Ch6

The macro-economic
environment

Study guide

Define macro-economic policy

Main types of economic policy
Impact of fiscal and monetary policy
Determinants of level of business activity and its
influence on individuals, households and
business
Impact of economic issues (inflation,
unemployment, stagnation, international
payments disequilibrium) on individuals,
households and business

1 Government policies and objectives

4 main objectives of economic policy:

To achieve economic growth: increases caused

by price inflation are not real increases
To control inflation
To achieve full employment: unemployment
level is low and involuntary unemployment is
short-term
To achieve a balance between exports and
imports

*R-15:#11

Significance of gov. tax and spending

Gov. expenditure affects suppliers to the gov.
to companies

Gov. spending has a knock-on effect on the

whole economy
Taxation affects consumers purchasing power
Taxation affects after-tax return on investment
of companies
Public sector investment affects public sector
companies and private sector companies

Gov. role in economic planning

Gov. should not plan economic activity in

detail, but act as enabler of private sector
activity and corrector of market imperfection.

Provide legal system relating to business

Responsible for macro-economic management
Raise trade barriers to protect domestic industry
Subsidise and promote exports
Encourage inward investment by foreign countries
Carry out regional policy

Gov. can influence commercial decisions

Output capacity; competition; sales demand

Through tax or grants; acts and practice;
policies

Gov. can influence operational decisions

Health and care; employment; consumers; tax

Through legislation; regulations; standards; tax
laws

2 Fiscal policy

Fiscal policy provides a method of managing aggregate

demand in the economy.
Aggregate demand
=consumption + investment + gov. expenditure +export
*Pilot paper#16

Gov. must plan its spending, borrowing and taxation

(how much, when, in what form) . The formal planning of
fiscal policy is in the budget.

Expenditure
Revenues=taxation+direct charges
Borrowing(PSNCR) =expenditure-revenues

*R-14:#1; R-14:#2

Budget surplus and deficit

Gov. can use fiscal policy to influence

demand in economy in 2 ways:
Expenditure changes
Tax changes
Aggregate demand can be boosted by more
government spending (directly) or by tax cuts
(indirectly), financed by a higher PSNCR.
Aggregate demand can be reduced by cutting
government spending or by raising tax, using the
savings to cut gov. borrowing.

Gov. income>expenditure, budget surplus

Gov. income< expenditure, budget deficit

Functions of taxation
To raise revenues for the government
To discourage certain activities regarded as
undesirable
To cause certain products to be priced to
take into account their social costs
To redistribute income and wealth
To protect industries from foreign
competition
To provide a stabilising effect on national
income
*R-51:#1

Types of tax

Regressive tax takes a higher proportion of a

poor persons income than a rich persons.
Progressive tax takes a higher proportion of
a rich persons income than a poor persons.
Proportional tax takes the same proportion
of all incomes.
The gov. of a certain country decides to
introduce a poll tax, which involve a flat rate
levy of $200 on every adult member of
population. The tax is _______ tax.

Direct and indirect tax

Direct tax is paid direct by a person to the

Revenue authority.

Levied on income and wealth

Tend to be progressive or proportional tax

Indirect tax is collected by the Revenue

authority from a intermediary (a supplier)

Levied on expenditure
Can be regressive
Two types:
Specific tax: fixed sum per unit
Ad valorem tax: fixed percentage of the price

*R-14:#3

Activity

Which of the following government aims

might be achieved by means of fiscal policy?
1.A redistribution of income between firms
and households.
2.A reduction in aggregate monetary demand
3.A change in the pattern of customer demand
A Objectives 1 and 2 only
B Objectives 1 and 3 only
C Objectives 2 and 3 only
D Objectives 1,2 and 3

3 Monetary policy

Monetary policy uses interest rates, exchange

rate, money supply or credit controls/expansion
to influence aggregate demand.
(R-15:#8; R-52:#3)
Intermediary objectives can be set for monetary
policy in order to achieve ultimate economic
objectives:

Increase in money supply will rise prices and

income, leading to increasing demand for money.
A rise in interest rates will raise the price of
borrowing, curtail investment, postpone individual
consumptions, leading to reduced demand for
money.(pilot paper#24)

High interest rates will attract foreign investors into

sterling investments and keep the value of sterling( )
higher
A fall in exchange rate will decrease the cost of
exports and increase the cost of imports,thus stimulate
exports and reduce demand for imports, thus reduce
deficits in current account, and tends to increase
domestic inflation rate.(*R-14:#5; R-52:#7)
Strict credit controls will reduce lending and so reduce
demand in the economy

3.6(P190) Monetary policy can be made to act as a

subsidiary support to fiscal policy (likely), or can
be given prominence over fiscal policy (might not
be possible).

Economic indicators

An economic indicator provides information

about economic conditions and can be used
as a way of judging the performance of gov.

Leading indicator: gives an advance indication

of what will happen to the economy in
future.E.g. exchange rate change
Coincident indicator: gives an indication of
changes in economic conditions at the same
time when changes are occurring. E.g. money
supply change
Lagging indicator: is one which lags behind
the economic cycle. E.g. unemployment rate

Monetary indicators

Size of money stock

Interest rates
Exchange rate against US dollar
Size of governments borrowing
Size of governments borrowing as a
percentage of GDP

National income

Equilibrium national income is reached

where aggregate demand(AD) equals
aggregate supply(AS).

Ideal equilibrium: AD and AS are in balance at

the full employment level .
Inflationary gaps: AD and AS are in balance at
a level where demand exceeds the productive
capabilities of the economy at full employment
Deflationary gaps: AD and AS are in balance at
a level of employment which is below the full
employment of national income

Price

AD

AS
Equilibrium

Quantity
Price

AD

AS

Inflationary
gaps

Full
employment
Price
AD

Equilibrium

Equilibrium

AS
Deflationary
gaps

Quantity
Full

Quantity
Full

stagflation

Stagflation: a combination of unacceptably

high unemployment and unacceptably high
inflation.
Can be caused by any long-term major
increase in costs (e.g. a price shock).

The business cycle (trade cycle)

Recession (dropping AD)

Depression (lowest AD)

Recession will be developed into full depression in the

absent of stimulus to aggregate demand

Recovery (rising AD)

Consumer demand falls; investment projects unprofitable;

orders cut; inventory levels reduced; production and
employment fall; general price level fall

Output, employment and income begin to rise; rising

level of demand; increased production; price level rise;
optimistic business expectations

Boom (highest AD)

Capacity and labour become fully utilised, usually

accompanied with inflation and speculation

*R-51:#2

Wide fluctuations in levels of economic

activity are damaging to the overall economic

Inflation and speculation accompanies boom

periods
High unemployment accompanies depression
periods

Gov. generally seek to stabilise the economic

system, tying to avoid the distortions of a
widely fluctuating trade cycle.

6 Inflation

Inflation is an increase in price level generally,

manifesting in the decline in the purchasing power
of money.
High rate of inflation may be harmful:

Leads to a redistribution of income and wealth in

undesirable ways
Balance of trade may suffer: high inflation tends to
increase imports and decrease exports and decrease
value of sterling
Uncertainty of value of money increase, leading
resource allocation less efficient and decision-making
more difficult
More Time and costs spent on planning
May be harmful to a countrys economic growth and
level of investment

*R-15:#9; pilot paper#27

Measure of inflation rate

CPI(consumer prices index) is based on a

chosen basket of items which consumers
purchase, excluding most housing costs.
RPI(retail prices index) is average level of
prices of the commodities and services,
including housing costs.
Adjusted RPI

RPIX: exclude mortgage interest payments

RPIY: exclude mortgage interest payments and
effects of VAT

UKs inflation target is measured on basis of

CPI.

Causes of inflation

Demand pull inflation

Inflation arises from an excess of aggregate demand

over the productive capacity of the economy

Cost push inflation

Inflation resulting from an increase in the costs of

production of goods and services.
E.g. from wage increases

Import cost factors: e.g. fall in the value of

domestic currency
Expectations: wage-price spiral
Excessive money supply growth
*R-52:#4; P563#17

Unemployment

number of unemployed
unemployment= total workforce *100%

Rate of
Flow of workers

Flows into unemployment

Flows out of unemployment

Consequences

Loss of output
Loss of human capital
Increasing inequality in the distribution of
income
Social costs
Increased burden of welfare payments

Causes of unemployment

Real wage
Real wages do not fall for the
unemployment labour market to clear

Short-term Frictional

Difficulty in matching
unemployment unemployed workers with
available jobs
Seasonal
Resulting from demand for
unemployment labour fluctuates in seasonal
patterns

Long-term Structural

Arising from a long-term decline

unemployment in a particular industry
Technological Occurs when new technologies
unemployment are introduced
Cyclical
In the downswing of an
unemployment economy in between two booms

*R-15:#12; R-52:#5; pilot paper#12

Gov. employment policies

Gov. can create new jobs or reduce unemployment

Spending more money directly on jobs

Encourage growth in private sector of economy
Encourage training in job skills
Offering grant assistance to employers
Encouraging labour mobility
Reduce real wages to market clearing levels

It is possible to create more jobs without reducing

unemployment. It is also possible to reduce the
unemployment without creating new jobs.
*R-14:#7

Economic growth

Measured by increases in the real GNP per head of

the population.
Actual growth

Potential growth

Annual percentage increases in national output

Determined by the demand and supply
The rate at which the economy would grow if all
resources were utilised
Determined by supply side
Caused by increases in the amount of resources or
increases in the productivity of resources

Sustained growth

Depends on an adequate level of new investment, which

is in turn dependent on business confidence in future

*R-15:#10

Sources of economic growth

Natural resources
Technological progress

Capital saving: use less capital and the same

amount of labour per unit of output
Neutral: use less of labour and capital in the
same proportion per unit of output
Labour saving: use less labour and the same
amount of capital per unit of output

Technological progress may stimulate growth but at

the same time conflict with the goal of full
employment

External trade influence

Adv. and disadv. of economic growth

Advantages

Higher income per head

Higher level of consumption
Better standard of living
More easy to provide welfare services

Disadvantages

Faster use of natural resources

Create pollution
Structural unemployment
Financing for more investment may come from
higher savings, which leads to cut in
consumption.

Balance of payments

Balance of payment

Current account
Trade in goods
Trade in services
Income: income from employment by overseas
firms and income from capital investments overseas
Transfer: public sector and non-government sector
payments and receipts from overseas bodies

Capital account: flows of capital into and out of

the country

* R-52:#6

Surplus or deficit in the current account

A surplus or deficit on the balance of payments

usually means a surplus or deficit on the current
account.
Export > import, surplus in the current account
Import > export, deficit in the current account
Problems of deficit

Build up external liabilities

Sell more and more of its assets

Measures of gov. to rectify a deficit

Depreciation of currency (devaluation)

Restrict imports
Domestic deflation to reduce domestic aggregate demand

*R-15:#6

summary

To increase the aggregate demand, and

reduce unemployment and boost economic
growth:

Increase public expenditure

Reduce taxes
Reduce interest rates
Increase money supply
Reduce credit control

* R-14:#4; Pilot paper#11

summary

To reduce the aggregate demand, and reduce

inflation and slow economic growth:

reduce public expenditure

increase taxes
increase interest rates
reduce money supply
increase credit control

summary

The effects of increasing interest rates:

Reduce aggregate demand

Increase unemployment, slow down economic

growth

Increase value of sterling(exchange rate of )

Increase imports
Reduce exports
Increase the deficit in the current account or reduce
the surplus in the current account
Reduce inflation rate

The value of sterling is higher when interest

rate in UK is higher and inflation rate in UK
is lower.