Managing the environment
Both fiscal and monetary policy can be used to manage the economy, when we say manage the economy we refer to controlling aggregate demand.
-aggregate demand consists of the following components AD= C+I+G+(X-M)
C= Consumption, I= Investment, G= Government spending and (X-M)= exports minus imports
so any policy aimed at 'managing the economy' will no doubt have an effect these components.
So why does the economy need to be managed?
This is because excessive growth in aggregate demand can cause unstable short term growth which leads to higher rates of inflation. On the flip side to little AD can result in a recession- this is when the economy slows down, resulting in negative growth and rising unemployment
-aggregate demand consists of the following components AD= C+I+G+(X-M)
C= Consumption, I= Investment, G= Government spending and (X-M)= exports minus imports
so any policy aimed at 'managing the economy' will no doubt have an effect these components.
So why does the economy need to be managed?
This is because excessive growth in aggregate demand can cause unstable short term growth which leads to higher rates of inflation. On the flip side to little AD can result in a recession- this is when the economy slows down, resulting in negative growth and rising unemployment
Fiscal policy
Fiscal policy aims to control AD by changing the balance between government expenditure (an injection into the circular flow of income) and taxation (a withdrawal)
Fiscal policy has two possible roles as far as possible as controlling AD is concerned. The first is to remove any severe deflationary and inflationary gaps. The second is to iron out any fluctuations in the economy associated with business cycle. The business cycle is also known as the economic cycle (Boom, Recession, Recovery and Slowdown. We will discuss how fiscal policy tackles these two issues in due course.
KEY POINT TO REMEMBER THERE ARE TWO TYPES OF FISCAL POLICY
EXPANSIONARY AND DEFLATIONARY
Expansionary fiscal policy
An expansionary policy can be used to prevent an economy experiencing or a prolonged recession like the one we had around the world in 2008. During the recent recession there was substantial tax cuts and increased government expenditure to combat the onset of the recession.
Deflationary fiscal policy
This helps smooth out fluctuations in the business cycle. By reducing government expenditure and increasing tax rates when the economy starts to boom. This will dampen (slow down) the expansion and prevent the economy from 'over heating'. When the economy over heats the following problems arise; rising inflation and deteriorating current account balance of payments.
the current account balance of payments is part of the balance of payments and shows deficits and surpluses. The link below explains the current account in detail
http://www.investopedia.com/articles/03/061803.asp
On the other hand, if a recession looms, the government can cut taxes or raise government expenditure in order to boost the economy.
if these polices are successful what it means for the government is a case of only fine tuning. Problems of excess or deficient demand will never be allowed to get severe.
Fiscal policy can also be used to influence aggregate supply. For example, the government can increase its expenditure on infrastructure, or give tax incentives for investment.
KEY CONSIDERATION!
Government deficits and surpluses. Considering expansionary fiscal policy involves raising government expenditure and/or lowering taxes, this will either increase the budget deficit or reducing the budget surplus.
A budget deficit occurs when government expenditure exceeds its revenue from taxation.
A budget surplus is when tax revenues exceed government expenditure.
The budget deficit occurs over one year but a constant year on year deficit is known as national debt .
It should be noted at this point a national debt is not the same as a government overseas debt. In the case of the UK a small fraction of the national debt is owed overseas.
The Governments fiscal stance
refers to the fiscal measures that the government will pursue, so they will either pursue expansionary or deflationary fiscal policy measures.
The governments fiscal stance is dependent upon the state of the economy. For example if the economy is experiencing a boom where the unemployment levels are low and revenues from taxes increase. Low unemployment levels also means benefits related to employment will also be low. The combined effect of the increased tax revenues and reduced benefits is to give the public sector a surplus.
On the other hand if the economy is experiencing a recession tax revenues will be low and the amount paid in benefits would be high. The public sector deficit would thus be high.
The public sector is made up of four parts
1)Current expenditure
include items such as wages and salaries of public-sector staff and administration
2) Capital expenditure
investment that gives rise to benefits over time such as roads, hospitals and schools
3) Final expenditure
on goods and services
4)Transfers
include subsidies and benefit payments, such as payments to the unemployed.
The distinction recognises that the public sector directly adds to the economy's aggregate demand through its spending on goods and services, including the wages of public sector workers, but that it also redistributes incomes between individuals and firms
The current budget
if the sum of the public sector's current expenditure is less than it earns (through taxes and the revenues of public corporations, etc), then it runs a surplus on the current budget. So basically, the cost of public sector current expenditure is being fully met out of the public sector receipts and the sector can meet some of the cost of its net investment (i.e gross capital expenditure-depreciation).
However, if it is running a deficit on the current budget of the public sector is not generating sufficient receipts to afford its current expenditures, let
KEY POINT TO REMEMBER THERE ARE TWO TYPES OF FISCAL POLICY
EXPANSIONARY AND DEFLATIONARY
Expansionary fiscal policy
An expansionary policy can be used to prevent an economy experiencing or a prolonged recession like the one we had around the world in 2008. During the recent recession there was substantial tax cuts and increased government expenditure to combat the onset of the recession.
Deflationary fiscal policy
This helps smooth out fluctuations in the business cycle. By reducing government expenditure and increasing tax rates when the economy starts to boom. This will dampen (slow down) the expansion and prevent the economy from 'over heating'. When the economy over heats the following problems arise; rising inflation and deteriorating current account balance of payments.
the current account balance of payments is part of the balance of payments and shows deficits and surpluses. The link below explains the current account in detail
http://www.investopedia.com/articles/03/061803.asp
On the other hand, if a recession looms, the government can cut taxes or raise government expenditure in order to boost the economy.
if these polices are successful what it means for the government is a case of only fine tuning. Problems of excess or deficient demand will never be allowed to get severe.
Fiscal policy can also be used to influence aggregate supply. For example, the government can increase its expenditure on infrastructure, or give tax incentives for investment.
KEY CONSIDERATION!
Government deficits and surpluses. Considering expansionary fiscal policy involves raising government expenditure and/or lowering taxes, this will either increase the budget deficit or reducing the budget surplus.
A budget deficit occurs when government expenditure exceeds its revenue from taxation.
A budget surplus is when tax revenues exceed government expenditure.
The budget deficit occurs over one year but a constant year on year deficit is known as national debt .
It should be noted at this point a national debt is not the same as a government overseas debt. In the case of the UK a small fraction of the national debt is owed overseas.
The Governments fiscal stance
refers to the fiscal measures that the government will pursue, so they will either pursue expansionary or deflationary fiscal policy measures.
The governments fiscal stance is dependent upon the state of the economy. For example if the economy is experiencing a boom where the unemployment levels are low and revenues from taxes increase. Low unemployment levels also means benefits related to employment will also be low. The combined effect of the increased tax revenues and reduced benefits is to give the public sector a surplus.
On the other hand if the economy is experiencing a recession tax revenues will be low and the amount paid in benefits would be high. The public sector deficit would thus be high.
The public sector is made up of four parts
1)Current expenditure
include items such as wages and salaries of public-sector staff and administration
2) Capital expenditure
investment that gives rise to benefits over time such as roads, hospitals and schools
3) Final expenditure
on goods and services
4)Transfers
include subsidies and benefit payments, such as payments to the unemployed.
The distinction recognises that the public sector directly adds to the economy's aggregate demand through its spending on goods and services, including the wages of public sector workers, but that it also redistributes incomes between individuals and firms
The current budget
if the sum of the public sector's current expenditure is less than it earns (through taxes and the revenues of public corporations, etc), then it runs a surplus on the current budget. So basically, the cost of public sector current expenditure is being fully met out of the public sector receipts and the sector can meet some of the cost of its net investment (i.e gross capital expenditure-depreciation).
However, if it is running a deficit on the current budget of the public sector is not generating sufficient receipts to afford its current expenditures, let
![Picture](/uploads/2/8/0/6/28063831/2382013.jpg?1398780173)
The diagram illustrates the relationship between the governments fiscal stance and the state of the economy .
The tax revenue function is upward sloping. Its slope depends on tax rates. The government expenditure function, is drawn sloping slightly downwards (although the picture illustrates a vertical line it should be slightly downward sloping). showing that at higher levels of income and employment less is paid out in benefits.
The tax revenue function is upward sloping. Its slope depends on tax rates. The government expenditure function, is drawn sloping slightly downwards (although the picture illustrates a vertical line it should be slightly downward sloping). showing that at higher levels of income and employment less is paid out in benefits.
so far we have covered budget surpluses and budget deficits another possibility is a budget balance
so to recap a budget deficit occurs whenever government spending exceeds government revenue from taxation and other sources. A budget surplus os when government revenue exceeds government spending. So in theory a budget deficit can be reduced by cutting public spending or increasing taxation, the balance budget can either move to a surplus. If a deficit persists it is financed by borrowing. This is known as public sector net cash requirement (PSNCR). During a surplus, public sector debt repayment is known as (PSDR). Means that the government can use the excess revenue over expenditure to repay previous borrowing.
Automatic fiscal stabilisers
the public sector surplus or deficit will automatically change according to the level of national income. The effect of this will be to reduce the level of fluctuations in national income without the government having to take any deliberate action.
Taxes whose revenues rise as national income rises and benefits that fall as national income rises are called automatic stabilisers. They have an effect of reducing the size of the multiplier, reducing both upward and downward movements of national income.
so therefore in theory, the business cycle should be dampened by such built-in stabilisers. The more taxes rise or benefits fall, the bigger the marginal tax propensity ( mtp) will be, the bigger the mtp, the smaller the multiplier and the greater will be the stabilising effect.
(you do not to have a in depth understanding of this it is more of an A2 unit)
The effectiveness of automatic stabilisers
- act instantly as soon as AD fluctuates
- it may take some time for governments to put discretionary measures in place, especially if forecasts are off
Conversely they can not be relied upon soley especially if they only focus on reducing the multiplier- so reduces the severity of the fluctuations does not eliminate the fluctuations.They also effect aggregate supply (AS) and causes a fiscal drag.
we will go into more detail with regards to AS and the multiplier effect in due course.
so to recap a budget deficit occurs whenever government spending exceeds government revenue from taxation and other sources. A budget surplus os when government revenue exceeds government spending. So in theory a budget deficit can be reduced by cutting public spending or increasing taxation, the balance budget can either move to a surplus. If a deficit persists it is financed by borrowing. This is known as public sector net cash requirement (PSNCR). During a surplus, public sector debt repayment is known as (PSDR). Means that the government can use the excess revenue over expenditure to repay previous borrowing.
Automatic fiscal stabilisers
the public sector surplus or deficit will automatically change according to the level of national income. The effect of this will be to reduce the level of fluctuations in national income without the government having to take any deliberate action.
Taxes whose revenues rise as national income rises and benefits that fall as national income rises are called automatic stabilisers. They have an effect of reducing the size of the multiplier, reducing both upward and downward movements of national income.
so therefore in theory, the business cycle should be dampened by such built-in stabilisers. The more taxes rise or benefits fall, the bigger the marginal tax propensity ( mtp) will be, the bigger the mtp, the smaller the multiplier and the greater will be the stabilising effect.
(you do not to have a in depth understanding of this it is more of an A2 unit)
The effectiveness of automatic stabilisers
- act instantly as soon as AD fluctuates
- it may take some time for governments to put discretionary measures in place, especially if forecasts are off
Conversely they can not be relied upon soley especially if they only focus on reducing the multiplier- so reduces the severity of the fluctuations does not eliminate the fluctuations.They also effect aggregate supply (AS) and causes a fiscal drag.
we will go into more detail with regards to AS and the multiplier effect in due course.
Discretionary fiscal policy (contractionary)
Automatic stabilisers cannot prevent fluctuations. They only reduce the magnitude. If there is a fundamental disequilibrium in the economy or substantial fluctuations in other injections and withdrawals, the government may choose to alter the level of government expenditure or the rates of taxation. This is known as discretionary fiscal policy
changing the taxation level does not only effect AD it will also have an effect on AS an example of this would be tax incentives to encourage people to work.
taxation can also be used to alter the distribution of income from rich to poor.
Discretionary fiscal policy and government spending
if government spending on goods and services (infrastructure, hospitals etc) increases, this will create a full multiplied rise in national income. This is because all the money is spent and thus boosts AD.
Discretionary fiscal policy changing taxation.
cutting taxes will have a smaller effect on national income than increasing government spending on goods and services. The reason is cutting taxes increases peoples disposable income, of which only part will be spent. Some will be put aside for savings. So therefore not all tax cuts will be passed around the circular flow of income as extra expenditure. This is because the tax multiplier is smaller than the government spending multiplier.
- to achieve a given rise in income through tax cuts would require a bigger budget deficit than if it were achieved through increased government expenditure. In other words, the required tax cut would be bigger than the required government expenditure increase.
changing the taxation level does not only effect AD it will also have an effect on AS an example of this would be tax incentives to encourage people to work.
taxation can also be used to alter the distribution of income from rich to poor.
Discretionary fiscal policy and government spending
if government spending on goods and services (infrastructure, hospitals etc) increases, this will create a full multiplied rise in national income. This is because all the money is spent and thus boosts AD.
Discretionary fiscal policy changing taxation.
cutting taxes will have a smaller effect on national income than increasing government spending on goods and services. The reason is cutting taxes increases peoples disposable income, of which only part will be spent. Some will be put aside for savings. So therefore not all tax cuts will be passed around the circular flow of income as extra expenditure. This is because the tax multiplier is smaller than the government spending multiplier.
- to achieve a given rise in income through tax cuts would require a bigger budget deficit than if it were achieved through increased government expenditure. In other words, the required tax cut would be bigger than the required government expenditure increase.
Effectiveness of the policy
when assessing the effectiveness of the policy two main problems arise
1) magnitude of the effects- if G AND T are changed how much would this change the total injections and withdrawals.
how much will a change in AD affect output and employment, how much will it affect prices?
2) TIME- timing of the effects, how quickly can the policy be changes and how long will it take before the changes have an impact on the economy?
Problems of magnitude
before changing government spending or taxation, the government will need to calculate any effect on national income, employment and inflation. Predicting this effects is often unreliable.
1) magnitude of the effects- if G AND T are changed how much would this change the total injections and withdrawals.
how much will a change in AD affect output and employment, how much will it affect prices?
2) TIME- timing of the effects, how quickly can the policy be changes and how long will it take before the changes have an impact on the economy?
Problems of magnitude
before changing government spending or taxation, the government will need to calculate any effect on national income, employment and inflation. Predicting this effects is often unreliable.
The multiplier
John Maynard Keynes suggested that there may be multiplier effects in response to certain types of expenditure.
So the multiplier effects is hard to explain without using examples, it is the notion that an initial expenditure results in a domino effect and the end result is greater then the initial expenditure.
for example if the government decided to spend on infrastructure such as roads, this will generate an income for those contractors, these contractors will spend a part of their income on certain goods lets say lunch, the purchasing of lunch will generate an income for the shop keeper, newsagents and cafe owners, who in turn spend part of their income.
so one persons spending becomes another persons income. Thus the original increase in government spending triggers further income generation and subsequent spending, causing the multiplier effect.
the size or value of the multiplier depends most importantly on the size of withdrawals or leakages from the circular flow of income, so how much of the generated income will be saved, spent on imported goods and taxes.
So the multiplier effects is hard to explain without using examples, it is the notion that an initial expenditure results in a domino effect and the end result is greater then the initial expenditure.
for example if the government decided to spend on infrastructure such as roads, this will generate an income for those contractors, these contractors will spend a part of their income on certain goods lets say lunch, the purchasing of lunch will generate an income for the shop keeper, newsagents and cafe owners, who in turn spend part of their income.
so one persons spending becomes another persons income. Thus the original increase in government spending triggers further income generation and subsequent spending, causing the multiplier effect.
the size or value of the multiplier depends most importantly on the size of withdrawals or leakages from the circular flow of income, so how much of the generated income will be saved, spent on imported goods and taxes.
Supply side fiscal policy
changes to fiscal policy not only effects AD but also has an effect on AS these tend to show in the long run
1) Labour market incentives
cut in income tax may create an incentive for people to seek employment
2) Capital spending
reducing the rate of corporate tax may attract over seas investment and also increase investment overall
3) Entrepreneurship
government spending might be used to fund the start up of small businesses
4) Research and Development
tax allowances can be used to encourage private business sector research and development designed to make domestic products internationally competitive
5) Improvements in human capital
this would involve increased spending on education and training to improve skills sets and may reduce structural unemployment.
1) Labour market incentives
cut in income tax may create an incentive for people to seek employment
2) Capital spending
reducing the rate of corporate tax may attract over seas investment and also increase investment overall
3) Entrepreneurship
government spending might be used to fund the start up of small businesses
4) Research and Development
tax allowances can be used to encourage private business sector research and development designed to make domestic products internationally competitive
5) Improvements in human capital
this would involve increased spending on education and training to improve skills sets and may reduce structural unemployment.
Monetary Policy
Involves controlling the macroeconomy through changes in interest rates, money supply and exchange rates.
However the government does not change the factors above it is done by the monetary policy committee (MPC) who are a part of Bank of England.
The government decide on the goals of the policy, so is the main aim to control inflation, affect output and employment or does it want to control the exchange rate?
so the government decides on the targets but the MPC decides independently how to achieve those targets.
Money supply
money supply can be controlled by how much the Bank of England hold on to - so its reserves this will affect the ability of banks to lend.
Money supply can also be controlled through quantitative easing, which involves increasing the supply of money through the sales of government bonds.
The MPC tends to meet the governments targets by changing interest rates, in March 2009, the MPC reduced the interest rates to a 0.5% base rate. The purpose of this was to discourage consumers from saving and also to lower the cost of borrowing. Reducing interest rates also has an effect on the exchange rate.
Changes in interest rates can also affect the exchange rate. An unexpected rise in the rate of interest in the UK relative to overseas would give investors a higher return on UK assets relative to their foreign-currency equivalents, tending to make sterling assets more attractive. That should raise the value of sterling, reduce the price of imports, and reduce demand for UK goods and services abroad.
If interest rates are high, there is usually an influx of something called 'hot money' hot money refers to money that is saved in UK banks or to purchase financial assets.
However the government does not change the factors above it is done by the monetary policy committee (MPC) who are a part of Bank of England.
The government decide on the goals of the policy, so is the main aim to control inflation, affect output and employment or does it want to control the exchange rate?
so the government decides on the targets but the MPC decides independently how to achieve those targets.
Money supply
money supply can be controlled by how much the Bank of England hold on to - so its reserves this will affect the ability of banks to lend.
Money supply can also be controlled through quantitative easing, which involves increasing the supply of money through the sales of government bonds.
The MPC tends to meet the governments targets by changing interest rates, in March 2009, the MPC reduced the interest rates to a 0.5% base rate. The purpose of this was to discourage consumers from saving and also to lower the cost of borrowing. Reducing interest rates also has an effect on the exchange rate.
Changes in interest rates can also affect the exchange rate. An unexpected rise in the rate of interest in the UK relative to overseas would give investors a higher return on UK assets relative to their foreign-currency equivalents, tending to make sterling assets more attractive. That should raise the value of sterling, reduce the price of imports, and reduce demand for UK goods and services abroad.
If interest rates are high, there is usually an influx of something called 'hot money' hot money refers to money that is saved in UK banks or to purchase financial assets.