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Essential Economics Notes, Study notes of Economics

Economics

These comprehensive A-Level Economics notes cover essential topics and theories required for high academic performance in A-Level courses. Ideal for students and teachers, the notes are structured to support a clear understanding of both microeconomics and macroeconomics concepts

Typology: Study notes

2023/2024

Available from 11/08/2024

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Topic: Effectiveness of policy options to meet all macroeconomic objectives
1. effectiveness of fiscal policy
There are a number of reasons why fiscal policy may not be effective in achieving all
the macroeconomic objectives at the same time:
Economic growth and low unemployment versus balance of payments
stability and price stability
Expansionary fiscal policy can increase actual economic growth and reduce
cyclical unemployment. However, the higher aggregate demand can increase
demand-pull inflation and can increase a deficit on the current account of the
balance of payments.
Contractionary fiscal policy can improve two of the macroeconomic objectives but
can also threaten to worsen the other two. In this case, a lower aggregate demand
may help a government to achieve low inflation and a balance on the current account
of the balance of payments. This may be at the expense of higher cyclical
unemployment and lower actual economic growth.
Crowding out and crowding in
New classical economists argue that higher government spending,
financed by increased borrowing, reduces funds available to lend to the
private sector and drives up the rate of interest. So increased public
sector spending crowds out private sector spending. The higher interest
rate can also attract foreign financial investment which could increase
the exchange rate and reduce net exports.
Keynesians reject the idea that crowding out occurs. They argue
that crowding in occurs. This is the view that higher government
spending will raise GDP by a multiple amount.
The higher income will increase saving, which will provide the funds
available to lend. The higher income will also encourage a rise in
consumption and investment. This would mean that higher public sector
spending can increase private sector investment.
Difficulties of reversing an increase in government spending
Some forms of government spending can involve a long-term commitment
to higher spending. For example, if a government decides to build more
state-run hospitals, it will have to finance the extra staff and equipment
costs for decades even when the economy is booming. The alternative
would be to face considerable unpopularity in closing them.
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Topic: Effectiveness of policy options to meet all macroeconomic objectives

1. effectiveness of fiscal policy There are a number of reasons why fiscal policy may not be effective in achieving all the macroeconomic objectives at the same time:  Economic growth and low unemployment versus balance of payments stability and price stability Expansionary fiscal policy can increase actual economic growth and reduce cyclical unemployment. However, the higher aggregate demand can increase demand-pull inflation and can increase a deficit on the current account of the balance of payments. Contractionary fiscal policy can improve two of the macroeconomic objectives but can also threaten to worsen the other two. In this case, a lower aggregate demand may help a government to achieve low inflation and a balance on the current account of the balance of payments. This may be at the expense of higher cyclical unemployment and lower actual economic growth.

 Crowding out and crowding in

New classical economists argue that higher government spending,

financed by increased borrowing, reduces funds available to lend to the

private sector and drives up the rate of interest. So increased public

sector spending crowds out private sector spending. The higher interest

rate can also attract foreign financial investment which could increase

the exchange rate and reduce net exports.

Keynesians reject the idea that crowding out occurs. They argue

that crowding in occurs. This is the view that higher government

spending will raise GDP by a multiple amount.

The higher income will increase saving, which will provide the funds

available to lend. The higher income will also encourage a rise in

consumption and investment. This would mean that higher public sector

spending can increase private sector investment.

 Difficulties of reversing an increase in government spending

Some forms of government spending can involve a long-term commitment

to higher spending. For example, if a government decides to build more

state-run hospitals, it will have to finance the extra staff and equipment

costs for decades even when the economy is booming. The alternative

would be to face considerable unpopularity in closing them.

Redistribution of income and development versus the incentive to

work

Fiscal policy is the main policy used to redistribute income and promote development. Progressive taxes and transfer payments move money from the rich to those on low incomes. Government spending on state healthcare and state education can also benefit those on low incomes and raise life expectancy and educational performance. There is a risk, however, that an increase in transfer payments may reduce the incentive for the unemployed to seek work. If this is the case, the unemployed and their children may experience greater poverty in the long run than if they had accepted a low paid job now. Being in employment can increase workers’ skills and their chance of gaining a higher paid job in the future.

The Laffer curve

The Laffer curve shows that when tax rates are high, raising them further will be counterproductive. Laffer drew the curve to support his view that a cut in tax rates may increase tax revenue by stimulating both total economic activity, because of the greater incentive effect, and declared economic activity. At a tax rate of 0% there will obviously be no tax revenue. There will also be no tax revenue at a rate of 100% as workers will not be prepared to work if all their income goes in tax. The curve suggests there is a tax rate that will generate the most tax revenue. Raising the tax rate beyond this point would reduce tax revenue as it will discourage work and encourage tax evasion. Figure 1 below indicates that a cut in the tax rate from 50% to 40% would increase tax revenue Figure 1 Laffer curve

Demand and supply-side shocks The success of both fiscal policy and monetary policy depends on the ability of government and central bank officials to assess current macroeconomic performance and future private sector economic activity. Both types of policy can also be thrown off course by demand and supply-side shocks. A central bank may forecast an economic boom and may raise its interest rate so that it can reduce the growth of aggregate demand in, for instance, one year’s time. If there is a global recession during the time it takes for the change in the interest rate to affect aggregate demand, the economy may experience a more severe recession.  Co-ordination It is important that monetary and fiscal policies are co-ordinated. A government’s attempt to boost economic growth may fail if the central bank increases the interest rate.

3. The effectiveness of supply-side policy Supply-side policy measures can be divided into those which are market-based and those which are interventionist  Market-based supply-side policy Market-based supply-side policy includes tools that increase the role of market forces: cuts in direct tax, cuts in unemployment benefit, privatisation, deregulation and labour market reforms. I. Cuts in direct tax and unemployment benefit seek to raise aggregate supply by increasing incentives to work and be entrepreneurial. II. Privatisation, deregulation and labour market reforms are aimed at raising aggregate supply by increasing competition and reducing the cost and effort involved in complying with government rules and regulations. Market-based supply-side policy may increase economic growth and reduce inflation, but may conflict with the objectives of redistribution of income and lower unemployment. It is also possible that they may reduce rather than increase economic growth.  Cuts in income tax and unemployment benefit are likely to transfer money from people on low incomes to the rich rather than the other way round.  Privatisation has resulted in some individuals and groups of individuals who have bought out state-owned industries becoming very rich. In pursuit of profits, some privatised firms have increased the price of their products, taking a higher proportion of the income of people on low incomes.  Labour market reforms, which reduce the power of trade unions, and deregulation in the form of the removal of a national minimum wage can also reduce the relative pay of those on low incomes.

Cuts in income tax and unemployment benefit will increase the gap between paid employment and transfer payments, but they will not necessarily increase employment and growth. There may not be job vacancies, the unemployed may lack the skills and qualifications to take those job vacancies that do exist or the jobs may be in different areas to the unemployed. Cuts in income tax may have unintended consequences. Instead of encouraging workers to work more hours, workers may decide to maintain their current disposable income and take more leisure time. Privatisation may not necessarily increase efficiency and lower costs of production. This is because it does not guarantee increased competition. A state-owned industry may be sold off as a monopoly. Even if it is sold off as a number of firms, they may later merge to form a monopoly. The removal of rules and regulations may also increase the chances of monopolies occurring. The removal of rules on health and safety may damage the health of workers and result in accidents. These effects could reduce labour productivity and economic growth.

1. Interventionist supply-side policy

Interventionist supply-side policy involves the government taking a larger role in the economy. Its policy tools include government spending on education, training, infrastructure and support for technological improvement. Spending on education and training can take some time to have an effect but if they are successful, they have the potential to improve all the macroeconomic objectives. They can increase actual and potential economic growth, reduce inflation, improve the current account of the balance of payments, reduce unemployment, increase development and reduce income inequality. Improvements in infrastructure and technology can help a government achieve its macroeconomic objectives. There is a risk, however, that building more roads and airports may create more air and noise pollution and reduce development. Advances in may result in some structural unemployment. The effectiveness of exchange rate policy there are reasons why exchange rate policy may not be successful in achieving all the macroeconomic objectives:  A government can lower the exchange rate to improve the current account of the balance of payments, increase economic growth and reduce unemployment. However, a lower exchange rate may cause cost-push inflation and demand-pull inflation. The price of imported raw materials and capital goods will rise. The competitive pressure on domestic firms to keep down rises in their costs of production will be reduced. The increase in net exports will raise

The problems arising from conflicts between policy objectives The decision as to which policy tools a government will use is influenced by the risk that these may conflict between policy objectives.  Low unemployment and economic growth versus price stability Government expansionary fiscal and monetary policy tools designed to either reduce unemployment and/or increase the economic growth rate A government may seek to avoid these policy conflicts by introducing supply-side policy tools that may, in the long run, reduce the inflation and unemployment rates and increase the economic growth rate.  Low inflation versus balance of payments stability A conflict may also arise between the aims of low inflation and a reduction in a current account deficit. A central bank may raise the rate of interest. Such a move will not only increase unemployment; there will also be a knock-on effect on the balance of payments position and the exchange rate. A rise in the interest rate is likely to lead to an appreciation in the exchange rate. This could worsen the current account position but may attract hot money flows.  Redistribution of income versus economic growth There may be a conflict between creating greater income equality and stimulating economic growth. Making income tax rates more progressive and increasing benefits to low-income groups may discourage effort and enterprise and may reduce foreign direct investment. There is, however, the possibility that raising the living standards of the poor may improve the health and education of part of the labour force and so raise productivity. To avoid conflicts between policy objectives, a government may employ a separate policy tool for each objective In practice, governments use a combination of fiscal, monetary and supply-side policy tools.

Government failure in macroeconomic policies

reasons for government macroeconomic failure:

  1. **Miscalculating the size of the multiplier For instance, if a government understates the size of the multiplier, it may increase its spending by too much. This may result in swapping one problem, a negative output gap, with another problem, a positive output gap.
  2. Desire to win elections Some elected governments may be tempted to introduce popular policy tools when elections are approaching. Measures such as an increase in government spending on pensions may win votes but may not necessarily improve economic performance.
  3. Pressure groups and corruption Government policy tools may be influenced by powerful pressure groups and there is the possibility of government corruption.
  4. Time lags By the time a policy tool does have an impact on economic behaviour, the level of economic activity may have changed, which may make the policy tool inappropriate. Indeed, governments may seek to use fiscal and monetary policy tools to offset the effects of the business cycle, but these measures sometimes reinforce the business cycle rather than acting counter-cyclically.** As well as there being a delay before households, workers and firms react to policy tools, there is the possibility that they may not respond in the expected way.