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Conflicts between objectives

Is there a trade-off between economic growth and inflation?

Arguments for the trade-off

Sustained growth caused by rising aggregate demand can lead to acceleration in inflation as the economy uses up scarce resources and
short run aggregate supply becomes inelastic. When SRAS is elastic, an outward shift of aggregate demand can easily be met by a rise in
real GDP (there is plenty of spare capacity and supply responds elastically to the higher level of AD). But when SRAS becomes inelastic,
the trade-off between growth and inflation worsens – an increase in AD tends to lead to higher prices rather than increased output and
employment.

LRAS has moved to the right (an increase in potential GDP). Aggregate demand has also shifted out (perhaps due to lower interest rates or
higher real incomes for consumers). Equilibrium national output increases from Y1 to Y2 – the level of output Y2 would not have been
feasible without a shift in LRAS.

Clearly those countries that grow very quickly are at risk of rising inflation. The key is to keep control of aggregate demand
(using monetary and fiscal policy) whilst at the same time seeking to increase aggregate supply through improvements in
efficiency and the stock of available resources.

In the late 1980s, an economic boom got out of control and excess demand led to a sudden and sharp rise in cost and price inflation. The
rate of inflation peaked at over 10% in 1990 and interest rates were increased up to a maximum of 15% in order to bring aggregate
demand under control. The result of this was a deep recession lasting for nearly two years – the effect of which was to reduce inflation
but which also caused a huge rise in unemployment.

Economic Growth and the Balance of Payments

Arguments for the trade-off

When aggregate demand is high and domestic producers are unable to meet all of this demand, so the demand for imported goods and
services will increase leading to an increase in the trade deficit. This trade-off is evident when the main source of rising AD is a high level
of consumer spending. British consumers have a high propensity to import goods and services. As their incomes increase, so too does their
demand for imports. The trade-off is worsened by the lack of international competitiveness of many UK industries compared to other
leading countries.
Main problems of managing the economy pg 146

• Selecting the right policy instrument: Each macroeconomic objective requires a separate policy instrument: The usual ‘rule of
thumb’ is that one main policy instrument should be assigned to one policy objective. So, for example, interest rates might be
assigned as the main instrument for keeping control of inflation, whilst fiscal policy instruments such as changes to the tax
system might be allocated to achieving some supply-side objectives such as increasing the labour supply, boosting incentives,
raising investment and increasing productivity. There are quite deep-rooted disagreements between some economists (who
belong to different ‘schools of thought’) as to which policies are most effective to meet a certain objective

Supply-side policies pg 159


Supply-side economic policies are mainly micro-economic policies designed to improve the supply-side potential of an
economy, make markets and industries operate more efficiently and thereby contribute to a faster rate of growth of real
national output. Most governments now accept that an improved supply-side performance is the key to achieving sustained
economic growth without a rise in inflation. But supply-side reform on its own is not enough to achieve this growth. There must
also be a high enough level of aggregate demand so that the productive capacity of an economy is actually brought into play.

There are two broad approaches to the supply-side. Firstly policies focused on product markets where goods and services are
produced and sold to consumers and secondly supply-side policies applied to the labour market – a factor market where labour
is bought and sold.

Effects of monetary and fiscal policy on the economy


1) Composition of output
2) Effectiveness
3) Time lags to take effect

Effects of Policy on the Composition of National Output

Monetary policy is often seen as something of a blunt policy instrument – affecting all sectors of the economy although in different
ways and with a variable impact.

In contrast, fiscal policy can be targeted to affect certain groups (e.g. increases in means-tested benefits for low income
households, reductions in the rate of corporation tax for small-medium sized enterprises, investment allowances for businesses in
certain regions)

Consider as an example the effects of using either monetary or fiscal policy to achieve a given increase in national income because
actual GDP lies below potential GDP (i.e. there is a negative output gap)

i) Monetary policy expansion

Lower interest rates will lead to an increase in consumer and business capital spending both of which increases national income. Since
investment spending results in a larger capital stock, then incomes in the future will also be higher through the impact on LRAS.

(ii) Fiscal policy expansion

An expansion in fiscal policy (i.e. an increase in government spending) adds directly to AD but if financed by higher government
borrowing, this may result in higher interest rates and lower investment. The net result (by adjusting the increase in G) is the same
increase in current income. However, since investment spending is lower, the capital stock is lower than it would have been, so that
future incomes are lower

Time Lags of Monetary and Fiscal Policies

Monetary and fiscal policies differ in the speed with which each takes effect

Monetary policy in the UK is flexible (interest rates can be changed each month) and emergency rate changes can be made in between
meetings of the MPC, whereas changes in taxation take longer to organize and implement. Because capital investment requires planning
for the future, it may take some time before decreases in interest rates are translated into increased investment spending. Typically it
takes six months – twelve months or more before the effects of changes in UK monetary policy are felt.

The impact of increased government spending is felt as soon as the spending takes place and cuts in direct and indirect taxation feed
through into the economy pretty quickly. However, considerable time may pass between the decision to adopt a government spending
programme and its implementation. In recent years, the government has undershot on its planned spending, partly because of problems
in attracting sufficient extra staff into key public services such as transport, education and health.

Monetary policy pg 154


The Bank of England prefers a gradualist approach to monetary policy – believing that a series of small movements in interest rates is a
more effective strategy rather than sharp jumps in the cost of borrowing money. Their aim is not to shock consumers and businesses to
control their spending, but to gradually increase the cost of borrowing money and increase the incentive to save, so that the pace of
growth moderates and the economy can continue to grow without causing rising inflation.

Monetary Policy Asymmetry

Fluctuations in interest rates do not have a uniform impact on the economy. Some industries are more affected by interest rate changes
than others (for example exporters and industries connected to the housing market). And, some regions of the British economy are also
more exposed (sensitive) to a change in the direction of interest rates.

The markets that are most affected by changes in interest rates are those where demand is interest elastic in other words, market
demand responds elastically to a change in interest rates (or indirectly through changes in the exchange rate).

Good examples of interest-sensitive industries include those directly linked to demand conditions in the housing market¸ exporters of
manufactured goods, the construction industry and leisure services. In contrast, the demand for basic foods and utilities is less affected
by short term fluctuations in interest rates.

The rate of interest is under the control of the Bank of England, but most other economic variables are not! The MPC’s decisions can
influence consumer and business behaviour but it cannot determine directly the rate of inflation.

Fiscal policy pg 147


• Keynesians believe that there is a clear and justified role for the government to make active use of fiscal policy measures to
manage the level of aggregate demand.

• Monetarist economists on the other hand believe that government spending and tax changes can only have a temporary effect
on aggregate demand, output and jobs and that monetary policy is a more effective instrument for controlling demand and
inflationary pressure. They are much more sceptical about the wisdom of relying on fiscal policy as a means of demand
management
• The fiscal policy transmission mechanism
How does a change in fiscal policy feed through the economy to affect variables such as aggregate demand, national output, prices and
employment? This simple flow-chart above identifies some of the possible channels involved with the fiscal policy transmission mechanism

Government (or public) spending each year takes up over 40% of gross domestic product. Spending by the public sector can be broken
down into three main areas:

• Transfer Payments: Transfer payments are government welfare payments made available through the social security system
including the Jobseekers’ Allowance, Child Benefit, the basic State Pension, Housing Benefit, Income Support and the Working
Families Tax Credit. These transfer payments are not included in the national income accounts because they are not a payment
for output produced directly by a factor of production. Neither are they included in general government spending on goods and
services. The main aim of transfer payments is to provide a basic floor of income or minimum standard of living for low
income households in our society. And they also provide a means by which the government can change the overall distribution
of income in a country.
• Current Government Spending: i.e. spending on state-provided goods & services that are provided on a recurrent basis every
week, month and year, for example salaries paid to people working in the NHS and resources used in providing state education
and defence. Current spending is recurring because these services have to be provided day to day throughout the country. The
NHS claims a sizeable proportion of total current spending – hardly surprising as it is the country’s biggest employer with over
one million people working within the system!
• Capital Spending: Capital spending would include infrastructural spending such as spending on new motorways and roads,
hospitals, schools and prisons. This investment spending by the government adds to the economy’s capital stock and clearly can
have important demand and supply side effects in the medium to long term.

Fiscal Policy and Aggregate Supply

Changes to fiscal policy can affect the supply-side capacity of the economy and therefore contribute to long term economic growth. The
effects tend to be longer term in nature.

• Labour market incentives: Cuts in income tax might be used to improve incentives for people to actively seek work and also
as a strategy to boost labour productivity. Some economists argue that welfare benefit reforms are more important than tax
cuts in improving incentives – in particular to create a “wedge” or gap between the incomes of those people in work and those
who are in voluntary unemployment.

0 Capital spending. Government capital spending on the national infrastructure (e.g. improvements to our motorway network or
an increase in the building programme for new schools and hospitals) contributes to an increase in investment across the whole economy.
Lower rates of corporation tax and other business taxes might also be used as a policy to stimulate a higher level of business investment
and attract inward investment from overseas
1 Entrepreneurship and new business creation: Government spending might be used to fund an expansion in the rate of new
small business start-ups
2 Research and development and innovation: Government spending, tax credits and other tax allowances could be used to
encourage an increase in private business sector research and development – designed to improve the international competitiveness of
domestic businesses and contribute to a faster pace of innovation and invention
3 Human capital of the workforce: Higher government spending on education and training (designed to boost the human capital
of the workforce) and increased investment in health and transport can also have important supply-side economic effects in the long run.
An enhanced transport infrastructure is seen by many business organisations as absolutely essential if the UK is to remain competitive
within the European and global economy

Free market economists are normally sceptical of the effects of government spending in improving the supply-side of the
economy. They argue that lower taxation and tight control of government spending and borrowing is required to allow the
private sector of the economy to flourish. They believe in a smaller sized state sector so that in the long run, the overall
burden of taxation can come down and thus allow the private sector of the economy to grow and flourish.

However targeted government spending and tax decisions can have a positive impact even though fiscal policy reforms take a
long time to feed through. The key is to help provide the right incentives for individuals and businesses – for example the
incentives to find work and incentives for businesses to increase employment and investment.
Therefore we justify government spending on these grounds:

• To provide a socially efficient level of public goods and merit goods


• To provide a safety-net system of welfare benefits to supplement the incomes of the poorest in society – this is also part of
the process of redistributing income and wealth
• To provide necessary infrastructure via capital spending on transport, education and health facilities – an important
component of a country’s long run aggregate supply
• As a means of managing the level and growth of AD to meet the government’s main macroeconomic policy objectives such as
low inflation and high levels of employment

The Private Finance Initiative (PFI)

• The Private Finance Initiative is a way of funding expensive infrastructure developments without running up debts. Rather
than borrowing to fund new projects, John Major's government entered into a long-term leasing agreement with private
contractors. Under a PFI, companies borrow the cash to build and run new hospitals, schools and prisons for a period of up to
60 years. So far, about 150 PFI contracts have been signed, worth more than £40bn, with more in the pipeline. PFI is often
portrayed as using private money to pay for improvements in public services. But, critics argue, it is still paid for through the
public purse. It is not new money. Furthermore, the critics say, private finance is, by its nature, more expensive than public
capital. The government of the day may feel it is getting a hospital or school at a bargain price but the country will pay more
in the long run.

• Direct taxation is levied on income, wealth and profit. Direct taxes include income tax, national insurance contributions,
capital gains tax, and corporation tax.

• Indirect taxes are taxes on spending – such as excise duties on fuel, cigarettes and alcohol and Value Added Tax (VAT) on many
different goods and services

Progressive, proportional and regressive taxes

• With a progressive tax, the marginal rate of tax rises as income rises. I.e. as people earn more income, the rate of tax on each
extra pound earned goes up. This causes a rise in the average rate of tax (the percentage of income paid in tax). The UK
income tax system is progressive. Everyone is entitled to a tax-free income. Thereafter, as income grows, people pay the
starting rate of tax (10%) before moving onto the basic tax rate (22%). Higher income earners pay the top rate of tax (40%) on
each additional pound of income over the top rate tax limit. This is the highest rate of income tax applied.

• With a proportional tax, the marginal rate of tax is constant. For example, we might have an income tax system that applied a
standard rate of tax of 25% across all income levels. If the marginal rate of tax is constant, the average rate of tax will also be
constant. National insurance contributions are the closest example in the UK of a proportional tax, although low-income
earners do not pay NICs below an income threshold, and NICs also do not rise for income earned above a top threshold.

• With a regressive tax, the rate of tax falls as incomes rise – I.e. the average rate of tax is lower for people of higher incomes.
In the UK, most examples of regressive taxes come from excise duties of items of spending such as cigarettes and alcohol.
There is well-documented evidence that the heavy excise duty applied on tobacco has quite a regressive impact on the
distribution of income in the UK.

EXCHANGE RATES
The UK operates with a floating exchange rate system where the forces of market demand and supply for a currency determine the daily
value of one currency against another. If, for example, overseas investors want to buy into sterling to take advantage of higher interest
rates on offer in UK bank accounts, they will swap their own currencies for pounds. This causes an increase in the demand for sterling in
the foreign exchange markets, and in the absence of other offsetting factors, this will force sterling higher against other currencies.

How does a change in the exchange rate influence the economy?

Changes in the exchange rate can have a powerful effect on the macro-economy affecting variables such as the demand for exports and
imports; real GDP growth, inflation and unemployment – but as with most variables in economics, there are time lags involved.

• The scale of any change in the exchange rate.


• Whether the change in the currency is short term or long term.
• How businesses and consumers respond to exchange rate fluctuations – the concept of price elasticity of demand is important
here.

Advantages of an appreciation in the currency

• Cheaper imports for consumers: A high pound leads to lower import prices – this boosts the real living standards of
consumers at least in the short run – for example an increase in the real purchasing power of UK residents when travelling
overseas or the chance to buy cheaper computers or motor vehicles from the United States or Europe.
• Lower costs for producers: When the sterling exchange rate is high, it is cheaper to import raw materials, component parts
and capital inputs such as plant and equipment – this is good news for businesses that rely on imported components or who are
wishing to increase their investment of new technology from overseas countries. A fall in import prices has the effect of
causing an outward shift in the short run aggregate supply curve. And if a country can now import more productive technology,
the LRAS curve may shift out.
• Lower inflation: A strong exchange rate helps to control the rate inflation because domestic suppliers now face stiffer
international competition from cheaper imports and will look to cut their costs and prices accordingly in order not to suffer
from a loss of international competitiveness. Cheaper prices of imported foodstuffs and beverages will also have a negative
effect on the rate of consumer price inflation.
• If inflation is lower, then interest rates will be lower than if the exchange rate was weaker – and cheaper money will
eventually stimulate higher consumer spending and capital spending in the circular flow

Disadvantages of a Strong Pound

0 Increase in the trade deficit: The lower price of imports leads to consumers increasing their demand and this can cause a
large trade deficit. Exporters lose price competitiveness because they will find it more expensive to sell in foreign markets and face
losing market share – this can damage profits and employment in some sectors and industries.
1 Slower economic growth: If exports fall, this causes a reduction in aggregate demand and reduces the short-term rate
economic growth as measured by the % change in real GDP. Some regions of the economy are affected by this more than others. In the
North east for example, manufacturing industry accounts for over 28% of regional GDP whereas the percentage for the UK as a whole is
just 19%.
2 If exports fall, then so will business confidence and capital investment – because investment is partly dependent on the
strength of demand
Showing the effects of currency movements using AD-AS analysis

3
4 Changes in the exchange rate have quite a powerful effect on the economy but we tend to assume ceteris paribus – all other
factors held constant – which of course is highly unlikely to be the case

5 Counter-balancing use of fiscal and monetary policy: For example the government can alter fiscal policy to manage the level
of AD and the Bank of England has the flexibility to change interest rates (e.g. lower interest rates if they felt that a high exchange rate
was damaging export sectors and causing much lower inflation)
6 Low elasticity of demand: In the short term, the effects of exchange rates on export and import demand tends to be low
because of low price elasticity of demand
7 Business response to the challenge of a high exchange rate: Businesses can and do adapt to a high exchange rate. There are
several ways in which industries can adjust to the competitive pressures that a strong pound imposes. Some of the options include:
8 Cutting their export prices when selling in overseas markets and therefore accepting lower profit margins to maintain
competitiveness and market share
9 Out-sourcing components from overseas to keep production costs down
10 Seeking productivity / efficiency gains to keep unit labour costs under control or perhaps trying to negotiate a reduction in
pay levels
11 Investing extra resources in new product lines where demand is price inelastic and less sensitive to exchange rate
fluctuations. This involves producing products with a higher income elasticity of demand, where non-price factors such as product quality,
design and effective marketing are as important in securing orders as the actual price

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