macro-economic policy

http://www.bized.co.uk

Copyright 2007 – Biz/ed

Macroeconomic Policies



Monetary Policy



Monetary Policy

• Attempts to influence the level of economic activity (the amount of buying and selling in the economy) through changes to the amount of money in circulation and the price of money – short-term interest rates.

• Interest rates the key area of Monetary Policy



Monetary Policy

• Short-term interest rates set by the Monetary Policy Committee (MPC) of the Bank of England

• Meets for 2 days each month to decide on rates

• The ‘official rate’ is the rate at which the Bank of England will lend to the financial system and influences the structure of all other interest rates



Monetary Policy



Monetary Policy

• Basis of Monetary Policy is that there is a long run relationship between the amount of money and inflation

• Demand for Money – the amount people wish to hold as cash as opposed to other assets

• The Supply of Money – the amount of money in circulation in the economy



• The Classical Quantity Theory of Money:

• MV = PY – (where M = the money stock, V =

velocity of circulation, P = price level and Y = level of national income

• More formally:

Monetary Policy



Monetary Policy• Md = k PY where:

– P is the price level– Y is the level of real national income– Md is demand for money for transactions

purposes– K = proportion of national income held as

transactions balances

• In equilibrium Md = Ms

– So: P = 1/kY x M– A rise in Ms will lead to a proportional rise in P



Monetary Policy

• Supply of Money:–Narrow Money – notes and coins in circulation (M0)–Broad Money – Notes and coins plus money held in bank and building society accounts (M4)

• A rise in either (ceteris paribus) might signal a rise in aggregate demand (AD)



Monetary Policy

• The Interest Rate Transmission Mechanism

– The process by which a change in interest rates feeds through to AD



The Interest Rate Transmission Mechanism 1

Interest Rates

Borrowing

Individuals

Credit

Loans

Consumption

FirmsNew

LoansInvestment

Existing Loans

Costs EmploymentMargins Consumption




Interest Rates Mortgages

Existing

New

Consumption

Investment

Disposable Income

Property Equity

Demand for New Housing

Savings Consumption




Interest Rates

Exchange Rates

Appreciation

Mp

Xp

Dm

Dx

Depreciation

Mp

Xp

Dm

Dx

Balance of Payments



Supply Side Policy



Supply Side Policy

• Intention is to shift the aggregate supply curve to the right, increasing the long term productive capacity of the economy

• Tend to be long-term policies• Arguments about how effective they are

– e.g. lowering taxes increases incentives, reducing welfare dependency increases the urge to find work



Supply Side PolicyInflation

Real National Income

AS

Yf

AS1

Yf2

AD

2.3%2.0%

Supply side policies can help to push the AS curve to the right increasing the capacity of the economy from Yf to Yf2

Increases in long-term capacity can help the economy to grow without undue pressure on inflation.



Supply Side Policies

• Policies aim to influence productivity and efficiency of the economy

• Key feature – open up markets and de-regulate to improve efficiency in the working of markets and the allocation of resources



Supply Side Policy• Main areas of policy:

– Labour Market – reduce impediments to free market, reduce bureaucracy and ‘red tape’ – flexible labour markets

– Reduce power of trade unions – legislation of the eighties still has an impact in this respect

– Short term contracts– Flexible working arrangements– Hiring and firing – Contracts, terms and conditions, pay– Criticism of such policies is that they put the needs

of employers above those of workers which can lead to exploitation



Supply Side Policy

• Tax and Welfare Reform:– More stringent benefit regime– Tax reform to encourage people

to work– Improving access to training

and education– ‘New Deal’ scheme



Supply Side Policy

• Education and Training:– Reform of 14 – 19 education– Modern Apprenticeships– National Qualifications framework –

coherent set of qualifications– Expansion of vocational qualifications– Expansion of university access



Supply Side Policy

• Incentives and technology:– Tax reform to encourage incentives

and entrepreneurial spirit– Incentives to develop new technology –

investment– Drive to embracing ‘knowledge driven

economy’– Regional policies to encourage enterprise,

investment, location, expansion



Fiscal Policy



Fiscal Policy

• Influencing the level of economic activity though manipulation of government income and expenditure

• Associated with Keynesian Demand Management Policies

• Now seen in wider terms:



Fiscal Policy

• Influence Aggregate Demand – – Tax regime influences consumption

(C) and investment (I)– Government Spending (G)

• Influences key economic objectives• Acts as an ‘automatic stabiliser’• BUT:



Fiscal Policy

• Also used to influence non-economic objectives and provide framework for supply side policy

• e.g. education and health, poverty reduction, welfare reform, investment, regional policies, promotion of enterprise, etc.



Government Income

• Tax Revenue• Sale of Government Services – e.g.

prescriptions, passports, etc.• Borrowing (PSNCR)



Public Sector Income

0

100

200

300

400

500

600

700

Year

£bn

33

34

35

36

37

38

39

40

41

%GDP

Public sector total receipts1 £ billionPublic sector total receipts1 % GDP

Source: http://www.hm-treasury.gov.uk/media//E3CCB/PublicFinancesDatabank280104.XLS



Government Income (£ billion)

Source: http://www.hm-treasury.gov.uk/media/F6C/7E/public_fin_databank_211204.xls

Inland Revenue 1998-99

1999-00

2000-01

2001-02

2002-03

2003-04

Income Tax (gross of tax credits) 88.4 95.7 106.1 110.3 112.6 118.3

Income Tax Credits -1.9 -1.8 -1.0 -2.3 -3.4 -4.3

Corporation Tax 30.0 34.3 32.4 32.0 29.5 28.1

Windfall Tax 2.6 0.0 0.0 0.0 0.0 0.0

Petroleum Revenue Tax 0.5 0.9 1.5 1.3 1.0 1.2

Capital Gains Tax 2.0 2.1 3.2 3.0 1.6 2.2

Inheritance Tax 1.8 2.1 2.2 2.4 2.4 2.5

Stamp Duties 4.6 6.9 8.2 7.0 7.5 7.5

NICs 55.1 56.4 60.6 63.2 64.6 72.5

Total Inland Revenue 183.2 196.5 213.4 216.8 215.8 228.0





Customs and Excise 1998-99

1999-00

2000-01

2001-02

2002-03

2003-04

VAT 52.3 56.4 58.5 61.0 63.5 69.1

Fuel Duties 21.6 22.5 22.6 21.9 22.1 22.8

Tobacco Duty 8.2 5.7 7.6 7.8 8.1 8.1

Spirits Duties 1.6 1.8 1.8 1.9 2.3 2.4

Wine Duties 1.5 1.7 1.8 2.0 1.9 2.0

Beer and Cider Duties 2.7 3.0 3.0 3.1 3.1 3.2

Betting and Gaming Duties 1.5 1.5 1.5 1.4 1.3 1.3

Air Passenger Duty 0.8 0.9 1.0 0.8 0.8 0.8

Insurance Premium Tax 1.2 1.4 1.7 1.9 2.1 2.3

Land Fill Tax 0.3 0.4 0.5 0.5 0.5 0.6

Climate Change Levy 0.0 0.0 0.0 0.6 0.8 0.8

Aggregates Levy 0.0 0.0 0.0 0.0 0.2 0.3

Customs Duties and Levies 2.1 2.0 2.1 2.0 1.9 1.9

Total Customs and Excise 94.0 97.3 102.2 104.9 108.7 115.7





1998-99

1999-00

2000-01

2001-02

2002-03

2003-04

VED 4.6 4.9 4.3 4.3 4.3 4.8

Oil Royalties 0.3 0.4 0.6 0.5 0.4 0.0

Business Rates 14.7 15.4 16.3 17.9 18.5 18.4

Council Tax 12.2 13.1 14.1 15.2 16.9 18.8

Other Taxes and Royalties 7.5 7.9 8.5 9.4 10.2 11.2

Net Taxes and NICs conts 316.6 335.4 359.3 369.1 374.9 196.7

Interest and Dividends 5.0 4.3 6.0 4.7 4.5 4.4

Gross Operating Surplus and Rent 18.2 18.1 18.8 19.9 19.0 19.4

Other Receipts and Accounting Adjustments

-5.3 -0.7 -3.8 -5.7 -5.2 -1.8

Current Receipts 334.5 357.2 380.4 387.9 393.2 418.7



Government Income – Inland Revenue 2003-04




Government Income – Customs and Excise 2003-04




Other Government Income 2003-04




Fiscal Policy• Need to remember subtleties in use of fiscal policy

– Adjustment of income tax allowances rather than rates of income tax

– Extending or amending range of goods covered by VAT– Changing the rules under which tax has to be paid –

married persons allowances, inheritance taxes, stamp duties, etc.

– Abolishment of certain tax allowances – MIRAS (Mortgage Income Relief At Source)

– Accusations of ‘stealth taxes’ – much of it is a ‘tinkering’ with the tax system to achieve certain aims – mostly non-economic (governments these days, for example, rarely ‘increase taxes’ to dampen down the economy)

• Be aware of these subtleties when you are writing!



Government Expenditure

• Social Security• Law and Order• Emergency

Services• Health• Education• Defence• Foreign Aid

• Environment• Agriculture• Industry• Transport• Regions• Culture, Media

and Sport



Public Spending

0.0

50.0

100.0

150.0

200.0

250.0

300.0

350.0

400.0

450.0

500.0

(£bn)

19

89

-90

19

90

-91

19

91

-92

19

92

-93

19

93

-94

19

94

-95

19

95

-96

19

96

-97

19

97

-98

19

98

-99

19

99

-00

20

00

-01

20

01

-02

20

02

-03

20

03

-04

20

04

-05

20

05

-06

Year

Cash (£bn)

Real Terms(£bn)per cent of GDP

Source: http://www.hm-treasury.gov.uk



Public Sector Net Cash Requirement (PSNCR)

-17

-7

3

13

23

33

43

53

£bn

1991-92

1992-93

1993-94

1994-95

1995-96

1996-97

1997-98

1998-99

1999-00

2000-01

2001-02

2002-03

Central government

Local authority

General government

Public corporations

Public sector

Source:http://www.hm-treasury.gov.uk/media//E3CCB/PublicFinancesDatabank280104.XLS



The Golden Rule!

• Fiscal policy frameworkThe Government's fiscal policy framework is based on the five key principles set out in the Code for fiscal stability - transparency, stability, responsibility, fairness and efficiency.

The Code requires the Government to state both its objectives and the rules through which fiscal policy will be operated. The Government's fiscal policy objectives are:



The Golden Rule!

• over the medium term, to ensure sound public finances and that spending and taxation impact fairly within and between generations; and

• over the short term, to support monetary policy and, in particular, to allow the automatic stabilisers to help smooth the path of the economy.



The Golden Rule!• These objectives are implemented through two fiscal

rules, against which the performance of fiscal policy can be judged. The fiscal rules are:

• the golden rule: over the economic cycle, the Government will borrow only to invest and not to fund current spending; and

• the sustainable investment rule: public sector net debt as a proportion of GDP will be held over the economic cycle at a stable and prudent level. Other things being equal, net debt will be maintained below 40 per cent of GDP over the economic cycle.



The Golden Rule!• The fiscal rules ensure sound public finances in the medium term while

allowing flexibility in two key respects:– the rules are set over the economic cycle. This allows the fiscal

balances to vary between years in line with the cyclical position of the economy, permitting the automatic stabilisers to operate freely to help smooth the path of the economy in the face of variations in demand; and

– the rules work together to promote capital investment while ensuring sustainable public finances in the long term. The golden rule requires the current budget to be in balance or surplus over the cycle, allowing the Government to borrow only to fund capital spending. The sustainable investment rule ensures that borrowing is maintained at a prudent level. To meet the sustainable investment rule with confidence, net debt will be maintained below 40 per cent of GDP in each and every year of the current economic cycle.

Source of information about the Golden Rule: http://www.hm-treasury.gov.uk/budget/bud_bud03/budget_report/bud_bud03_repchap2.cfmCrown Copyright, reproduced under licence



Fiscal Policy In ActionInflation

Real National Income

AS

AD

2.0%

U=5%

Assume an initial equilibrium position with a level of National Income giving an unemployment rate of 5% (U = 5%)

If government ‘reduces taxes’ (remember the subtleties) and or increases spending, it will have various effects:

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

Apart from G, C and I are also likely to be affected directly or indirectly by the policy change.

AD 1

AD therefore shifts to the right to AD1

2.5%

U=3%

The rise in AD leads to an increase in real national income, ceteris paribus, unemployment would fall to 3% but at a cost of higher inflation



Fiscal Policy In Action

• Fiscal Policy influences AD in the short term but can be used to affect AS in the long run – depending on the nature of the policy.

• Try your hand at Fiscal Policy by going to the Virtual Economy(http://www.bized.ac.uk/virtual/economy/policy/advisors/fiscal.htm)