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Macro economic policies

What does it mean if there is a government budget


Budget deficit or surplus

When government expenditures
exceed government tax revenues in
a given year, the government is
running a budget deficit for that
When government expenditures are
less than tax revenues in a given
year, the government is running a
budget surplus for that year.

Monetary policy involves changing the

interest rate and influencing the money
Fiscal policy involves the government
changing tax rates and levels of
government spending to influence
aggregate demand in the economy.

They are both used to pursue policies of

higher economic growth or controlling

Monetary Policy
Monetary policy is usually carried out
by the Central Bank / Monetary
authorities and involves:

Setting base interest rates (e.g.

Bank of England in UK and Federal
Reserve in US)

Influencing the supply of money.

How Monetary Policy Works

The Central Bank may have an inflation

target of 2%. If they feel inflation is going to
go above the inflation target, due to
economic growth being too quick, then they
will increase interest rates.

Higher interest rates increase borrowing

costs and reduce consumer spending and
investment, leading to lower aggregate
demand and lower inflation.

If the economy went into recession, the

Central Bank would cut interest rates.

Fiscal Policy
Fiscal Policy is carried out by the government and
involves changing:

Level of government spending

Levels of taxation

Expansionary fiscal policy is defined as an increase

in government expenditures and/or a decrease in taxes
that causes the government's budget deficit to increase.
Contractionary fiscal policy is defined as a decrease
in government expenditures and/or an increase in taxes
that causes the government's budget deficit to

Example of Expansionary Fiscal Policy

In a recession, the government may decide
to increase borrowing and spend more on
infrastructure spending.
The idea is that this increase in government
spending creates an injection of money into
the economy and helps to create jobs.
There may also be a multiplier effect, where
the initial injection into the economy causes a
further round of higher spending.
This increase in aggregate demand can help
the economy to get out of recession.

If the government felt inflation was a

problem, they could pursue contractionary
(deflationary) fiscal policy (higher tax
and lower govt. spending) to reduce the
rate of economic growth.
Multiplier effect the amount by which an
increase in spending produces an increase
in total spending in the economy

Supply Side economics is the branch of

economics that considers how to
improve the productive capacity of the
Supply Side Policies are government
attempts to increase productivity and
shift Aggregate Supply (AS) to the right.
Q) Discuss with a partner what these
supply side policies could be.

Supply Side Policies

Most supply side policies aim to enable the free market
to work more efficiently by reducing govt interference.
This involves selling state owned assets to the private
sector. It is argued that the private sector is more
efficient in running business because they have a profit
motive to reduce costs and develop better services.

This involves reducing barriers to entry in order to
make the market more competitive. For example BT
used to be a Monopoly but now telecommunications is
quite competitive.

Reducing Income Taxes.

It is argued that lower taxes (income and corporation) increase
the incentives for people to work harder, leading to more output.
Increased education and training
Better education can improve labour productivity and increase
Often there is under-provision of education in a free market.
Therefore the govt may need to subsidise suitable education and
training schemes.
However govt intervention will cost money, requiring higher
taxes, It will take time to have effect and govt may subsidise the
wrong types of training
Reducing the power of Trades Unions
This should:
a) increase efficiency of firms e.g. less time lost to strikes

Reducing State Welfare Benefits

This may encourage unemployed to take jobs. It cannot be
reduced TOO MUCH! Can you think of why?
Providing better information about jobs
This may also help reduce frictional unemployment

Lower Tariff barriers this will increase trade

Removing unnecessary red tape and bureaucracy which
add to a firms costs
Improving Transport and infrastructure.
Due to market failure this is likely to need govt intervention to
improve transport and reduce congestion. This will help
reduce firms costs.

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.

What policies could be used to

decrease unemployment?

Policies for Reducing Unemployment

There are two main strategies for reducing
unemployment Demand side policies (fiscal and monetary) to
reduce demand-deficient unemployment
(unemployment caused by recession)
Supply side policies to reduce structural

Demand Side Policies

Demand side policies are important when there is a
recession and rise in cyclical unemployment. (e.g.
after 1991 recession and after 2008 recession)

Policies for Reducing Unemployment

Fiscal Policy
Fiscal policy can decrease unemployment by helping to
increase aggregate demand and the rate of economic growth.
The government will need to pursue expansionary fiscal policy
- this involves cutting taxes and increasing government
spending. Lower taxes increase disposable income (e.g. VAT
cut to 15% in 2008) and therefore help to increase
consumption, leading to higher aggregate demand (AD).
With an increase in AD, there will be an increase in Real GDP
(as long as there is spare capacity in the economy.) If firms
produce more, there will be an increase in demand for workers
and therefore lower demand-deficient unemployment. Also,
with higher aggregate demand and strong economic growth,
fewer firms will go bankrupt meaning fewer job losses.

Impact of Higher AD on Economy

1. It depends on other components of AD. e.g. if confidence is low, cutting
taxes may not increase consumer spending because people prefer to save.
Also, people may not spend tax cuts, if they will soon be reversed.
2. Fiscal policy may have time lags. E.g. a decision to increase government
spending may take a long time to have an effect on increasing AD.
3. If the economy is close to full capacity an increase in AD will only cause
inflation. Expansionary fiscal policy will only reduce unemployment if there is
an output gap.
4. Expansionary fiscal policy will require higher government borrowing this
may not be possible for countries with high levels of debt.
5. In the long run expansionary fiscal policy may cause crowding out.
Crowding out refers to when government must finance its spending with taxes,
leaving businesses with less money and effectively "crowding them out." They
have less to spend and therefore AD doesnt increase.

Monetary Policy
Monetary policy would involve cutting
interest rates. Lower rates decrease the
cost of borrowing and encourage people
to spend and invest. This increases AD
and should also help to increase GDP and
reduce demand deficient unemployment.
Also lower interest rates will reduce
exchange rate and make exports more
In some cases, lower interest rates may
be ineffective in boosting demand.

Similar problems to fiscal policy. e.g. it
depends on other components of AD.
Lower interest rates may not help
boost spending, if banks are still reluctant
to lend.
Demand side policies can help to
reduce demand deficient unemployment
e.g. in a recession. However, they cannot
reduce supply side unemployment.
Therefore, their effectiveness depends on
the type of unemployment that occurs.

Supply Side Policies for Reducing

Supply side policies deal with more microeconomic issues. They dont aim to boost
overall Aggregate Demand, but seek to
overcome imperfections in the labour
market and reduce unemployment caused
by supply side factors. Supply side
unemployment includes:
Classical (real wage)

What kind of
supply side
policies could be
used to reduce

Supply Side Policies for Reducing


Education and Training.

The aim is to give the long
term unemployed new skills
which enable them to find
jobs in developing industries.

. Employment Subsidies.
Firms could be given tax breaks
or subsidies for taking on long
term unemployed. This helps
give them new confidence and
on the job training.

Improve Labour Market Flexibility and

It is argued that higher structural rates of
unemployment in Europe is due to
restrictive labour markets which
discourages firms from employing workers
in the first place.

Stricter Benefit requirements.

Governments could take a more proactive role in making the unemployed
accept a job or risk losing benefits.
After a certain time period the
government could guarantee some
kind of public sector job (e.g. cleaning
streets). This could significantly
reduce unemployment.

Improved Geographical Mobility.

Often unemployment is more concentrated
in certain regions.
To overcome this geographical
unemployment, the government could give
tax breaks to firms who set up in depressed

Evaluate the policies that could help

to reduce unemployment.