AS.
Usually this is done by lowering the costs of production and/or Increasing productive capacity by increasing efficiency. The supply side policy increases performance on particular markets instead of entire economy. (Sometimes referred as microeconomic policies)
The supply side policies do have some advantages and disadvantages.
The main advantages include:
- Increase of productive potential
- May reduce structural and frictional unemployment
- May help prevent inflation.
- Improve country’s trade position.
- Increasing AS enables AD to grow over time without inflationary pressures building up. (AS curve shifts to the right enabling AD to move to AD1)
The main disadvantages include:
- Might not work because the results of certain policies are debatable. (EG the reduction in unemployment benefit will only rise AS for structural unemployment issues. )
- Might not work because of time lags.
- Won’t work if there’s a lack of AD: the extra capacity won’t be used.
Examples of supply-side policies:
1) Education and training. This will result in a more efficient economy and therefore in a rise of AS.
2) Government assistance to new firms. (New firms create employment and new ideas)
3) Reduction in direct taxes. This raises Investments raising both AS and AD.
4) Reduction in unemployment benefit. Reduction in jobs seeker allowance results in unemployed being forced to seek work and accept work at lower wages. This will however only work if the unemployment is of structural uses. When there are no jobs the consumption will fall as real disposable income falls and AD will – ceteris paribus- fall, causing firms to reduce output and make workers redundant.
5) Reduction in other benefits. Reducing benefits for economically inactive people will make more people go to work increasing productive capacity.
6) Reduction in trade union power. Wages will be lower; lowering costs of production. This will cause firms to employ more people which will raise output. This is also debatable because trade unions may also help labour markets work efficiently. They may act as a counterbalance to the market imperfection of very powerful employers. They may also reduce firms’ costs by acting as a channel for communication between employers and workers on issues, since it is cheaper to negotiate with one body than with individual workers.
7) Privatisation.
8) Deregulation: removal of barriers of entry.
The policies discussed above are used to deal with macro-economic objectives, they seek to:
1) Reduce unemployment
This can either be done by demand-side policies or by supply side policies.
Using the demand side policy the government will try to – by using fiscal policies- increase AD by cutting taxes or increasing government spending. Increasing G will work more effectively because this has a multiplier bigger than 1 and the cutting of taxes tend to have a multiplier lower than 1. (10 billion tax cut will result in 6 billion stimulus because 3 billion is saved and 1 billion is imported)
Also the government will try to – by using monetary policies- lower interest rates or increase the money supply.
However, those ‘expansionary’ fiscal and monetary policies may have undesirable side-effects. One consequence of a rise in AD may be a rise in the price level if the economy moves close to full employment. The higher level of spending may also increase any existing deficit on the current account of the balance of payments as UK residents buy more imported products.
Using the supply side policies unemployment can exist even where there is not a shortage of AD if there are supply-side problems. This is the structural unemployment. Things causing structural unemployment are: lacking appropriate skills, geographically or occupationally immobile or family circumstances etc.
Those problems cannot be solved by simply stimulating the AD; things that do help are better education, better infrastructure, greater provision of low-cost-child-care may enable more lone parents to work.
Also increasing the economic incentive to work by increasing the gap between income received from working and income received from benefits might help out.
Of course; most of the time unemployment is built up by a combination of both cyclical unemployment and structural unemployment. Therefore a combination of supply-side and demand-side policies is required.
2) Control inflation
There are two kinds of inflation to be controlled: Cost-push inflation and Demand-pull inflation.
To control the Cost-push inflation in the short run there are a few options:
- If a government thinks that the inflation is caused by excessive increases in wage rates, it may try to restrict wages. The government can do this by limit wage increases to for example 3%. In the public sector it’s more easy because the government itself employs those people.
- A government may try to lower the costs of production by reducing corporation tax. This will also have the advantage of stimulating investments (and therefore AD and AS). Governments may also give subsidies to stimulate investments. This all has the result that firms can cover rising costs without putting up prices.
To control Demand-pull inflation demand-side policies are used. The AD is being lowered by for example raising income tax. The main short-run-anit-inflationary policy instrument being employed in the UK is the interest rate.
In the long run the aim is that AS and AD will grow at the same rate so that people can enjoy a higher GDP without inflationary pressures.
3) Promote economic growth
In the short run the government basically tries to increase AD, the best policies for economic growth are policies like a interest rates because a lower interest rates increases both AS and AD. (As everything does that increases Investments; other examples of both an AD and AS increase might be the improvement of infrastructure or education) Since the AS is growing the long-term economic growth will be enabled.
Governments try to make the AD rise in line with the trend growth to ensure stable growth.
4) Improve balance of payments.
Policies to improve the balance of payments usually focus on instruments to influence the current account position.
In the short run there are three main ways a government may try to increase export revenue and/or decrease import revenue:
- Causing a fall in exchange rate; central banks can do this by selling their currency and/or lowering interest rates. This also increases AD and reduces unemployment. The only thing is that it might cause inflationary pressures.
- Reducing demand for all products: lowering imports by higher taxation and/or higher interest rates. This may cause AD to fall and unemployment to rise.
- Import restrictions; reducing imports using tariffs and quotas
In the long run a deficit arises from lack of quality competitiveness, low labour productivity or high inflation, then reducing the value of the currency, deflationary demand-side policy instruments and import restrictions will not provide long-term solutions. What may be long-term solutions is giving subsidies to small companies in the belief that they have potential to grow and become internationally competitive.
There might, however, be some conflicts between several policy objectives. For example:
1) Economic growth and low unemployment may benefit from expansionary demand-side policy measures, but these measures may make it more difficult for a government to achieve low inflation and a satisfactory balance of payments position.
2) Raising the interest rate will reduce inflationary pressure but these moves also have an effect on the exchange rate and so on the balance of payments and employment.
Governments try not to make policies clash and try to ensure that the growth in AD is in line with the growth in AS and the economy is working at its full capacity.
THE ADVANTAGES OF INTERNATIONAL TRADE
International trade has a lot advantages: the consumer gets more choice since there are more firms on the markets. Also the consumer probably ending up paying a lower price for the products since there is more competition.
For firms it works both ways: domestically they have more competition but they also have acces to way larger markets to sell their products to.
Despite those advantages some countries still restrict the international trade using a few protectionistic tools to protect the domestic industries from foreign competition:
- Tariffs: these are basically taxes on imported goods.
- Quotas: These are a maximum on the amount of imported goods.
- Voluntary export restraint (VER) : a limit placed on imports from a country with the agreement of that country’s government. (most of the time this is a two-way export quota)
- Foreign exchange restrictions: A government may seek to reduce imports by limiting the amount of foreign exchange made available to those wishing to buy imported goods and services or to invest or travel abroad.
- Embargoes: the ban on export or import of a product and/or ban on trade with a particular country. EG: A country may ban the export of arms to a country that has a low human rights standard.
- Red tape: Time-delaying customs procedures to encourage imports.
- Requesting certain quality standards, seeking to raise costs for companies that would like to export to the country.
- Government may reduce imports by buying from domestic firms rather than foreign firms even when the price is higher.
Note: Entire AS book summaries are now to be found on this blog; I will include a written version of chapter 5 later
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