Economic Objectives

• 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

Possible Exam Questions

• Explain two macro economic objectives of the government (4)

• Evaluate two strategies to improve economic growth in the UK (6)

• Evaluate two strategies to reduce unemployment in the UK (6)

• Discuss why it is difficult for the UK government to achieve all of its macro economic objectives simultaneously (8)

• To what extent will an expansionary fiscal policy benefit the macro economic objectives of the UK government (8)

Key Terms

• Economic Growth – growth in output of the economy over time – a growth of Real GDP over time

• GDP (gross domestic product) – the total value of goods and services produced in a country over a year

• GDP per capita – GDP per head for a period of time – total GDP divided by the total population

• Recession – two consecutive quarters of negative growth

• Slowdown – when the rate of growth slows – eg from 2% pa to 1.5% pa – note it is still growing!

Causes of Growth

• Investment (Increases in Capital)

• Changes in Technology

• A larger workforce

• Education and Training (Increases in Human Capital)

• Natural Resources

• Government Policies

Strategy – Evaluation!!!

• Increased Immigration • Will lead to higher growth as will provide labour

for businesses to produce more goods and services and some businesses cannot find enough skilled labour. Many British businesses have benefited from this as a result of our membership of the EU.

• GDP per capita may not rise as population will increase. May put pressure on local services such as schools and hospitals and increase unemployment of UK people.

Benefits & Costs of Growth

• BENEFITS • Rise in material living

standards – if GDP per capita rises there is more output per person

• Rise in welfare of population – health, education, life expectancy

• Rise in employment – more output means more people are needed to produce it

• Reduction in Poverty – more tax revenue to raise living standards

• COSTS • Environmental – pollution,

climate change etc (external costs)

• Congestion (external costs) • Loss of renewable

resources • Lower Quality of Life • Inequalities of Income and

Wealth • Inflation

Exam Questions

• Explain the difference between GDP and GDP per capita (3)

• Explain the difference between a recession and a slowdown (3)

• Explain two policies to achieve economic growth and discuss how successful each is likely to be (8marks)

• To what extent is a growing economy desirable? (8 marks)

• Should the government use macro economic policy to try to ensure the economy grows? Give reasons for your answer (8 marks)

Key Terms

• Inflation – a sustained rise in the general level of prices over time

• Price Stability – the general level of prices is kept constant or stays at an acceptably low rate over time (eg 2%)

• Rate of Inflation – the rate at which the general level of prices rises over time – usually expressed as a % per annum

Measuring Inflation

• CPI – Consumer Price Index – Looks at changes in the prices of a weighted basket of goods and services. Looks at the prices of goods and service that people tend to buy

Cause – Demand Pull

• Inflation caused by excess demand in the economy. Aggregate Demand growing faster than Aggregate Supply.

Cause – Cost Push

• Inflation caused by a rise in production costs in the economy – eg wages, fuel, raw materials etc

• Businesses may increase prices to maintain profit margins

Wage Price Spiral

Benefits of Price Stability

• Helps business and consumers to plan ahead • Overcomes the disadvantages of inflation

• UK – target 2% Inflation A small low rate of inflation is better than zero inflation

because: • Incentive for business to invest • Zero inflation may be too costly to achieve • Risk of deflation – people may stop spending if prices

are falling

Costs of Inflation

• Shoe Leather Costs

• Menu Costs

• Income Redistribution Problems

• Wage Price Spiral

• Loss of Competitiveness (BofP problems)

• Uncertainty and lack of confidence for business

• Danger of Hyperinflation

Evaluating the Costs / Consequences

• Low rate – 2% good - we may not wish to target 0% inflation

• Inflation other than a low rate is considered harmful to the economy

Policies to Bring Inflation Down

• Contractionary Fiscal Policy

• Not often used as a tool to control inflation

• Contractionary Monetary Policy

• MPC of Bank of England target 2% inflation and can raise interest rates to reduce inflationary pressures

• Supply Side Policies

• These allow demand to grow without causing inflation as supply is also growing

UK Today

• Inflation is above target but interest rates are low why?

• Threat of recession if rates were to rise

• Monetary Policy set for the future (takes 2 years for interest rate changes to feed through fully) and Bank of England expects inflation to fall

• Explain what is meant by inflation(2)

• Explain how inflation is measured(2)

• The Bank of England wishes to achieve price stability, explain why (6)

• Discuss the current causes of UK Inflation(6)

• Explain two costs of high inflation to the UK (4)

• To what extent is inflation undesirable? (6)

• Explain how the Bank of England trys to achieve low and stable inflation.

• Evaluate two strategies to reduce inflation in the UK (6)

• To what extent should the Bank of England be worried about inflation in the UK currently being above target? (8)

Employment & Unemployment

• Full Employment – occurs when an economy is using all of its workforce. This does not mean 100% employment as there will always be some people between jobs.

• Unemployment – Occurs when workers who are able and willing to work are unable to find jobs. People who are not seeking work (students, retired people, housewives/ husbands) are not counted as unemployed.

Measuring Unemployment

• Claimant Count – measures number of people claiming benefits

• Labour Force Survey (ILO) – a survey of a sample of households, counting people as unemployed if they are actively seeking work but do not have a job. Comparable with other countries. Larger figure as some people who are unemployed may choose not to claim benefits.

Unemployment Types

Seasonal

Structural Technological

Voluntary

Cyclical Frictional

Consequences of Unemployment

• Waste of Scarce Resource- could be adding to UK ouput

• Lower Living Standards • Excluded Workers – if people remain

unemployed for too long they may become unemployable

• Cost to Taxpayer –increased spending on Benefits

• Lost Tax Revenue • Cost to Economy – Less Demand, Budget

Deficit • Regional Problems – including downward

multiplier • Social Problems

Evaluation – Unemployment is bad but….

• Frictional – A thriving economy will always have people moving between jobs

• Changing Patterns of Demand – in the short term unemployment may rise due to structural change and changing patterns of demand. This will always happen in a dynamic economy. If this persists it is a problem!

Government Policy

• Evaluation - It depends upon the type and cause!!!

Policies

• Expansionary Fiscal Policy - Cyclical • Expansionary Monetary Policy - Cyclical • Supply Side Policies 1. Increase Incentives to Work - Voluntary – cut

benefits, increase min wage, raise income tax threshold

2. Education and Training – Structural – make workforce more skilled and flexible

3. Cut Minimum Wage – lower costs to business of employing workers

Questions

• Explain what is meant by unemployment (2)

• Explain why the Labour Force Survey measure of unemployment is higher than the claimant count (2)

• Discuss the current causes of UK unemployment (8)

• Explain two costs of high unemployment to the UK (4)

• To what extent is unemployment undesirable? (6)

• Evaluate two strategies to reduce unemployment in the UK (6)

• Examine strategies to deal with the current high unemployment in the UK (8)

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

• Distribution of Income – how incomes are shared out among people in the economy

• Income Inequalities – incomes are distributed unevenly so some people have much higher incomes than others.

• External Cost – the negative impact of an economic transaction on a third party. eg pollution

• Demerit Good – a good or service whose consumption is considered unhealthy or undesirable due to its bad effects on consumers eg tobacco, alcohol, junk food.

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)

Main Taxes

• Income Tax

• National Insurance

• Corporation Tax

• Inheritance Tax

• VAT – Value Added Tax

• Excise Duties

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.

The distribution of income looks at how evenly income is distributed

among the population.

• Income Redistribution – a policy to reduce the inequalities in income so that incomes are distributed more easily.

• The aim of income redistribution is to reduce inequalities of income so as to create a fairer society. So it can be said that income redistribution might be done to increase equity. There will still be large income differences between households but not as large as before the redistribution.

• Income redistribution also aims to provide every family with a basic standard of living so as to prevent poverty

Transfer Payments

• These are benefits to citizens that are paid out of tax revenue. They are called transfer payments as the money is transferred from tax payers. These include job seekers allowance, child benefit and tax credits.

Redistribution of Income – How can it be done?

• If the government wishes to reduce inequalities it will increase progressive direct taxes and reduce regressive indirect taxes. It will also increase transfer payments paid to lower income groups. In addition it can increase its own spending on measures that will help reduce inequalities. For example it could spend more on education and training as this will help people to earn more in the future.

Why redistribute income?

• The aim of income redistribution is to reduce inequalities of income so as to create a fairer society. So it can be said that income redistribution might be done to increase equity. There will still be large income differences between households but not as large as before the redistribution.

• Income redistribution also aims to provide every family with a basic standard of living so as to prevent poverty

Disadvantages - Disincentive Effects

• But there will be other effects on the economy. In particular there might be adverse effects on incentives. High direct taxes may have adverse effects on the supply side of the economy.

• High Benefits – may reduce incentive to work • High Progressive Taxes – may also reduce incentives to work

and may reduce incentive to work hard and try to get a better job if people know 40% of any extra income will be paid in tax.

• High tax earners leave UK – some high tax earners may move abroad to escape the tax and then the UK government loses tax revenue.

• Disincentive to Invest – high tax on business act as a disincentive to invest

INCOME & WEALTH

• Income – is a flow of money received over time (eg wages)

• Wealth – is a stock of assets which are owned. Wealth can earn income for the owner in the future

• Wealth is even more unevenly distributed than income.

Possible Questions

• Use examples to explain the difference between a direct and an indirect tax (4 marks)

• Explain the difference between a regressive and a progressive tax (4 marks)

• Explain two reasons why income and wealth is unevenly distributed in the UK (6 marks)

• The government has been spending more money and needs to pay for its spending. To what extent should this extra revenue come from direct or from indirect taxation. (6 marks)

• To what extent is a more equal distribution of income and wealth desirable (8 marks)

• Explain how the government redistributes income in the UK (6 marks)

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 total demand and 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 total demand and spending in the economy.

You need to be able to explain.

• Example • A cut in direct taxation such as income tax. • Will increase people’s disposable income. • As a result there will be more 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

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

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

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%)

Money and Interest Rates • Money – anything that is generally acceptable as a medium of exchange

• Money – is more than just cash, it includes bank and building society deposits

• Interest Rate – This is the cost of money - the reward for saving and the cost of borrowing

• Why different interest rates?

• Saving V Borrowing – banks lend at higher rates than they pay to savers so as to make a profit

• Competition – banks and building societies offer different rates as they are in competition with each other

• Savings Rates – may differ depending upon: the amount saved, the longer the time the money is tied up etc

• Loan rates – may differ depending upon: the risk, and the amount of security. For example a bank will typically lend at a lower rate to somebody who has a good credit rating and who has some security such as a house as they know the loan is safer and is more likely to be paid back

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

Policy Demand Side Supply Side

Fiscal

Monetary

Demand can be affected

fairly quickly by policy changes

Long Term

Eg – changes in education

may take years to be effective

Changes made annually in

budget

MPC meet monthly

Quite Flexible but….

Not Flexible enough to

react to changes in the economy in the

short term

Possible Exam Questions

• Explain how fiscal policy can be used to bring the economy out of a recession (6)

• Explain how monetary policy can be used to control inflation (6)

• Explain two reasons why there are different rates of interest (4)

• Discuss how supply side polices might be used by the government to achieve macro economic objectives (8)

• Evaluate two strategies to improve economic growth in the UK (6)

• Evaluate two strategies to reduce unemployment in the UK (6)

• Discuss why it is difficult for the UK government to achieve all of its macro economic objectives simultaneously (8)

• Compare monetary / fiscal policy and supply side policies as methods of achieving macro economic objectives

Market Failure – A summary • Market Failure is when the market fails to

allocate resources in the best interests of society as a whole

Externality • – a third party side effect or spill over effect in

the production or consumption of a good

Negative Production Externalities

• When production takes place there can be effects on people in society that are not part of the production process. Negative externalities or external costs arising from production include things like pollution.

Negative Consumption Externalities

• Consumption can also lead to negative externalities. For example driving can lead to external costs such as pollution, congestion, accidents and even climate change.

Positive Externalities

• There may be external benefits from production or consumption of goods. An example is a vaccination against a contagious disease. Getting the vaccination not only benefits me but others as I will not be able to catch and pass the disease on.

Merit Good (Positive Externalities) • Goods which have positive externalities are also known as

Merit Goods. These include health and education. If provision of these were left to the market they would be underconsumed and some people may not be able to afford them. This would not only be a disadvantage to the individual but to third parties and to the economy as a whole (can you explain why?). In the UK the government provides state education and health care that is free at the point of consumption.

Demerit Goods

• In economics, a demerit good is a good or service whose consumption is considered unhealthy, degrading, or otherwise socially undesirable due to the perceived negative effects on the consumers themselves. It is over-consumed if left to market forces. Examples of demerit goods include tobacco, alcoholic beverages, recreational drugs, gambling, junk food and prostitution.

Demerit Good

Government Policy and Externalities

• Taxes and Charges – One way the government can reduce external costs is through taxation. The objective here is to internalise the externality and make consumers pay for the external costs. For example fuel duty is put on petrol. As the increased tax puts the price up consumption should fall as should the externalities such as harmful emissions. Other ways include road tolls and congestion charges

Government Policy and Externalities

• Laws and Regulations – The government might impose laws to reduce or eliminate negative externalities. Eg banning the use of lead in petrol and banning smoking in public places

Government Policy and Externalities

• Subsidies – The government can encourage producers or consumers to alter their behaviour by giving incentives to change. If the government were to subsidise public transport it should make it cheaper for consumers, encouraging people to use this and drive less (also cycle to work scheme?

Evaluation

• Look at which policy will be most effective in a particular situation? For example to encourage people to drive less would fuel tax or road tax be more effective?

• Look at problems with strategies. For example a rise in fuel tax might raise costs for british business and will it work as demand for petrol is price inelastic.

Other Evaluative Points

• How much will strategies cost? – remember we have a budget deficit

• Will they raise revenue for the government?

• What will the impact be on the redistribution of income? Is it fair? Remember taxes on booze, fags and fuel are regressive and hit poorer sections of society hard

Some Questions

• Explain two reasons why markets fail (4 marks)

• Explain how people smoking leads to market failure (4 marks)

• Use a diagram to show how a tax on cigarettes can be used to tackle market failure associated with smoking (6 marks)

• Use a diagram to show how subsidised bus travel can be used to tackle market failure associated with road use (6 marks)

Some Questions

• Evaluate two strategies to deal with market failures associated with smoking (8 marks)

• Examine strategies to deal with market failures associated with road use (8 marks)

• Examine strategies to deal with market failures associated with alcohol consumption (8marks)