Chapter 6 ( summary)

Fiscal policy

Fiscal policy is the taxation and spending decisions of the government. It’s one of the three main economic policies that government use. There are two other policies which are called monetary policy and supply-side policies. Government can change tax rates. The aim of fiscal policy is to influence aggregate demand. Government can raise AD to increase either by increase it’s spending or by reducing taxes. To increase AD government may raise it’s spending and cut taxes this is called reflationary, expansionary or loose fiscal policy. To reduce AD government reduces spending and raises taxes this is called deflationary, contractionary or tight fiscal policy.

The nature of fiscal policy

Government may want to influence AD in order to make it match AS and so to avoid unemployment and inflation. If private sector demand (C+I+(x-m) is low government may try to increase AD, but if AD is high, government may try to reduce it. Government is seeking to create greater economic stability by offsetting changes in private sector spending.

To achieve this objective, a government can use something called discretionary fiscal policy, which is a change in government spending and taxation to influence AD. Or it can allow automatic stabilizers, which are forms of government spending and taxation that change automatically to offset fluctuations.

Types of taxes

The first most important source of tax revenue is income tax, and the second most important is value added tax(VAT). Income tax is a direct and progressive tax, a tax that takes a higher percentage from the rich peoples income. VAT is indirect and regressive tax, a tax that takes a greater percentage of the income of poor.

Government spending

Government spending, which is also called public spending or public expenditure can be divided into:

- Capital expenditure(e.g, hospitals, schools roads etc.

- Current spending (e.g public services, teachers pay etc)

- Transfer payment ( e.g pensioners unemployed)

- Debt interest payment ( e.g, payments made to holders of government debt)

Budget

Budget provides information on the budget position in the past year and prediction for future years. Budget position shows relationship between government spending and tax revenue. A budget deficit may occur because of the cyclical or structural factors. If there is a recession( fall in real GDP or negative growth), taxes revenue will likely to fall and government spending on benefits is likely to increase.

Monetary policy

Monetary policy is the government decisions on the rate of interest, the money supply and the exchange rates. Main monetary policy that is used almost in the whole world is the rate of interests. A higher interest rate may reduce consumption and lower firms investment. Rise in interest rates may decrease AD by reducing consumption, investment and exports minus imports.

Supply-side policies

It’s a policy that government use to increase aggregate supply by improving the efficiency of labour and product markets. There are some examples of supply-side policies. For example government invests in training, education, small firms, to encourage competitions. Training and education should raise the efficiency of labour and output per worker will be increased, potential output of the economy will rise, AS will shift to right. Government provides for unemployed people an educational and training courses, so they can raise their skills and experience.

Government assistance to new firms

New small firms provide employment, develop entrepreneurial skills, provide new ideas. But also they may find it difficult to break in established market. Government may help them buy subsidizing them charging low rate of corporation tax(a tax on firms, profit).

Privatisation

Privatasion is the transfer of assets from public sector to private sector. Some economists argue by saying that government shouldn’t intervene, they believe that private sector firms are in the best position to make decisions about what to produce, how to produce what to charge.

But other economist think opposite. They argue that government should intervene, because of the high risks of the market failure.

Policies to reduce umenployment

Demand-side policies

Because of the unemployment, economy could be operating below it’s productive capacity, but unemployment may be reduced by increase in AD. In that case , expansionary fiscal or monetary policy could be used to create jobs. Increase in the money supply or lower interest rates are also likely to raise AD. A fall in interest rates or increase in money supply should stimulate consumption and investment.

Supply-side policies

Unemployment may exist even if there is not shortage of AD, it’s because of the supply side problems. Those people who are out work when the level of AD is high. And inefficiency of labour, lack of skills can cause output to decrease.

Supply-side policies can be applied to increase incentives and the quality of labour services offered by the unemployed.

Policies to control inflation

Cost-push inflation

If government thinks that inflation is caused by excessive increase in wage rates, it may try to stop an increase in wage rates. It can also restrict wage rises in both public and private sectors by introducing an income policy. Government may try to reduce firms cots by reducing corporation tax. This will have the advantage to stimulate investment. Government can even provide subsidies in order to help firms to cover their costs. But subsidies may be a failure if the firms will still be inefficient.

Demand-pull inflation

In order to reduce demand-pull inflation government may use deflationary fiscal or monetary police instruments. These help to reduce inflation by lowering AD. Government could raise income tax. This would reduce people’s disposable income, and they will spend less.

Effectiveness of fiscal policy

Advantages

- Number of taxes, forms of government spending set automatically to offset Fluctuations in real GDP.

- Government spending and taxation, including cuts in corporation tax and training grants, have a chance to increase both AD and AS

Disadvantages

It takes time for government spending and taxation to affect the economy.

There is a time lag between introducing fiscal policy instruments.

Number of government spending is inflexible( difficult to spending on health, education)

Based accurate information(a prediction saying that recession might lead to a change in expectations.)

Firms and households may react in unexpected ways( cut in income taxes etc)

Adverse effect on incentives and other macroeconomic objectives.

Can be offset by changes in the economic activities in other countries.

Possible conflicts between policy objectives

The objectives of economic growth and low unemployment may benefit from expansionary demand-side policy measures. Such a measures may make government to achieve low inflation and a satisfactory balance of payments position.

Methods of protection

International free trade occurs when there is no restrictions imposed on the movement of goods and services into and out of countries. Protectionism ( protection of domestic industries from foreign competitions) results in the careful restrictions of free movements of goods and services.

Voluntary export restraint(VER)

It’s a limit placed on imports from a country with the agreement of that country’s government. A country may agree to restrict it’s exports in return for a similar limit being put on the exports of the other country.

Chapter 5(summary)

Chapter 5

Key performance indicators

To find out how well an economy is performing, there are certain indicators that economist examine. One of the most significant of these is economic growth. Actual economics growth is said to occur when an economy increases it’s output. Long run, economic growth takes place when the productive capacity of an economy increases.

When a county’s output increases, unemployment usually falls. An economy is doing well because of the low unemployment. Unemployment exists when people who are looking for jobs are without jobs. Some people aged between 16 and 65 are not in the labour force because, they are disabled, homemakers, retired or students. These people are said to be economically inactive.

Another indicators is inflation, it’s caused when the price level rises. Also If the price levels falls it’s called deflation.
Balance of payments. This is record of country’s transactions with the rest of the world.

Government Objectives

- Achieve economic growth
- Reduce Inflation
- Raise employment
- Reduce unemployment
- Balance of payment(international trade)
- Economic stability
- Income redistribution

GDP and real GDP

Economists first calculate what is called money or nominal GDP. For example GDP of country may rise from $800 billion in 2008 to $900 billion in 2009, it’s 12,5% increase. Nominal GDP has risen by 12.5%. To calculate the rise in the volume of output, the effects of changes in the price level are taken out by multiplying GDP by the base year index divided by the current year price index.

GDP figure*base year price index/current year price index.
So, if price index in 2008 was 100 and 105 in 2009, real GDP was:
$900 billion*100/105 = 857,14 billion
In real terms, GDP has risen by $57,14 billion/$800 billion*100%=7,14%

Measuring Unemployment

Economists measure number of people who are unemployed and find the unemployment rate. These are people that are jobless and seeking employment. It is calculated as:
The unemployment*100%/labour force.
In practice, it can be difficult to decide who is unemployed.

Measuring Inflation

There are numbers of measures of inflation. The main measure of inflation is the consumer prices index(CPI).
Another measure of inflation used in the UK is Retailed prices indes(RPI)

The causes of economic growth

In the short run, an economy with the spare capacity can cause economic growth, which increases aggregate demand. For example a fall in exchange rate may increase net exports and result in export-led growth.

There may also be consumption-led growth. Or a growth caused by investment.

Types of Unemployment

Cyclical: Unemployment arising from a lack of Aggregate demand.

Structural: Unemployment caused by the decline of some industries due to changes in demand and supply.

Frictional: Short term unemployment when workers are in-between jobs.

Types of Inflation

Demand-pull inflation: Rise in the price level caused by an increase in aggregate demand.

Cost-push inflation: Rise in the price level caused by increase in the costs of production.

Causes of deficit and surplus on the current account

A deficit on the current account occurs when government spending are higher than the revenue.
Which is more imports than exports.

A surplus on the current account occurs when country’s revenue from abroad is greater then the government spending. Mainly it means exports exceeds imports.

Hysteresis

It’s when unemployment causes problems. The longer people are out work, it will be more difficult for people to gain jobs.

The costs and benefits of economic growth

Economic growth may have costs. Economy is using all of it’s resources, and thus producing in it’s production possibility curve, the only way it may increase it’s output is to switch resources from making consumer goods to capital goods.

Most governments believe that benefits of economic growth exceeds the costs. The main benefit of economic growth is the rise of people’s standard living, and the rise in the real GDP. Economic growth reduces the level of poverty. Because the money coming from taxes can be used to help poor.

Exchange rates

It’s the price of the currency in the terms of another currencies.
The main factors which influence the demand for and supply of a currency and so it’s exchange rate.

- The demand for pound is likely to be high and supply is likely to be low if UK products are internationally competitive.
- Changes in income abroad influences the exchange rate.
- Rising incomes at home may have a downward pressure on the value of pound.
- Rise in UK interest rates, according to other countries interest rates, will be likely to increase demand for pounds.
- Pounds are also brought and sold by those who are wishing to undertake foreign direct investment(FDI).

Chapter 4(summary)

CHAPTER 4 AGGREGATE DEMAND AND AGGREGATE SUPPLY AND THEIR INTERACTION.

Aggregate demand

Aggregate demand is the total demand for goods and services produced in an economy at a given price level and time period. This expenditure comes from households, government, firms and foreigners. It’s made up of C+I+G+(X-M), which is Consumption + Investment + Government spending + net exports (which is Exports – Imports.)

If country has a trade surplus, which means exports are more than imports, but if we ad to it C + I + G that will increase aggregate demand. If the country has trade deficit, this means aggregate demand would be lower than domestic demand.

Consumer expenditure

Range of influences, how much households spend? They include:

-Real disposable income. For example richer, spend more than poor. They have more money to spend. The income which is spent is called Average propensity to consume (APC) may fall as disposable income rises. For example an office worker which is earning 10000$ a week will spend more than teacher earning 1000$ per week. An office worker can spend 7500$ per week, while the teacher will spend 900$. In this case the teaches has higher APC- 0,90 (900$/1000$) than and office worker who has an APS of 0.75 (7500$/10000$)

-Consumer confidence and expectations: It’s when consumers feel optimistic about the future. Because of their over confidence they spend more.

Saving

Influences on saving include:

- Real disposable income
- The rate of interest
- Confidence and expectations
- Saving schemes
- Range of financial institutions
- Government policies
- The age structure of the population

Investment

Influences on investment include:

- Change in real disposable income
- Expectations
- Capacity utilization
- Current profit levels
- Corporation tax
- The rate of interest
- Advances in technology
- Price of capital equipment
Government Spending

Government spending decisions are influenced by a number of factors. These include:

- The government view on the extent of market failure and it’s ability to correct it.
- The level of economic activity in the economy can influence government spending.
- A desire to please the electorate
- War, terrorist attacks and rising crime, or their threat, can also boost government spending.

Net exports

The influences on export revenue and import expenditure are:

- Real disposable income abroad
- Real disposable income at home
- The domestic price level
- The exchange rate
- Government restrictions on free trade

aggregate demand curve

An increase in aggregate demand

Downward sloping AD curve

Three effects which explain downward slope in AD:

The wealth effect: Relates to a change in households and firms real wealth. Fall in the price level increases the amount of goods and services, that wealth kept in the form of money in bank accounts and other financial assets, can buy. Therefore rise in the price levels causes aggregate demand to contract.

The rate of interest effect: Rise in the price level means that some people will sell assets to obtain more money to pay greater prices. A high interest rate may reduce consumption and investment. A fall in the price level will reduce the interest rate and cause an extension in AD, because of the higher consumption and investment.

The international trade effect: Rise in the price level, but exchange rates and foreign prices had no change will make country’s products less internationally competitive. Households and firms will buy more from foreign producers and less from domestic producers. And net exports would fall causing AD to contract. So Ad curve slopes down from left to right, since the rise in price level will cause a decrease in monetary wealth and an increase in interest rate and country’s international competitiveness will be reduced.

Aggregate supply

Aggregate supply is the total output of goods and services that producers in an economy are willing to supply at different price levels in a given time period.

Any increase in output can be achieved by employing more efficient workers and new machinery’s. But as the resources become more scarcer, producers have to employ less efficient workers and new machinery’s. At full capacity it’s not possible to produce any more, even if the price level is really high.

A change in AS means total output that produces are willing to so supply at a given price changes. A decrease in AS is represented by a shift to left, Increase in AS is represented by shift to right. The main change in AS are because of the changes in cost of production. If cost of production falls, AS will shift to right, causing an economics growth. Rise in the cost of productions will shift AS to left.

Macro economic Equilibrium

Occurs when Aggregate demand and Aggregate supply are equal. When Aggregate demand and Aggregate supply are equal, there’s no reason for the economy’s output to change. Total output and price level will be stable.

If Aggregate demand would be higher than aggregate supply, it would cause shortage of goods and services. Firms will extend their output to increase the total capacity.

If the Aggregate supply exceeds aggregate demand, the economy would move back to equilibrium. This time unsold goods and services would contract aggregate supply.

Anything that causes aggregate demand or aggregate supply to change will move the economy to new macroeconomic position.

Output gap

Output gap exists when economy is not producing at full capacity. Negative output gap occurs when economies actual output is less than it’s potential output. But opposite if this process causes positive output gap.

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