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GDP = C+ I + G + (X-M)

Domestic Demand = C + I + G
Net Export = (X-M)
Public Sector (Spending/Saving)= G + X
Private Sector = C+ I + M

See Lecture 1 Notes & Assignment


Government balance = taxes government expenses
Cyclical and Structural Deficits in Danish Government

Cyclical deficit is the portion of a country's budget deficit, which reflects changes in
the economic cycle. Budget positions tend to deteriorate as economies slow as tax
revenues fall and welfare spending rises; they improve as economic growth returns,
tax revenues rise and welfare spending is reduced.
Structural deficit is a budget deficit that results from a fundamental imbalance in
government receipts and expenditures, as opposed to one based on one-off or shortterm factors
-

The cyclical deficit will automatically disappear as the economic development


turns from a recession to a boom once again
The remaining deficit will not automatically disappear with stable and successful
economic periods

Structural deficit can only be solved by a change in monetary policy (increasing


taxes or decreasing spending, or a mixture of the two)
Real Growth, GDP & Business Cycles
Real Growth (GDP) of Denmark, USA & Spain
6.0
4.0
2.0
Denmark

-2.0

1999
2000
2001
2002
2003
2004
2005
2006
2007
2008
2009
2010
2011
2012
2013
2014
2012
2013
2014

0.0

United States
Spain

-4.0
-6.0
-8.0

Explain the business cycle development


To analyze the booms and recessions in a GDP real growth graph compare
the actual growth rate compared to what you can expect in the long run
(potential growth rate) for the country
Analyze the real growth of the 3 countries:
GDP = C + I + G + (X-M)
Domestic demand= C+I+G
Net export= (X-M)

GDP increase means real income and production are growing (real growth)
increasing living standard
Nominal terms GDP means that there is no real growth in living standards
(higher wages, higher prices, inflation)

Inflation & Unemployment


AD/AS & Phillips
Macroeconomic goals (short-term):
Inflation low
Unemployment low
Economic growth
Governmental balance

Low inflation rate is important to economists, central bank directors, and politicians
because by keeping inflation rate low, a low unemployment rate will be the result in
the long run.
In the long run, the best way to keep unemployment low is to keep inflation low. In
the short run, these policies and strategies to lower inflation can cause
unemployment rates to increase temporarily. But over time this balances and the
inflation rate impacts the unemployment rate significantly.
8.0
7.0
6.0
5.0
4.0

Unemployment rate

3.0

Inflation

2.0
1.0
1997
1998
1999
2000
2001
2002
2003
2004
2005
2006
2007
2008
2009
2010
2011
2012

0.0

Unemployment and inflation have a correlation Phillips curve


As unemployment increases, inflation decreases
As inflation increases, unemployment rate decreases
Trade off between inflation and unemployment rate Short-run
In the long run, this trade off doesnt exist more important to keep inflation rates
low to keep unemployment low
Phillips Curve

Demand-Pull Inflation (notes below)

Unemployment is low when inflation rate is high


Unemployment rate is high when inflation rate is low
Denmark - Philips Curve
3.5
3.0
2.5
2.0
1.5
1.0
0.5
0.0
2.0

4.0

6.0

8.0

3.2% unemployment rate, 3.2% inflation rate


2008 highest inflation rate and the lowest unemployment rate
Bottleneck on the Danish labor market (2008 point)
Construction industry is a bottleneck industry
Demand for work is much higher than the supply of qualified building
employees (shortage of qualified workers)
If AD shifts to the right point-to-point left on Phillips curve
If AD shifts to the left point-to-point right on Phillips curve
If SRAS shifts to the right Phillips curve shifts left
If SRAS shifts to the left Phillips curve shifts right

Different Kinds of Inflation


Demand-pull

Increasing private consumption (C)


Increasing Investments (I)
Increasing government consumption (G)
Increasing net-export (X-M)

National output = GDP total production society


Price level = price level average
Price level goes up equal to inflation
Combination of increasing national output and increasing price

(2 AD/AS & Phillips.doc)


1= with a normal unemployment rate of 5%, inflation is also at a normal level
2= with an artificially low unemployment rate of 2%, inflation goes up
significantly due to increased wage costs, increasing the prices of products

Cost-push
Increasing oil and other commodity prices
Increasing wages
Expected inflation
Inflation targets of the central bank
Historic inflation

Aggregate supply = aggregate marginal costs (wages go up, pushing AS


left/upwards)
Combination of lower national output and higher price
Higher unemployment rate and higher inflation rate
GDP down = unemployment rate up (Q1 to Q2)
Price up = inflation increasing (P1 to P2)
Phillips curve normally only works for demand-pull inflation, but if we use
the Phillips curve for cost-push inflation, the curve needs to be shifted to the
right (for high inflation and high price)
To the left for low inflation and low unemployment
Phillips curve correlation increased private consumption (C)= lower
unemployment and higher inflation (moving to the left on the curve)
Other factors impact inflation other than the unemployment rate
Cost-push = pushes prices up, doesnt pull prices up

***Expected inflation***
What do different parts of the economy expect of the inflation rate in the next
years (labor unions, employer associations)
Negotiating the wages for the next two years, inflation impacts the wages
Unions might request a wage increase of 5%
Nominal wage: 5%
CPI (inflation increase): 2%
Real wage = 3%
Expected inflation rate lately has been around 2% a year
Based on historic values of inflation rates in previous years, the inflation rate
can be expected to increase at the same rate

The director of the ECB is responsible for using different monetary


instruments to keep inflation rates in the Euro area on or below 2% every
year
Central bank directors job is to monitor and influence the inflation rates (i.e.
his job is to keep the inflation rate low)
Problems of Inflation
1.
2.
3.
4.

More difficult to make long term decisions limits economic growth


Shoe leather costs
Bad for competitiveness in a system with fixed exchange rates
Deflation might keep the economy in recession
***A low and stable inflation rate is good for business***
Low inflation = stability

Stability is extremely important to convince private companies to invest in


modern technology
Central banks and politicians guarantee economic business stability
business will take more risks and make more investments, and create new
products
This keeps unemployment down in the long run
Explains the reasoning behind why inflation is such a high priority for
economists and politicians
Inflation should be stable and low, advantages from 1 & 2
With a fixed exchange rate (if Denmark has 5% inflation rate and Germany
has 2%) the prices will be higher and Denmark will lose competitiveness
(export from Denmark will go down and import to Denmark will go up)
With a floating exchange rate, if the Euro area inflation is 2% and the UK
inflation is 5% = the GBP exchange rate depreciates by 3%
EUR-area inflation = 2%
UK-area inflation = 5%
GBP-exchange rate = -3%
A depreciation of the currency will increase British company
competitiveness (export from Britain will go up, cheaper goods with a lower
exchange rate)
As they lose 3% in the inflation area, they win with 3% in the depreciation of
the currency leaving the competitiveness unchanged
Shoe leather costs: in periods of inflation, the value of cash in hand
decreases, people choose to carry less cash and make more trips to the bank

***AD/AS & Inflation Notes***

AD= C+I+G+(X-M)
C is 60% of the Aggregate Demand structure
Investment: house building, etc.
Government consumption: government salary, expenses, etc.
Net export: in Denmark it is positive to aggregate demand, export is higher
than import
Net export is the main reason that the AD curve slopes down, because the
price level creates a level of competitiveness that allows Denmark to
compete on a global scale and export more (if price was too high,
competitiveness would be low, and there would be less export and more
import)
AS short-run = MC (Marginal Costs)
If price level is low, it would be less profitable for companies to produce and
sell, so supply would be lower
AS long-run
In the long run, the economy will have the tendency to move towards the
long run aggregate supply curve
Economic forces will start to move output towards long run aggregate supply
Long term equilibrium also relates to the labour market (AD,ASL, and labour
market)
The natural unemployment rate or structural unemployment rate (5%-5.5%
in Denmark) has to do with the labour market and flexibility of citizens,
equilibrium is where the actual unemployment rate is equal to the structural
unemployment rate (Demand = Supply)
If it is regular 5%, and the rate is at 3% then companies cannot find the
qualified workers; the supply is lower than demand
If the rate is 8%, the supply is higher than the demand by 3%; this has to do
with cyclical unemployment (those who are in transition to a new job, or will
be unemployed for a short period of time)
Structural unemployment is very high in Spain; has something to do with
flexibility, where Spanish people are very unlikely to move to the other side
of the country for a job due to cultural factors
Inflation
2% inflation rate is a generally accepted target in most countries
Export prices go up with higher inflation (domestic inflation), bad for
competitiveness
Flexible exchange rate: If domestic inflation is higher than another country, the
competitiveness will go down, import will go up for foreign currency, the
demand for foreign currency will go up, exchange rate of foreign currency will
go up, the exchange rate of domestic currency will depreciate
With flexible exchange rates, higher inflation rate will cause currency to
depreciate and the competitiveness will go unchanged in relation to imports
and exports

With fixed exchange rates, inflation is bad for domestic competitiveness


because the currency does not respond to the changes in inflation since DKK is
fixed to EUR
Keeping inflation rate low creates a stable frame for business, business will
be able to make better long term decisions for investments
Deflation inflation rates are below 0%; on the demand side, if consumers
and businesses expect prices to be lower next year than this year, companies
long term investments and private consumer spending will be very low due
to expectations (C & I low)

AD/AS: Potential Output (Yp) & Inflation/Recession

YP: AS long run, equilibrium on the labor market (actual=structural


unemployment rate)
Y>YP: inflationary gap, bottlenecks on the labor market, increasing inflation
Y<YP: recessionary gap, cyclical unemployment, decreasing inflation
Y=YP: Long run equilibrium, inflation constant

Short run aggregate supply = aggregate demand = equilibrium


Potential output = structural unemployment rate = actual unemployment rate
Long-run Aggregate Supply Curve & Inflationary Gap

Yp= (potential output) unemployment rate equal to structural


unemployment rate
Y2= > potential (booming economy), unemployment rate lower than
structural level (artificially low not sustainable in the long run)

Equilibrium A= long term equilibrium


Equilibrium B= increasing aggregate demand (could be: consumer
spending, investments, government spending, net export)
Space between Yp and Y2 = inflationary gap
Gap will be closed by wages going up, increasing company costs, which
increases the price (AS1 to AS2)
B to C = unemployment from 3% (artificial) to 5% for long term equilibrium
This also increases inflation (P3) but unemployment rate is normal
Long-run AS Curve & Inflationary Gap
AD1 to AD2: Increasing C, I, G, or (X-M)
Opens up an inflationary gap YP-Y2 (shortage of qualified workers)
AS1 to AS2: shortage of workers forces up wages, MC up, and AC shifts to the
left in the long run
Higher inflation rate in the long run
Removing the Inflationary Gap
Inflation might increase inflation expectations
Force AD2 back to AD1 (Keynes)
Taxes up (fiscal policy)
G down (fiscal policy)
Interest rate up (monetary policy)
Increase potential output (labor force)
Long-run Aggregate Supply Curve & Structural Unemployment Rate

ASLong = potential output


Equilibrium on the labor market
No shortage of qualified labor and no cyclical unemployment
Inflation constant
Output>ASLong: shortage of qualified workers and inflation growing
Output<ASLong: cyclical unemployment and inflation decreasing

Long-run Aggregate Supply Curve & Recessional Gap

AD11 to AD2: Decreasing C, I, G, or (X-M)


Opens up an recessional gap YP-Y2 (cyclical unemployment)
AS1 to AS2: cyclical unemployment forces down wages, MC down, and AS
shifts to the right in the long run
Y returns to YP in the long run
Lower inflation rate in the long run
Removing the Recessional Gap
In the long run we automatically return to YP but in the long run we are all
dead (Keynes)
Force AD2 back to AD1 (Keynes)
Taxes down (fiscal policy)
G up (fiscal policy)
Interest rate down (monetary policy)
Different Kinds of Unemployment

Unemployment rate = number of unemployed/labor force

Cyclical unemployment: recession on the goods market decreases demand


for labor (demand deficient)

Structural unemployment (natural)


Lack of qualifications
Lack of mobility (geographical/commuting & unwillingness to work in
different business areas)
Many women work, so if the husband gets a job in a different
area it is unlikely he will go unless she can get a job there too
Lack of motivation

Frictional (skiftearbejdslshed)
The number of unemployed people this week, will be
temporary in correspondence with the fact that the majority of
these frictionally unemployed people will get a new job the
next week (up to 50,000 out of 160,000 unemployed are
frictional)

In the summer 2008 the unemployment rate was down to 2 %. How is this
unemployment compared to the structural? Analyse in an AD/AS chart
inflationary/recessional gap.

AD2= increasing consumer spending, 2008 house prices going up


significantly

Yp, Yo= inflationary gap (% difference between the two) bottleneck (labor
market)
Yo= 2% unemployment rate
-Artificially low, unsustainable
-Qualified workers were in high demand, companies competed for the
highly skilled workers and so have to go into wage competition,
increasing wage costs therefore increasing prices of products
increasing inflation
-Shortage of qualified workers but a low unemployment rate =
bottleneck on the labor market
-Higher wages is a huge component of marginal costs on the aggregate
supply curve, which pushes up prices of products

Macroeconomic Policy

Business Cycle and Potential Output

Horizontal axis = time (year)


If GDP starts in index 100, the GDP with a fixed growth rate of 2% will cause
potential output to develop in an upward slope (in the long run)

Potential output 2 & actual output:


Where actual output is above the potential output, there is an inflationary
gap (in the short run) Demand side economic policy to decrease demand
Where actual output is below the potential output, there is a recessional gap
(increase aggregate demand by lowering taxes or interest rates, change GDP
in the short run)
Potential output 1:
To change potential output, supply side economic policy must be used to
increase the growth rate in the long run (i.e. from 2% to 3%)

Demand Side Economic Policy

Demand side Short Run


Instruments
Fiscal policy mainly taxes
Monetary policy - mainly short term interest rates and money supply
(affects investments and asset prices: house prices and share prices)
Lower interest rates will cause house prices to increase
(demand goes up), share prices will increase because it
becomes more attractive to buy shares than bonds because
bonds have a ridiculous interest rate
Exchange rate policy

Impact on demand

Private consumption (C)


Government consumption (G)
Investments (I)
Net-export (X-M)

Short term (no effect in the long run)


Used to correct the business cycle; trying to increase demand in a
recession, reduce demand in a boom

Definition: when a government changes either the level of taxation and/or the level
of government spending to actively promote achievement of macroeconomic
objectives (note: short-term objectives)

Fiscal Policy Includes:


o Increasing/decreasing taxes
o Increasing/decreasing government spending

Expansionary Fiscal Policy = Increase AD by lowering taxes and/or


increasing government spending

Contractionary Fiscal Policy = Decrease AD by increasing taxes and/or


decreasing government spending

Objectives of Fiscal Policy:


o Full Employment Level
o Stable prices/controlled inflation
o Economic Growth
***All objectives above can be illustrated by using an AD/AS chart***
Equilibrium of the National Economy

Y*= potential national output & full unemployment (structural unemployment)


P0= equilibrium price level at full output and unemployment
(Typically, full unemployment and potential output = stable prices/ inflation)

Expansionary Fiscal Policy

Goal: increase Aggregate Demand or Aggregate Supply in the economy

Example When C and I decreased, AD decreased as well. This causes prices to drop (deflation,
price instability) and unemployment to go up, it also decreased national output.

Issues: recessional gap, deflation and increased unemployment


Goals: increase AD, price level, national output, and lower unemployment

Low AD causes recessional gap (recession with cyclical unemployment)


Aggregate demand decreases as in 2009
Private consumption down (F.x. due to decreasing house prices)
Decreased spending, increased savings
Consumers pessimistic about economic future
Net-export down due to recession abroad

Expansionary fiscal policy returns AD1 to AD2


Taxes down
Government consumption up

The economy is expected to reach potential output in the long run; fiscal policy will
try to push the aggregate demand back to equilibrium with potential output.
With
lower
taxes, people have more money to spend, which increases aggregate demand and
then directly increases price levels, output, and lowers unemployment to reach
equilibrium once again.

By increasing G (direct component of AD), price levels will rise, output will increase,
and unemployment levels will improve)

Government spending examples: infrastructure, roadwork, construction, defense,


public works, education, health, etc.)
Short-term Impact on Inflation & Unemployment

Demand-pull inflation:
Phillips curve correlation ( increased private consumption (C)= lower
unemployment and higher inflation (moving to the left on the curve)

Increasing private consumption (C)


Increasing Investments (I)
Increasing government consumption (G)
Increasing net-export (X-M)
Contractionary Fiscal Policy

Goal: Reduce Aggregate Demand or Aggregate Supply in the economy

Example currency depreciates and causes AD to increase


When a domestic currency becomes less valuable, their competitiveness goes up
because it is more attractive for other countries to buy in that currency. When that
happens, their net export increases because they are exporting more than they are
importing. This causes the price level to go up because resources become scarce and
as demand rises so does price level as response to Demand-pull inflation (increased
demand). When this occurs the unemployment rate drops, but it drops below the
natural unemployment rate and it is unsustainable; having an unemployment rate
that low is bad for the economy and the high inflation is also a serious issue.
-Pull

Issues: unsustainable unemployment (artificially low), inflationary problems i.e. high prices, and low
competitiveness
Goals: decrease AD, stabilize inflation and price level, adjust unemployment rate to match the
natural/structural level
Increased AD causes Inflationary Gap: real GDP is higher than potential output
They can increase taxes, and/or lower government spending to slow down an
economy that is moving too fast (or where unemployment is artificially low).

By
increa
sing taxes, the government will decrease the amount of money people have to spend
and private consumption will go down in response. Since C is a direct component of
AD, aggregate demand will decrease. Because of the decrease in AD, price levels will
start to go down and national output will decrease. Correspondingly, unemployment
levels will go up as the inflationary gap disappears. Normally this would be bad for
the economy, but because unemployment levels were above the natural level it was
bad for the economy.

Since G is a direct component of AD, it will directly lower aggregate demand. As this
occurs the price levels will go down, national output will reach potential output, and
unemployment levels will level out at the national natural level.

To illustrate contractional fiscal policys short-term impact on the inflation rate and
the unemployment rate, we can see that as the inflation rate (price level) decreases,
the unemployment rate will increase in response. This is okay when referring to
contractionary fiscal policy because those are two of the goals in the current
example.
***We would NOT use this policy if unemployment levels were an issue***
This policy is also used when there is a structural government deficit; by increasing
taxes and lowering government spending the government can start to repay its
debts.
The only way a country can repay their loans is to enforce a contractionary fiscal
policy, so that they can reach a surplus in the next booming period (if they have a
structural deficit). They are trying to correct the business cycle, and improve the
unemployment that is currently a problem in many countries. If they start to repay
their loans, and increase tax receipts compared to government spending, then they
can start to focus on increasing real growth.
With a contractional fiscal policy, they will reduce unemployment rates, lower
government debt, improve the current government balance, and later improve their
competitiveness and real growth. Ideally, if this policy works, then the structural
deficit and the financial crowding out will be significantly improved.
***General Fiscal Policy Note***

Fiscal Policy: Government spending policies that influence macroeconomic


conditions. Through fiscal policy, regulators attempt to improve unemployment
rates, control inflation, stabilize business cycles and influence interest rates in an
effort to control the economy. Fiscal policy is largely based on the ideas of British
economist John Maynard Keynes (18831946), who believed governments could
change economic performance by adjusting tax rates and government spending.
To illustrate how the government could try to use fiscal policy to affect the economy,
consider an economy thats experiencing a recession. The government might lower
tax rates to try to fuel economic growth. If people are paying less in taxes, they have
more money to spend or invest. Increased consumer spending or investment could
improve economic growth. Regulators dont want to see too great of a spending
increase though, as this could increase inflation.
Another possibility is that the government might decide to increase its own
spending say, by building more highways. The idea is that the additional
government spending creates jobs and lowers the unemployment rate. Some
economists, however, dispute the notion that governments can create jobs, because
government obtains all of its money from taxation in other words, from the
productive activities of the private sector.
_________________________________________________________________________________________________
Fiscal Policy Problems

Stabilizing or destabilizing (contra-cyclical or pro-cyclical)

Difficult to forecast effect size of multiplier

Expansionary policy, how will consumers respond to lower taxes?


Higher disposable income = more consumer spending or increased
savings? Taxes down and savings up ( economy, GDP, & AD unchanged
Short term effect only

Crowding out
Financial crowding out (interest rate) expansionary fiscal policy
(increase GDP, increase interest rates, I&C will go down, GDP will go
down, and the process starts over with fiscal policy to increase GDP
As interest rates increase making it difficult for some countries to pay
back loaned money, the only way to fix it is to lower government debtcontractionary fiscal policy
Inflationary crowding out a fiscal policy that is too expansionary
causing inflation and lower aggregate demand. Risk of inflationary
crowding out in Denmark and German, is quite high; unemployment

rate is already very small so an expansionary fiscal policy can cause


inflation to increase.
Fiscal Policy: Stabilizing or Destabilizing Effect?

Parliament makes the decisions about fiscal policy


A GDP to fiscal policy, neutral fiscal policy
B Stabilizing fiscal policy, successful policy affecting gaps in path A
C Destabilizing fiscal policy, where the fiscal policy starts to take effect as the
economy is already recovering, causing an exaggerated response to the economic
recession or boom (this is caused by a delayed response or action by politicians,
where policy isnt enforced quickly enough to affect economy in the right time)
Fiscal Policy and Automatic Stabilizers
Automatic Fiscal Stabilizers
A boom with rising demand and income =>
Taxes up and income transfers down automatically and without delay =>
Demand and income rise effectively reduced =>Stabilize the business cycle
Boom with rising
demand & income

Taxes Up
Income transfers
Down
Automatically and
without delay

Demand and
income rise
effectively reduced

Stabilized
business
cycle

More VAT will automatically increase through more people working, and income
rises. This will immediately impact private consumption as people pay more taxes.

As unemployment rate goes down, more people are working so government income
transfers will go down (social benefits). In Denmark, there is a high level of income
transfers & high level of taxes, which makes the automatic fiscal stabilizers very
effective; private consumption will be limited effectively from the high taxes.
In Denmark the increase in income will be taxed by at least 50%; in USA the
increase in income will be taxed by less so their private consumption is not very
limited. In this way, the USA also has a very weak unemployment benefit system
compared to Denmark so the recessional period would also be much more severe
than there.
Discretionary Fiscal Policy
A boom with rising demand and income =>A political decision to increase taxes or to
reduce G =>Demand and income down => Risk of destabilization of business cycle

Boom with
rising demand
& income

Political
decision:
increase taxes
or reduce G

Demand and
income
decrease

Risk of
destabilizing
business
cycle
(time lag)

This also means active fiscal policy, through political decisions to increase taxes and
reducing government spending. Through this system, the time might cause a delay
in the response to the economic cycle. This is a political decision to intervene, and
directly impact the aggregate demand through government policy. Discretionary
fiscal policys aim is to correct a business cycle that they do not believe will correct
itself in the short run or at all.
Automatic adjustment of LONG-TERM economy:
Recession ( increased cyclical unemployment ( wages go down ( competitiveness
goes up ( net export goes up ( GDP goes up (AS1 marginal costs decrease with lower
wages, curve shifts to the right to meet equilibrium with AD)
Are wages flexible or sticky? With cyclical unemployment, wages are very sticky, it
takes a very long time for wages to decrease (in a recessional period, the growth
rate of wages will decrease, but actual wages will not drop quickly)
Fiscal Policy & Government Balance
***Important to distinguish between Cyclical & Structural government deficit***

G is increased by 10 billion, and the government deficit is changed from 0 to 10 in the short run (a)
After 1 to 2 years Y is increased according to the multiplier, F.x by 12 bill (b)
Due to increased Y, tax receipts will go up and income transfers down and
government deficit will go down by for example 6 bill (c)
In the end an expansionary fiscal policy will increase government deficit, but
less than the increase in G
Tax receipts Government expenditures = government balance

Where (T-G)1 meets Y = the government balance is balanced


Government consumption is increased by 10 billion, the government balance
will face a deficit (b= budget line)
GDP will increase by 12 billion based on a 1.2 multiplier (includes an
increase in private consumption of 2, 10 for G)
Expansionary fiscal policy to increase demand, and reduce unemployment

Automatically, by spending 10, billion government deficit will increase in the short
run, but after 1-2 years GDP will increase and deficit will decrease with increased
tax receipts as unemployment decreases
Government Balance & Debt

Government deficit
o Cyclical: increasing unemployment decreases taxes and increases
government transfers
o Structural: if there is a deficit without cyclical unemployment, taxes
are basically smaller than government expenditures
o Deficit as pct. of GDP>GDP growth rate => Debt as pct. of GDP
increases =>Financial markets demand higher interest rates (risk
premium) => Financial crowding out

Structural deficits refer to deficits in a normal economic situation where there is a


deficit without an abnormally high level of unemployment; note that the
government balance will equal out in the long run.
With a structural deficit, (in Spain, Greece, Portugal, Ireland, etc.) they still faced a
deficit even as the boom peaked in 2006, they cant reach a surplus in a booming
period ( the booming periods dont compensate for the recessional periods (no extra
money to repay loans)
Booming periods allowed only a decreased deficit (will never be able to repay their
loans, risk premium caused interest rates to go up significantly) = they are enforcing
a contractionary fiscal policy, reducing government spending and increasing taxes
to impact the structural government deficit
Financial Crowding Out
Denmark: Government Balance & Debt
/
Financial Markets Reaction
Recession (cyclical deficit increases (deficit that would correct itself over time)
Due to expansionary fiscal policy (the structural deficit increases
The government debt as pct. of GDP increases
Financial markets get nervous ( a risk premium will be added to the interest rate
Higher interest rate ( decreased aggregate demand
Government Deficit- very important to distinguish between cyclical & structural
In a recession, the cyclical deficit will go up due to increased government
expenditures and less tax receipts (this is an automatic stabilizer through cyclical
deficit) In a boom, there will be a surplus in the government balance.
Over the total length of the business cycle, the government balance is even. So as
government spending increases in recessional periods, the booming periods will
allow them to pay back the loans under favorable conditions.
With a more expansionary fiscal policy, the deficit will be much bigger in a
recessional period and there is a risk that there will still be a deficit in the booming
period. This shows a structural deficit; where a country still faces a deficit even in
booming periods.
Financial markets would be skeptical of whether or not the country can repay the
loan. The country will never face a surplus, and will never be able to repay its loans;

the capital markets will increase interest rates with an added risk premium for the
countries they are skeptical about. This effect can be bad for GDP; increased interest
rates are worse for GDP than the positive effects of the expansionary fiscal policy on
GDP (cancels out positive effects). The financial crowding out has been reduced
significantly over the past couple years, due to a contractionary fiscal policy to
reduce the structural deficit so that they can face a surplus on the government
balance; only then can the countries start to repay their loans.

Crowding out: decrease in private expenditures that occurs as a consequence of


increased government spending or the financing needs of the deficit.
Fiscal policy is used to stimulate the economy but there could be an unintended
consequence of decreased C and I.
By increasing G or decreasing taxes, the government faces an increased deficit. If they
need to finance this additional government spending with borrowed funds, the interest
rates will increase correspondingly and could impact the private and business sectors.
Time-lag: political decisions take time to form, during this time the business cycle
they are attempting to correct may be correcting itself
Effectiveness-lag: when the policy is enforced, there is a risk they are stimulating
an economy that is already in a booming period (inflationary risk).
***From the book***
Before changing government expenditure or taxation, the government will need to
calculate the effect of any such change on national income, employment and
inflation. Predicting these effects, however, is often very unreliable for a number of
reasons.
A rise in government expenditure may lead to a rise in total injections (relative to
withdrawals) that is smaller than the rise in government expenditure. This will
occur if the rise in government expenditure replaces a certain amount of private
expenditure. For example, a rise in expenditure on state education may dissuade
some parents from sending their children to private schools. Similarly, an
improvement in the National Health Service may lead to fewer people paying for
private treatment.
Crowding out: Another reason for the total rise in injections being smaller than the
rise in government expenditure is a phenomenon known as crowding out. If the
government relies on pure fiscal policy that is, if it does not finance an increase in
the budget deficit by increasing the money supply it will have to borrow the
money from the non-bank private sector. It will thus be competing with the private
sector for finance and will have to offer higher interest rates. This will force the
private sector too to offer higher interest rates, which may discourage firms from

investing and individuals from buying on credit. Thus government borrowing


crowds out private borrowing. In the extreme case, the fall in consumption and
investment may completely offset the rise in government expenditure, with the
result that aggregate demand does not raise at all.

Comparing Macroeconomic Policy with Flexible & Fixed Exchange Rates

***If a country has a fixed exchange rate you should not use monetary policy (very
bad), but with a fiscal policy***
***If a country has a flexible exchange rate you should use monetary policy, but NOT
fiscal policy***
Expansionary Monetary policy, fixed exchange rates ( cannot be used in Denmark
because as soon as the Danish interest rate is a little lower than the Euro interest
rate there will be a capital outflow from Denmark into the Eurozone, and the
solution is to increase the interest rate to match the Euro interest rate. Denmark
cannot change its interest rate independent of the Euro interest rate, so it must be
the same. Otherwise, there will be a large capital inflow or outflow. Not an option for
Denmark (dependent on central bank in Frankfurt).
Capital outflow occurs because there is no risk taking advantage of the higher
interest rate in the Euro; no risk of loss due to fixed exchange rate (in USA with a
flexible exchange rate, there would be a risk that the dollar could depreciate and
there would be a loss in the savings).
A low interest rate is good for private consumption and more investments, which is
used to improve the economic growth. If the economic situation in Denmark is
similar to the economic situation in the Eurozone, there is no problem that Denmark
cannot enforce monetary policy (normally, the economic needs are the same in
Denmark and the Eurozone). If the relationship is unharmonious then it becomes a
problem that Denmark cannot use monetary policy to impact interest rate.

Remember: With flexible exchange rates, expansionary monetary policy is


extremely efficient, because it will impact competitiveness and improve net export.
Sweden is performing much better than Denmark, maybe due to monetary policy
with flexible exchange rates.
Fixed exchange rates expansionary fiscal policy
Good to use in Denmark, because the interest rate and the exchange rate will not be
affected by the changes in fiscal policy. But, if Denmark implements a very
expansionary fiscal policy the capital markets might become skeptical as the
government deficit increases significantly. Might increase interest rates due to
increased risk of Denmark not being able to pay back their loans; so if the capital
markets dont trust the Danish economy because it is being irresponsible then they
will increase interest rates. If the capital markets trust the Denmark and have
confidence, then there is no problem with using expansionary fiscal policy.
Flexible exchange rates expansionary fiscal policy
Not good to use, aggregate demand is reduced if interest rates rise and exchange
rate appreciation. So using expansionary fiscal policy is inefficient.

Monetary Policy

Monetary policy mainly short term interest rates and money supply (affects
investments and asset prices: house prices and share prices) Lower interest rates
will cause house prices to increase (demand goes up), share prices will increase
because it becomes more attractive to buy shares than bonds because bonds have a
ridiculous interest rate.
***Important for countries with flexible exchange rates***
Definition: The actions of a central bank, currency board or other regulatory
committee that determine the size and rate of growth of the money supply, which in
turn affects interest rates. Monetary policy is maintained through actions such as
increasing the interest rate, or changing the amount of money banks need to keep in
the vault (bank reserves).
In the United States, the Federal Reserve is in charge of monetary policy. Monetary
policy is one of the ways that the U.S. government attempts to control the economy.
If the money supply grows too fast, the rate of inflation will increase; if the growth of
the money supply is slowed too much, then economic growth may also slow. In
general, the U.S. sets inflation targets that are meant to maintain a steady inflation of
2% to 3%.
Expansionary Monetary Policy

Contractionary Monetary Policy

1. Expansionary monetary policy causes an


1. Contractionary monetary policy causes a
increase in bond prices and a reduction in
decrease in bond prices and an increase
interest rates.
in interest rates.
2. Lower interest rates lead to higher levels
of capital investment.

2. Higher interest rates lead to lower levels


of capital investment.

3. The lower interest rates make domestic


bonds less attractive, so the demand for
domestic bonds falls and the demand for
foreign bonds rises.

3. The higher interest rates make domestic


bonds more attractive, so the demand for
domestic bonds rises and the demand for
foreign bonds falls.

4. The demand for domestic currency falls


and the demand for foreign currency
rises, causing a decrease in the exchange
rate. (The value of the domestic currency
is now lower relative to foreign
currencies)

4. The demand for domestic currency rises


and the demand for foreign currency falls,
causing an increase in the exchange rate.
(The value of the domestic currency is
now higher relative to foreign currencies)

5. A lower exchange rate causes exports to


increase, imports to decrease and the
balance of trade to increase.

5. A higher exchange rate causes exports to


decrease, imports to increase and the
balance of trade to decrease.

Expansionary Monetary Policy

Expansionary Monetary Policy: A policy by monetary authorities to expand


money supply and boost economic activity, mainly by keeping interest rates low to
encourage borrowing by companies, individuals and banks. An expansionary
monetary policy can involve quantitative easing, whereby central banks
purchase assets from banks. This has the effect of lowering yields on bonds and
creating cheaper borrowing for banks. This, in turn, boosts banks' capacity to lend
to individuals and businesses. An expansionary monetary policy also risks ramping
up inflation.
Money supply is controlled by the ECB (European Central Bank)
Expansionary Monetary Policy Recession

Recessional Gap increase money supply lower interest rates increase I


Increase AD
The ECB can control the money supply and lower the short-term interest rates
directly. As they buy bonds, the money supply will increase and the interest rate
goes down in correspondence. When the interest rate drops investments increase
which directly increases AD. When AD increases the price levels will go up, national
output will increase, and unemployment levels will stabilize. As the other elements
take place, the lower interest rates will cause depreciation in the domestic currency
and national competitiveness will improve. As the competitiveness of the country
gets better they will export more and import less, also affecting the net export
element of AD.
A decrease in interest rates increases I & C, as well as (X-M)
AD2
to AD1
opens up a recessional gap (recession with cyclical unemployment)
Private consumption down due to F.x decreasing house prices

MS = IR = I

= AD PL , Y , Competitiveness , X , M

Net-export down due to recession abroad


Expansionary monetary policy increases AD1 to AD2
Central banks leading interest rates down (short term)
Long term market rates normally down as well
Monetary transmission mechanism
Monetary Policy Instruments Expansionary
Short-term interest rate

Leading rate down =>


Money market rate down =>
Money demand > supply
Central bank increases money supply until
Money demand = supply

Leading rate down

Money market
rate down

MD>MS

Central bank
increases MS

Money Demand
=
Money supply

The leading rate is the interest rate that is controlled by the central bank in
Denmark it is called the 1-Week interest rate
-

The central bank will first lower the short term interest rate, which will
cause money demand to increase ( since the central bank is also in control of
money supply, they will then increase the money supply until a new
equilibrium is formed at the higher level of demand for money
When the central bank lowers the interest rate, the demand for money
increases and equilibrium is lost (this is why the money supply also needs to
shift in order for there to be a balance of supply and demand curves)
The central bank will also impact the market rate from banks
Expansionary monetary policy normally only affects the short term interest
rate (refer to the horizontal interest rate structure)
Long- term interest Rate
Central bank buys long term bonds on the market =>Bonds price up =
Interest rate down

Central Bank buys long


term bonds directly off
market

Bond's prices go up

Interest Rate goes


down

For 30 years, until 1-2 years ago, long-term interest rate was not a factor in
expansionary monetary policy instruments (historically, this monetary policy only
directly affected the short term interest rates)

The long-term interest rate is important for government, because it


determines the interest they will need to pay for funding loans in
expansionary policy.
Important for private consumers in terms of mortgage interest rates, real
estate, and building houses
Ideally, the long term interest rate should also be impacted by expansionary
monetary policy
To do so, the central bank buys 10-year government bonds, increasing the
price of the bonds and lowering the interest rates (this will make the
horizontal interest rate structure less steep)
Every month, the fed buys for 80 billion dollars worth of long term
government bonds
This is good for investments, house building, and share prices (share prices
are extremely sensitive to the fed buying government bonds)
They directly impact the long-term interest rates
Monetary Transmission Mechanisms

Interest-rate transmission mechanism


-

Money supply up, interest rates down = expansionary monetary policy


Investments up, savings down (savings down = private consumption up)

***A lower interest rate will attract consumers to spend now and save less; with
a low interest rate the demand for houses will go up and the house prices will go
up; asset prices will go up i.e. house prices and share price; psychological effect
will cause people to feel they have more money, which increase private
consumption due to an optimistic view on economic stance for private
consumers***
Exchange-rate transmission mechanism
-

Interest rate down, demand for foreign assets up, exchange rate down =
capital outflow causing demand for foreign currency to go up, and the
exchange rate will go down (depreciation of domestic currency), increases

countries competitiveness because its attractive for countries to buy DKK as


it is depreciated
Consumption up, investments up, net exports up
Lower part of the chart is for countries with flexible exchange rates
(Denmark is not included in the effects of the exchange-rate transmission
mechanism, Denmark must follow the ECB activities)
Expansionary Monetary Policy & Government Balance

Expansionary monetary policy ( interest rate down


Aggregate demand and Y up
Tax receipts up and income transfers down
Government surplus up (or deficit down)
This process stops when the recessional gap is closed

An expansionary monetary policy has a positive impact on the GDP


Results in a surplus as Y increases (more tax receipts)
Contractionary Monetary Policy

Contractionary Monetary Policy: A type of policy that is used as a macroeconomic


tool by the country's central bank or finance ministry to slow down an economy;
contractionary policies are enacted by a government to reduce the money supply
and ultimately the spending in a country.
This is done primarily through:
1. Increasing interest rates
2. Increasing reserve requirements
3. Reducing the money supply, directly or indirectly
This tool is used during high-growth periods of the business cycle, but does not have
an immediate effect.

***Investopedia explains 'Contractionary Monetary Policy'***


When both spending and the availability of money are high, prices start to rise - this is
known as inflation. When a country is experiencing higher-than-anticipated inflation,
the government might step in with a contractionary policy to try to slow down the
economy. Their goal is to reduce spending by making it less attractive to acquire loans
or by taking currency out of circulation, and thus reduce inflation. The effectiveness of
these policies vary.
1. Increasing the interest rate at which the Federal Reserve lends will also
increase the rates at which banks lend. When rates are higher, it is more expensive for
individuals to obtain loans; this reduces spending.
2. Banks are required to keep a reserve of cash to meet withdrawal demands. If
the reserve requirements are increased, there is less money for banks to lend out. Thus
there is a lower money supply.
3. Central banks can borrow money from institutions or individuals in the form
of bonds. If the interest paid on these bonds is increased, more investors will buy them.
This will take money out of circulation. Central banks can also reduce the amount of
money they lend out or call in existing debts to reduce the money supply.

Contractionary Monetary Policy Inflationary Gap

This policy is typically used to slow down economic growth, prevent or reduce
inflation increases, increase interest rates, lower investments, and decrease AD. Not
usually seen unless inflation rates are above the 2% target rate.
MS = IR

=I

= AD PL , Y , Competitiveness , X , M

The increase in interest rates will decrease investments and lower AD, the
government will sell bonds . As bond prices drop, the interest rates go up and capital
investments decrease. The higher interest rates make domestic bonds more attractive on
the foreign market, and the exchange rate goes up (currency appreciates). This lowers their
competitiveness, and it becomes more expensive for countries to import from them; their
exports decrease and their imports increase, negatively affecting their net export and AD.
As the AD drops the price level drops and their national output decreases, with this the
unemployment levels will rise and in the best case scenario a new equilibrium will be met
and the inflationary gap will be closed.
Exchange Rate Policy Devaluation
Reasons to Devaluate a Currency:
Promote price stability, allowing a low & stable inflation rate
Improving a countries competitiveness
Promoting consumer and investor certainty
Enhancing export competitiveness
Devaluation with fixed (but adjustable) exchange rates

AD2 to AD1 opens up a recessional gap (recession with cyclical


unemployment)
Private consumption down due to decreasing house prices
Net-export down due to loss of competitiveness
Devaluation of the domestic currency returns AD1 to AD2
Improved competitiveness
Net export up
Problems: having more exports than imports can increase AD so much that it
causes inflation, and by making imported goods more expensive it can
negatively impact domestic industries effectiveness because they dont have
any pressure from competition.

Examples
Greece leaves the EUR and Drachmer depreciates
Denmark devaluates DKK (EUR 100 = DKK 700)

Devaluation = a deliberate downward adjustment to the value of a countrys


currency, to lower its exchange rate in a fixed or semi fixed exchange rate.
Therefore, technically devaluation is only possible if a country is a member of some
fixed exchange rate policy.

Depreciation = a fall in the value of a currency in a floating exchange rate. This is not
due to a governments decision, but due to supply and demand side factors,
although, if the government sold a lot of pounds, they could impact the depreciation.

Presently, Denmark does not need to devaluate the kroner because their
inflation rate is only at 1.5%. If they did, the capital market would expect the
exchange rate to go down, there would be a capital outflow and the interest
rate would increase immediately (people would take their money out of
Denmark before they devaluated the currency).

Normally, this would be used to improve competitiveness. This would impact


net export, shifting aggregate demand to the right (more exports than
imports). This would also cause private consumption to go down and
investments to go down though, as the interest rates increase with the
devaluation of the currency.
Comparing Macroeconomic Policy with Flexible & Fixed Exchange Rates

***If a country has a fixed exchange rate you should not use monetary policy (very
bad), but with a fiscal policy and vise versa
If a country has a flexible exchange rate you should use monetary policy, but NOT
fiscal policy***

Expansionary Monetary policy, fixed exchange rates ( cannot be used in Denmark


because as soon as the Danish interest rate is a little lower than the Euro interest
rate there will be a capital outflow from Denmark into the Eurozone, and the
solution is to increase the interest rate to match the Euro interest rate. Denmark
cannot change its interest rate independent of the Euro interest rate, so it must be
the same. Otherwise, there will be a large capital inflow or outflow. Not an option for
Denmark (dependent on central bank in Frankfurt).
Capital outflow occurs because there is no risk taking advantage of the higher
interest rate in the Euro; no risk of loss due to fixed exchange rate (in USA with a
flexible exchange rate, there would be a risk that the dollar could depreciate and
there would be a loss in the savings).
A low interest rate is good for private consumption and more investments, which is
used to improve the economic growth. If the economic situation in Denmark is
similar to the economic situation in the Eurozone, there is no problem that Denmark
cannot enforce monetary policy (normally, the economic needs are the same in
Denmark and the Eurozone). If the relationship is unharmonious then it becomes a
problem that Denmark cannot use monetary policy to impact interest rate.
Remember: With flexible exchange rates, expansionary monetary policy is
extremely efficient, because it will impact competitiveness and improve net export.
Sweden is performing much better than Denmark, maybe due to monetary policy
with flexible exchange rates.
Fixed exchange rates expansionary fiscal policy
Good to use in Denmark, because the interest rate and the exchange rate will not be
affected by the changes in fiscal policy. But, if Denmark implements a very
expansionary fiscal policy the capital markets might become skeptical as the
government deficit increases significantly. Might increase interest rates due to
increased risk of Denmark not being able to pay back their loans; so if the capital
markets dont trust the Danish economy because it is being irresponsible then they
will increase interest rates. If the capital markets trust the Denmark and have
confidence, then there is no problem with using expansionary fiscal policy.
Flexible exchange rates expansionary fiscal policy
Not good to use, aggregate demand is reduced if interest rates rise and exchange
rate appreciation. So using expansionary fiscal policy is inefficient.

Supply Side Macroeconomic Policy


Structural Reforms
Supply Side Economic Policy
Supply side (Long Run)

Stimulate the aggregate supply in the economy to reach macroeconomic


goals in the long run
LRAS indicates what is possible in the economy when it is producing at full
employment levels
Improve competition and productivity
Increase labor supply
Increase long run aggregate supply
No effect in the short run

Supply Side Macroeconomic Policy Structural Reforms in a Recession

The increased SRAS (short-run aggregate supply) closes the recessionary gap
while lowering price level at the same time (shift Phillips curve to the left)
Increase SRAS= higher national output, decreased unemployment rate, lower prices
The deflation is desirable for consumers, lower prices promotes spending.
Market-based supply side policy Instruments (Recessionary Gap)

Market-based supply side policies are used when government wants to reduce its
role in the economy. They are policies that are implemented by the government,
aimed at encouraging production and consumption by the free market and thus
stimulating economic activity without increased government intervention.
Deregulation: leads to lower costs among producers, encouraging producers to
increase their output, hire more workers, & charge lower prices for their goods to
lead to higher national output, improved unemployment rate, and lower prices.
(Examples: environmental regulation, work place safety laws,
requirements for employers to give benefits to employees, all cause higher
costs for companies)
Deregulation will attempt to remove these regulations
More output at lower costs of production (GDP up)
Free market competition, improves efficiency

Privatize public industries: Privatize services that are typically provided by or


funded by the government. F.x private schools, private healthcare, etc. This will
increase competition and efficiency, lower costs, and improve employment levels.
Reduction or elimination of minimum wage, employment benefits & health
benefits for the nations workers: by reducing these costly government forced
procedures, they would increase wage competition, competitiveness in the
workplace, encourage workers to accept jobs with lower wages, and lower costs
for firms as well.
Tax policy: reducing marginal taxes might motivate people to work more or
harder, increases GDP in the long run
Labor market policy: lowering unemployment rate permanently impacts the
economy by a higher permanent GDP
Unemployment Benefits Dropped from 4 to 2 Years

The unemployment rate being reduced from 4 to 2 years could reduce the structural
unemployment rate, because it causes a sense of urgency for people to accept
various jobs instead of waiting for the perfect one to appear. First 6 months, most
unemployed workers will find a job. After 6 months, it becomes very unlikely for
people to return into the labor market, until the period right before the 4 years
unemployment is finished (people are more accepting of lower paid jobs, because it
is necessary). After 2 years of unemployment, it becomes structural unemployment
employers feel that the person mightve lost their skills and abilities and it is
almost impossible to come back to a well-paid job. The probability of returning to
the labor market after 2 years is much higher than the probability after 4 years
lowering the structural unemployment rate permanently.

Retirement Age Increased

Retirement age up and removal (almost) of the so called


after wage which was an option from the age of 60
a. The retirement age was 65, but there was an option
of stopping at 60 if they had been in the workforce
for more than 25 years causing an average
retirement age of 61.
b. Increasing the formal requirement age, then the
average retirement age will increase as well. The
labor force will increase by lengthening number of
years worked before retirement.

Interventionist Supply Side Policy Instruments (Recessionary Gap)

Interventionist Policies: policies that involve a greater role of government but


lead to a greater productivity level or lower costs, encouraging a higher level of
production, economic growth, and employment (government taking larger role
in the economy in contrast to market based policies).

Infrastructure Investments: Government investments for better


infrastructure (roads, bridges, tunnels, mass transit, communication, highspeed internet, etc.) lead to lower costs among private sector providers,
increasing the level of economic activity in the private sector.
Education: Investments in the nations labor force through improved
education and skills training will make the producers more productive and
lead to more employment and output (increases productivity in the private
sector and increases AS).
Investments by Government in R&D: Research funded by government
agencies can lead to scientific or technological breakthroughs that ultimately
increase efficiency and productivity in the private sector.

Supply Side Economic Policy Structural Reforms

Most important chapter = monetary policy, fiscal policy, structural policy,


supply and demand side policy

Labor market or tax reforms increase labor supply


AS (long run) or potential output shifts to the right
This makes it possible to increase aggregate demand in the long run
Private or government consumption
Investments
Increasing Y improves government balance and government debt

Shift long run aggregate supply curve to the right through supply side economic
policy ( Yp to Y2
Supply side economic policy is important to move potential output to the right
because increasing the annual growth rate (3%) causes a progressive curve (100,
103.1, 106.4, etc.). Means living standard goes up every year. But, there will be
business cycle fluctuations over the GDP annual growth curve NOT shown above.
(Recessional gap = GDP could be higher = monetary, fiscal, devaluation policy to
reduce the gap) (Inflationary gap = GDP is higher than its potential).
USA has a huge IT sector, higher productivity per person than in Denmark. Per
working hour productivity, proficiency is much higher. Potential output curve is
a result of the production factors size and quality of these factors impact the
potential output. Structural reforms must be used on the supply side to impact the
potential increase size of production factors and quality of them.
Aging of the population will cause the potential output to go down the labor force
participation rate will decrease as more people retire. This would cause potential
output to move to the left from Yp.
The living standard will go down in the future fewer taxes will cause a permanent
structural government deficit. Can use contractionary fiscal policy to impact the
structural deficit. Or reforms such as increasing retirement age to impact the labor
force.
Impact the structural unemployment rate reducing unemployment benefit from 4
to 2 years to lower structural unemployment rate unemployed people will be
more accepting and willing to take different jobs quicker = good for structural
unemployment rate.
Hi Chelsea,
Supply side policy could be labour market policy. This will increase labour
supply and shift long run AS to the right. In this way Y can rise without an
inflationary gap. If increasing labour supply means lower wage growth this
policy reduces company costs (MC) and short run AS shifts to the right.
I hope - and I am sure - that you will perform very well tomorrow.
Niels

Structural Reforms & Government Balance

Due to increased labor force or increased productivity potential output is


increased
In the long run actual out put (Y) is increased (a)
Due to increased Y government surplus will go up (or deficit will go down)
This process may go on for ever
This could be one way to prevent government deficits with ageing of
population

**********Additional Notes Online Studying **********


Supply-side policy
Supply side policy includes any policy that improves an economys productive
potential and its ability to produce. There are several individual actions that a
government can take to improve supply-side performance.

Improving productivity of factors


Productivity improvements are measures trying to improve the factor productivity,
which is the marginal output generated by factors inputs, include the following:

6. Using the tax system to provide incentives to help stimulate factor output, rather
than to alter demand, is often seen as central to supply-side policy. This
commonly means reducing direct tax rates, including income and
corporation tax. Lower income tax will act as an incentive for unemployed
workers to join the labor market, or for existing workers to work harder.
Lower corporation tax provides an incentive for entrepreneurs to start and
so increase national output.
7. Other supply-side policies include the promotion of greater competition in labor
markets, through the removal of restrictive practices, and labor market
rigidities, such as the protection of employment. For example, as part of
supply-side reforms in the 1980s, trade union powers were greatly reduced
by a series of measures including limiting worker's ability to call a strike, and
by enforcing secret ballots of union members prior to strike action.
8. Measures to improve labor mobility will also have a positive effect on labor
productivity, and on supply-side performance. This improves labor market
flexibility.
9. Better education and training to improve skills, flexibility, and mobility also
called human capital development. Spending on education and training is
likely to improve labor productivity and is an essential supply-side policy
option, and one favored by recent UK governments. A government may
spend money directly, or provide incentives for private suppliers to enter the
market. Government may also set and monitor standards of teaching, and
force schools to include a skills component in their curriculum.
10.

The adoption of performance-related pay in the public sector is also seen as


an option for government to help improve overall productivity.

Government can encourage local rather than central pay bargaining. National pay
rates rarely reflect local conditions, and reduce labor mobility. For example, national
pay rates for Postmen do not reflect the fact that in some areas they may be in short
supply, while in other areas there may be surpluses. Having different rates would
enable labor to move to where it is needed most.

Improving the Performance of Firms


Measures to improve competition and efficiency in product markets, especially in
global markets, are also a significant part of supply-side policy. Example of
measures include:
1. Government may help to improve supply-side performance by giving
assistance to firms to encourage them to use new technology, and innovate.
This can be done through grants, or through the tax system.
2. Deregulation of product markets may be implemented to bring down

barriers to entry, encourage new and dynamic market entrants, and improve
overall supply-side performance. The effect of this would be to make
markets more competitive and increase efficiency. Promoting competition is
called competition policy.
3. Privatization of state industry was a central part of supply-side policy during
the 1980s and 1990s, and helped contribute to the spread of an enterprise
culture. As long as privatization is accompanied by measures to promote
competition, there are likely to be efficiency gains for the firm, and
productivity gains for the employees.
Supply side performance can also be improved if there is a constant supply of new
firms. Small businesses are often innovative and flexible, and can be helped in a
number of ways, including start-up loans and tax breaks.

Aggregate supply (AS) measures the volume of goods and services produced
within the economy at a given price level.
AS represents the ability of an economy to deliver goods and services to meet
demand
The nature of this relationship will differ between the long run and the short
run
1. Short run aggregate supply (SRAS) shows total planned output when prices
in the economy can change but the prices and productivity of all factor inputs
e.g. wage rates and the state of technology are held constant.
2. Long run aggregate supply (LRAS): LRAS shows total planned output when
both prices and average wage rates can change it is a measure of a
countrys potential output and the concept is linked to the production
possibility frontier

In the long run, the LRAS curve is assumed to be vertical (i.e. it does not change
when the general price level changes)
In the short run, the SRAS curve is assumed to be upward sloping (i.e. it is
responsive to a change in aggregate demand reflected in a change in the general
price level)

The short run aggregate supply curve

A change in the price level brought about by a shift in AD results in a movement


along the short run AS curve. If AD rises, we see an expansion of SRAS; if demand
falls we see a contraction of SRAS.
Shifts in Short Run Aggregate Supply (SRAS)

The main cause of a shift in the supply curve is a change in business costs for
example:
Changes in unit labor costs: Unit labor costs are wage costs adjusted for the
level of productivity. A rise in unit labor costs might be brought about by
firms paying higher wages or a fall in the level of productivity
Commodity prices: Changes to raw material costs and other components e.g. the
prices of oil, copper, rubber, iron ore, aluminum and other inputs will affect a
firms costs
Exchange rates: Costs might be affected by a change in the exchange rate, which
causes fluctuations in the prices of imported products. A fall (depreciation) in
the exchange rate increases the costs of importing raw materials and
component supplies from overseas
Government taxation and subsidies:

An increase in taxes to meet environmental objectives will cause higher costs


and an inward shift in the SRAS curve

Lower duty on petrol and diesel would lower costs and cause an outward
shift in SRAS
The price of imports:

Cheaper imports from a lower-cost country has the effect of shifting out SRAS

A reduction in a tariff on imports or an increase in the size of an import quota


will also boost the supply available at each price level
The exchange rate affects how much a business must pay for imported raw
materials and components

Long Run Aggregate Supply (LRAS)


In the long run, the ability of an economy to produce goods and services to meet

demand is based on the state of production technology and the availability and
quality of factor inputs.
Seemingly small differences in growth rates can have a large impact over a
period of many years. For example, if an economy grew by 2 per cent every
year, it would double in size within 35 years; if it grew at 2 per cent a year, it
would double in size after 28 years - seven years earlier
A long run production function for a country is often written as follows:
Y*t = f (Lt, Kt, Mt)
Y* is a measure of potential output
t is the time period
L represents the quantity and ability of labor input available
Kt represents the available capital stock
Mt represents the availability of natural resources
LRAS is determined by the stock of a countrys resources and by the productivity of
factor inputs (labor, land and capital). Changes in the technology also affect
potential real national output.
Causes of shifts in the long run aggregate supply curve
Any change in the economy that alters the natural rate of growth of output shifts
LRAS. Improvements in productivity and efficiency or an increase in the stock of
capital and labour resources cause the LRAS curve to shift out. This is shown in the
diagram below.

One of several specific aggregate supply determinants assumed constant when the
aggregate supply curves (both long run and short run) are constructed, and which
shifts the aggregate supply curves when it changes. An increase in the capital stock
causes an increase (rightward shift) of both aggregate supply curves. A decrease in
the capital stock causes a decrease (leftward shift) of both aggregate supply curves.
Other notable aggregate supply determinants include the technology, energy prices,
and the wages. Capital stock comes under the resource quantity aggregate supply
determinant.
Capital stock is the total quantity of capital used in the production of goods
and services, including factories, buildings, equipment, tools, and machinery.
Without capital, workers obviously have to do ALL production by hand. Capital
makes labor productive. More capital makes labor more productive. Changes
in the capital stock depend on the difference between business investment
expenditures and capital depreciation. If investment in new capital exceeds
the depreciation of existing capital, then the capital stock expands. If
depreciation exceeds investment, then the capital stock contracts.
The size of the capital stock affects the economy's production capabilities. A larger
capital stock means greater production capabilities and a small capital stock means
lesser production capabilities. In particular, a larger capital stock enables more real
production at a given price level, causing an increase in both long-run and short-run
aggregate supply. A smaller capital stock means less real production at a given price
level, causing a decrease in both long-run and short-run aggregate supply.

Larger Capital Stock


Suppose, for example, that investment is particularly intense in a given year, far
exceeding the depreciation of existing capital. As such, the business sector adds a
sizable quantity of factories, buildings, equipment, tools, and machinery to the
existing stock of capital. This increase in the capital stock leads to an increase in
aggregate supply, both short run and long run, causing the SRAS and LRAS curves to
shift rightward. Note that the increase in the capital stock makes it possible to
supply a larger quantity of real production at the same price level, which means an
increase in aggregate supply.

Evaluation
The Advantages
1. Supply-side policies can help reduce inflationary pressure in the long term
because of efficiency and productivity gains in the product and labor markets.
2. They can also help create real jobs and sustainable growth through their positive
effect on labor productivity and competitiveness. Increases in competitiveness will
also help improve the balance of payments.
3. Finally, supply-side policy is less likely to create conflicts between the main
objectives of stable prices, sustainable growth, full employment and a balance
of payments. This partly explains the popularity of supply-side policies over the last
25 years.
The Disadvantages
1. However, supply-side policy can take a long time to work its way through the
economy. For example, improving the quality of human capital, through
education and training, is unlikely to yield quick results. The benefits of
deregulation can only be seen after new firms have entered the market, and
this may also take a long time.
2. In addition, supply-side policy is very costly to implement. For example, the
provision of education and training is highly labor intensive and extremely
costly, certainly in comparison with changes in interest rates.
3. Furthermore, some specific types of supply-side policy may be strongly
resisted as they may reduce the power of various interest groups. For
example, in product markets, profits may suffer as a result of competition
policy, and in labor markets the interests of trade unions may be threatened
by labor market reforms.
4. Finally, there is the issue of equity. Many supply-side measures have a
negative effect on the distribution of income, at least in the short-term. For

example, lower taxes rates, reduced union power, and privatization have all
contributed to a widening of the gap between rich and poor.

Furthermore.
Most supply-side policies are designed to improve the long-term performance of the
economy. They clearly have short run effects - but we should really judge supplyside policies by measuring the extent to which the United Kingdom economy is able
to sustain economic growth over a number of years and raise total employment and
average living standards.
Long run aggregate supply is determined by productive resources available to meet
demand. Also, by the productivity of factor inputs (labor, land and capital). Changes
in technology also affect the potential level of national output in the long run.

In the short run, producers respond to higher demand (and prices) by bringing
more inputs into the production process and increasing the utilization of their
existing inputs. Supply does respond to change in price in the short run - we move
up or down the short run aggregate supply curve.
In the long run we assume that supply is independent of the price level (money is
said to be neutral) - the productive potential of an economy (measured by LRAS) is
driven by improvements in productivity and by an expansion of the available factor
inputs (more firms, a bigger capital stock, an expanding active labor force etc.). As a
result we draw the long run aggregate supply curve as vertical.

Improvements in labor productivity and efficiency cause the long-run aggregate


supply curve to shift out over the years.

Benefits of Supply Side Policies


1. Lower Inflation: Shifting AS to the right will cause a lower price level. By making
the economy more efficient supply side policies will help reduce cost push inflation.
2. Lower Unemployment: Supply side policies can help reduce structural, frictional
and real wage unemployment and therefore help reduce the natural rate of
unemployment.
3. Improved economic growth: Supply side policies will increase the sustainable
rate of economic growth by increasing AS.
4. Improved trade and Balance of Payments: By making firms more productive
and competitive they will be able to export more. This is important in light of the
increased competition from S.E. Asia.

Additional Definitions & Notes


Government balance as percentage of GDP Deficit or Surplus (target deficit of
3% of GDP)
Difference between government receipts (mainly tax revenue) and
government spending in a single year
Negative numbers indicate deficits
Positive numbers indicate surpluses
A government deficit year after year increases its government debt
Government debt as a percentage of GDP
The total amount of money owed by government to its creditors
Target= maximum 60% of GDP

Balance of Payments

Trade flows + Capital flows = BOP


Current account balance
A nations balance of payments of all international financial transactions with
other countries.
X>M trade surplus
X<M trade deficit
It includes the sum of the balances of:
o Net trade of goods
o Ned trade of services
o Net income from overseas assets
o Net transfers
Financial (Capital) Account Balance
A nations net balance of capital inflows and outflows of assets, ownership of
stocks, bonds, etc. in that country.
Capital inflow>capital outflow surplus (net capital outflow is
negative)
Capital inflow<capital outflow deficit (net capital outflow is positive)
Example: China has a trade surplus (more exports than imports) in comparison to
America, but they use that surplus of money to buy assets in dollars (so America has
a surplus of capital flow their net capital outflow is negative). This balances out the
payments. If a country has a trade surplus, they will have a financial deficit to

compensate. The two ratios reflect each other, it is also seen in historic economic
data.
Real GDP growth
An inflation-adjusted measure that reflects the value of all goods and services
produced in a given year, expressed in base-year prices. Often referred to as
"constant-price," "inflation-corrected" GDP or "constant dollar GDP".
Unlike nominal GDP, real GDP can account for changes in the price level, and
provide a more accurate figure.

Foreign Exchange Rates and Aggregate Demand


As foreign exchange rates decrease, exports increase, leading to an increase in
aggregate demand.
KEY POINTS
As the price level drops, interest rates fall, domestic investment in
foreign countries increases, the real exchange rate depreciates, net
exports increase, and aggregate demand increases.
A lower-valued currency will mean fewer imports and more exports.
The change in net exports will mean that the quantity of real GDP
produced is higher.
More general economic factors that explain fluctuating exchange rates
include: economic policy, disseminated by government agencies and
central banks, and economic conditions, generally revealed through
economic reports and other economic indicators.

Keynes's interest-rate effect law tells us that, as price levels decrease, saving
increases, and interest rates fall. This is good for individuals taking out money for
mortgages and loans. But for those investing in bonds and certificates of deposits
(CDs), this phenomenon decreases their return.
The Mundell-Fleming model proposes that in this situation people will begin to
invest in foreign countries. The real exchange rate for domestic currency
depreciates, and net exports increase because it is cheaper for foreigners to buy
domestic goods from a country whose currency value has decreased (Figure 1). The
increase in net exports causes aggregate demand to increase. As the price level
drops, interest rates fall, domestic investment in foreign countries increases, the
real exchange rate depreciates, net exports increase, and aggregate demand
increases. In other words, a lower price level at home will cause investment in other
currencies; this movement will depreciate the home currency. A lower-valued
currency will mean fewer imports and more exports. The change in net exports will
mean that the quantity of real GDP produced is higher.

Other possible models describing exchange rate fluctuation include:


International parity conditions: This is also known as relative purchasing
power parity, interest rate parity, the domestic Fisher effect, and the
international Fisher effect.
Balance of payments model: This model focuses largely on tradable goods and
services, ignoring the increasing role of global capital flows.
Asset market model: This model views currencies as an important asset class for
constructing investment portfolios. Assets prices are influenced mostly by
people's willingness to hold the existing quantities of assets, which in turn
depends on their expectations of the future worth of these assets. The asset
market model of exchange rate determination states that the exchange rate
between two currencies represents the price that just balances the relative
supplies of, and demand for, assets denominated in those currencies.
None of the models developed so far succeed in explaining exchange rates and
volatility in the longer time frames. For shorter time frames (less than a few days),
algorithms can be devised to predict prices. More general economic factors also
explain fluctuating exchange rates. These include: economic policy, disseminated by
government agencies and central banks, and economic conditions, generally
revealed through economic reports and other economic indicators.

Exchange Rates & Policy

1/0.01=100
Yen/USD = how many Yen you get for 1 USD

USD/Yen = how many USD you get for 1 yen


1) The bank of Japan uses expansionary monetary policy to stimulate demand.
Illustrate and explain the effect of this policy on the forex markets of Yen in
the USA and the USD in Japan (charts above).
There will be no immediate impact, but the expansionary monetary policy will cause
Japans interest rate to drop. When this happens, the value of the yen depreciates
against the dollar because it is not as attractive for foreign investors to have capital
in Japan they will get less profit on their investments held there. As the yen
depreciates, the USD appreciates because the supply of dollars decreases on the
Japanese market, which brings up the value of the USD.
Japanese interest rates Up Demand for Yen in USA Down Supply of USD in
Japan Down USD appreciates, Yen Depreciates
2) Explain the impact of the Bank of Japans policy on aggregate demand,
output, and unemployment levels in Japan.
Aggregate demand will increase, as interest rates decrease, C&I will go up
domestically. Aggregate demand will also increase due to the depreciation of the
Yen, their competitiveness will improve and net export will go up (they will export
more than they import). Price levels will go up with the increased AD, and output
will increase closing the recessional gap. As national output increases,
unemployment levels will go down and they will be closer to full employment.
3) There is widespread speculation that the USD will appreciate against other
foreign currencies. Illustrate the effect this will have on the two
currencies/markets below.

USD Appreciates

Yen Depreciates

Speculation: a prediction that the value of a certain asset will increase or decrease
in the future
Japanese investors would want to increase their amounts of assets in USD
now if it is expected to appreciate so that they can get a higher return on
their investment demand increases
Speculation of appreciation caused increased demand and appreciates the
currency as expected
Demand for USD in Japan increases supply of Yen in USA increases

4) How will this speculation impact the level of aggregate demand in the USA?
As the USD appreciates, Imports will increase and exports will decrease, causing
Aggregate Demand to decrease. Also, as prices go up consumer spending will go
down and domestic investments will go down as well. When the aggregate demand
decreases, their unemployment levels will worsen, national output will worsen, and
the price levels will go down.
Demand for a countrys exports and/or foreign investments increases then the
countrys currency will strengthen.

Changes in Consumption
Consumer expenditure is the largest element to aggregate demand, and it is
determined by a households disposable income.
Consumer Spending
Domestic consumers can affect aggregate demand because if they decide to buy
more output at each price level, the aggregate demand will shift to the left.
KEY POINTS
Disposable income is income after taxes, often written as (Y-T). Thus, a
change to either Y (income) or T (taxes) affects disposable income and
subsequently consumption.
If consumption decreases, the quantity demanded of goods and
services at every price level also decreases. The aggregate demand
curve thus shifts to the left.
Conversely, if consumption increases, the quantity demanded of goods
and services increases at every price level. The aggregate demand
curve thus shifts to the right.
EXAMPLES
The level of taxation is an example of an event that could change consumption
levels. Theoretically, people should know that an increase in taxes today means a
decrease in taxes tomorrow, so consumption should stay relatively the same.
However, humans do not always behave rationally. In actuality, decreased taxes
tend to lead to an increase in consumption and a rightward shift in aggregate
demand.
Recall that aggregate demand is made up of C + I + G + NX, with C being consumption,
I being investment, G being government spending, and NX being net exports.
Consumer expenditure, also termed consumption, is the largest element to
aggregate demand, and it is determined by a households disposable income.

Consumption is the amount of money people can and will spend on goods and
services. Disposable income is income after taxes, often written as (Y-T). Thus, a
change to either Y (income) or T (taxes) affects disposable income and subsequently
consumption.
Domestic consumers can affect aggregate demand because if they decide to buy
more output at each price level, the aggregate demand will shift to the left. However,
the opposite holds true when consumers buy less output.
The level of consumption is influenced by the following factors:
Consumer wealth: This includes financial assets such as stocks and bonds
and physical assets (house and land). An increase in the real value of
consumer wealth (the stock market) will convince people to buy more
products and save less. This is known as the wealth effect (the effect being a
shift to the right).
Consumer expectations: If people expect their income to rise in the future,
they will spend more of their current incomes, shifting the curve to the right.
Similarly, a widely held expectation of surging inflation in the near future
may increase aggregate demand today because consumers will want to buy
products before their prices escalate. Conversely, the aggregate demand
curve may shift to the left if the economy expects lower future income or
prices.
Household indebtedness: People will spend and borrow, but if they spend
past normal levels, consumers will cut spending, shifting the aggregate
demand curve to the left.
Taxes: A reduction of taxes will raise "take-home income" and ultimately
allow for more consumption. Tax cuts will shift the curve to the right.

Changes in Net Exports


As net exports decrease, aggregate demand decreases; while, if net exports
increase, aggregate demand would also increase.
The amount a country spends on exports and imports can cause deficits or
surpluses in the government.
When the price of domestic goods increases, net exports decrease, and vice
versa.
When the U.S. dollar appreciates, net exports decrease, and vice versa.
As foreign income increases, net exports decrease, and vice versa.
Net exports are the total value of a country's exports minus imports. The net
export input is, basically, consumption of domestic goods by international

consumers. Net export spending is used to calculate the aggregate expenditures, or


GDP of a country -- basically, how much more a country spends on buying foreign
goods and services, compared to how much of these it sells to other countries.
The main thing that has a major effect on net exports is the exchange rate. The
amount a country spends on exports and imports can cause deficits or surpluses in
the government. If the government spends more than the tax revenue it receives, a
deficit will result. If it spends less than the country's tax revenue, it will enjoy a
surplus.
Net export spending is autonomous because it doesn't depend on a country's
national income. If exports exceed imports there is a trade surplus, just as if
imports exceed exports there is a trade deficit. When prices go down, exports
increase, imports decrease, and net export spending increases.
Determinants of net export spending can be analyzed using the following examples in
relation to the United States and Canada:
The price of U.S. goods increases, causing export spending to decrease and
import spending to increase. Therefore, net exports decrease.
The price of Canadian goods increases, causing export spending to increase
and import spending to decrease. Therefore, net exports increase.
The U.S. dollar appreciates, import spending increases, export spending
decreases. Therefore, net exports decrease.
Foreign income in Canada increases, export spending increases, it has no
effect on import spending. In turn, net exports increase.
Preferences change, export spending increases with no effect on import
spending, and net exports increase.
As net exports decrease, aggregate demand decreases; while, if net exports
increase, aggregate demand would also increase. This suggests that an
increase in exports would boost aggregate demand.

Interest Rate Effect


As interest rates rise/fall, investments decrease/increase, and aggregate demand shifts
to the left/right.
When price level is low, consumers use less of their disposable income to
make purchases. They tend to save the rest, which in turn drives down the
interest rate.
The Keynes effect is a term used in economics to describe a situation where a
change in interest rates affects expenditure more than it affects savings.
A liquidity trap is a situation in which injections of cash into the private
banking system by a central bank fail to lower interest rates and hence fail to

stimulate economic growth.


Another reason for the downward slope of the aggregate demand curve is the
interest rate effect. An interest rate is the cost of borrowing money. As interest rates
rise, investments decrease, and aggregate demand shifts to the left. When interest
rates fall, investments increase, and the aggregate demand curve shifts to the right.
To put it another way, think of an interest rate as the cost of a good. As the cost
increases, the demand for that particular good decreases. All other things being
equal, this causes aggregate demand to decrease as well.
Moreover, when price level is low, consumers use less of their disposable income to
make purchases. Low prices can also lead to a higher level of absolute spending.
During periods of low prices consumers tend to save their remaining money, which
in turn drives down the interest rate. A low interest rate drives down the cost of
investments, so investments increase and aggregate demand increases.
The interest rate effect is also known as the Keynes effect. This is a term used in
economics to describe a situation where a change in interest rates affects
expenditure more than it affects savings. As prices fall, a given nominal amount of
money will become a larger real amount. As a result, the interest rate will fall and
investment demanded rises. This means that insufficient demand in the product
market cannot exist forever.