Explain the main instruments of macro economic policy - Fiscal Policy
Explain the main instruments of macro economic policy
Fiscal Policy
Fiscal policy is the use of government expenditure and taxation to manage the economy. The main changes in fiscal policy happen once a year in the Budget. It is in the Budget that the Chancellor sets the levels of taxation and government expenditure for the next fiscal year. The fiscal year runs from 5th April one year to 4th April the following year. This is why the budget is usually in March. The changes come generally into effect in the following month.
Fiscal policy can be used in various different ways. It may be used to try to boost the level of economic activity when the economy is flagging a little. In this case it is called reflationary policy. Alternatively the economy may doing a little too well and in need of slowing down. In this case deflationary policy is called for. The final use for fiscal policy is as a tool of supply - side policy
To help imagine how these policies work think of the economy as a balloon. The air in the balloon is the level of demand or economic activity. If the balloon is a little low and short of air you want to reflate it, but if it is over-expanded and in danger of bursting you deflate it. The same is true of the economy, though when it is over-expanded instead of bursting we get other problems such as higher inflation and a large balance of payments deficit.
Deflationary Fiscal Policy
Deflationary fiscal policy is likely to be most appropriate in times of economic boom. If the economy is growing at above its capacity this is likely to cause onflation and balance of payment problems. To try to slow the economy down the government could either raise taxes in some form or perhaps reduce government expenditure. Either of these will reduce the level of demand in the economy and therefore the level of economic growth. It may increase indirect taxes which will raise prices and deter people from spending so much, or it may increase direct taxes which will leave people with less money in their pockets and so stop them from spending so much
Deflationary fiscal policies could therefore include;
* Increasing the lower, basic or higher rate of tax
* Reducing the level of personal allowances
* Reducing the level of government expenditure
These policies should reduce growth, increase unemployment and cause inflation to fall (after a time lag perhaps)
Reflatioary Fiscal Policy
Governments may choose to use reflatioary fiscal policy in times of recession or a general turndown in economic activity. In this situation they will use their fiscal policy to give a boost to the economy. They may do this by lowering taxes in some form or by increasing the level of government expenditure. This will encourage people to spend more. If they lower indirect taxes then this will lower the prices of the taxed goods and encourage more demand. Alternatively they could lower direct taxes. This will raise people's disposable income(their take home pay) and therefore encourage them to spend more. Either way the level of demand in the economy should rise and help encourage economic growth
Reflatioary policies could therefore include;
* Cutting the lower, basic or higher rate of income tax
* Increasing the level of personal allowances
* Increasing the level of government expenditure
These policies should cause growth to increase, unemployment to fall and inflation to rise (after a time lag perhaps)
Supply - Side Policies
Fiscal policy as a supply side tool
Supply side policies are policies that aim to increase the capacity of the economy to produce . fiscal policy usually acts on the level of demand in the economy. However , it is also possible for fiscal policy to act on the level of supply as well.
Income tax will always have an effect on people's incentive to work. This will be true at most income levels. If income tax at low income levels is too high, people may choose not to work but to remain on benefits instead. If income tax on high levels of income is too high, people may choose not to work so hard and take risks. Ultimately they may even choose to leave the country if taxes elsewhere are much lower ( a brain drain)
Supply- side fiscal policies could therefore include
* Cutting the lower and basic rates of tax to open up the gap between earnings in and out of work and ensure people have an incentive to work
* In creasing the number of personal allowances for the same reason
* Reducing the top rate of income tax to encourage enterprise, risk taking and the incentive to work hard
When taxes are cut government expenditure has to be cut by an equivalent amount. This ensures that these policies have no overall impact on demand. In this way the supply side impact of these policies can be isolated. There should be an overall increase in economic growth over time as these policies begin to take effect
Other supply-side policies to help give more market freedom include;
. Union reform (the firemen's current dispute is a current example of government trying to impose a supply- side policy). The natural rate of unemployment will be reduced if the power of organised labour is weakened. Unions will be less successful in restricting labour supply and forcing up wages. Government intervention in the labour market to weaken the monopoly power of the unions should be classified as a supply-side policy aimed at reducing the natural state of unemployment and increasing equilibrium employment and potential output
2. Retraining grants aimed at increasing the effective labour supply at each real wage rate, and less government involvement in the economy in the hope that market forces stimulate effort and enterprise. Reducing inflation is also a kind of supply- side policy if high inflation has real economic costs.
3. The governments current lax stance on immigration and asylum seekers is probably a back door supply- side policy aimed at providing a huge, cheap workforce to do the jobs british citizens have lost there taste for.. The huge influx of west Indians in earlier decades to work ...
This is a preview of the whole essay
2. Retraining grants aimed at increasing the effective labour supply at each real wage rate, and less government involvement in the economy in the hope that market forces stimulate effort and enterprise. Reducing inflation is also a kind of supply- side policy if high inflation has real economic costs.
3. The governments current lax stance on immigration and asylum seekers is probably a back door supply- side policy aimed at providing a huge, cheap workforce to do the jobs british citizens have lost there taste for.. The huge influx of west Indians in earlier decades to work on the London transport system is another example of this policy. This would have positive cost reduction effects for firms.
4. Introducing competition in the natural monopolies by new devices
5. Removing institutional barriers in the capital markets(eg exchange control, the stock exchange)
6. An extensive privatisation policy(to increase competition, decrease prices and improve quality of goods to give the consumer more value for money and maximise the use of scarce resources)
7. Freeing them from government controls(eg incomes policy, minimum wage regulations, pricing policies of the nationalised industries)
8. Promoting competition (eg in real property conveying, optical and financial services)
9. Reducing national insurance contributions(an ad valorem tax on employing labour) to ease the burden on industry
0. Providing advisory services(eg on the EC's single market)
Incentives
Incentives designed to increase effort , reward enterprise and encourage savings and investment include
. An emphasis on the effect of a reduction in the marginal rate of income tax on effort,etc, even though it may reduce total tax revenue;
2. A lower corporation tax to encourage investment and the taking of entrepreneurial risks
3. Special help for new firms to obtain the initial capital, eg "start up" schemes, the Business Enterprise Scheme
4. Profit related pay(which gives employees a direct stake in the success of the company and enables pay to respond more readily to changing market conditions) share option schemes and wider share ownership generally)
The above represent a variety of measures to create conditions in which the free play of market forces can stimulate the economy to work more efficiently
The Thatcher government pursued these policies vigorously with the result of the UK having one of the leading world economies after inheriting a practically bankrupt country from the previous labour government The current labour government who inherited a strong economy from the previous conservative government have deviated from these policies and we can look forward to the chaos that will ensue in the next few years and the embarrassment of this government having to go begging to the world bank for funds to bail them out of the mess the have created
Come back Maggie all is forgiven
Income policies
The main aim of an incomes policy, introduced to reduce inflation, is to link the growth of incomes to the growth of productivity so as to prevent the excessive rises in factor incomes which raise costs and hence prices. Although an incomes policy may embrace all forms of income-wages, interest, rent and profits-it will tend to concentrate largely on wages because these account for about two thirds of total costs
Difficulties with Income Policies
A government will have to decide whether to set a percentage, e g 5%, or flat rate, e g £10 limit to pay rises. A percentage limit maintains wage differentials and benefits mainly the high paid. Whereas a flat rate limit reduces differentials and benefits mainly the low paid.
There is also the problem of whether exceptions should be allowed. If the government is anxious to encourage labour mobility it will have to allow industries which are short of labour to offer something higher than the limit while industries trying to shed labour will pay something less than the limit or nothing. There will also be demands from other groups for exceptional treatment. Workers who feel that they have been left behind in previous wage-price spirals will press for special treatment( the fire brigade is an example of this although it is only them that seem to think so). It might also be necessary to allow some exceptions in order to encourage greater efficiency by permitting increases above the limit where workers have made a substantial contribution to increased productivity
It is very difficult to introduce flexibility into an incomes policy without causing resentment amongst those who do not qualify for special treatment. It is also difficult tp impose and supervise an incomes policy. There are many thousands of separate wage settlements and the effective policing of these agreements to make sure that they conform with the general principles of the incomes policy is a formidable administrative task
Statutory rent control on privately owned houses can be imposed. Landlords can be required to satisfy a public rent tribunal before being allowed to raise rents. However, when this policy has been used to keep rents below the market price a number of disadvantages have arisen. In particular, supply has decreased with houses being sold rather than rented
Effectiveness of income policies
Income policies have sometimes taken the form of a complete freeze on wages and prices. It is difficult to maintain a wage and price standstill for more than a few months, Because demand and supply conditions will continue to change and hence relative prices must be allowed to change if the price mechanism is to perform any useful function. In addition, trade unions will strongly oppose any protracted wage freeze. While they are in force, wage and price freezes are likely to slow down the pace of inflation. However their effect may be like that of a temporary dam. Once the policy is relaxed, there may be a flood of wage claims and price increases which will soon bring prices and wages back on their former trend
It is difficult to assess the effectiveness of income policies which have been tried in a variety of countries. It is not sufficient to conclude that the measures are a failure if it is found that wages and prices have risen faster in periods of controls then in periods without them. Incomes policies are normally applied when inflationary pressure have become very intense. The effects of the policies should be judged by the difference between what actually happened and what might otherwise have happened in the absence of any controls
Income policies, unlike deflationary fiscal and monetary policies, do not cause unemployment. However new classical economists criticise them. They argue that they do not address the real causes of inflation and they interfere with free market forces, for instance, making it difficult for firms which wish to expand to recruit labour
Prices Policies
Free markets and price controls
Free markets allow prices determined purely by the forces of supply and demand
Government actions may shift demand and supply curves, as when changes in safety legislation shift the supply curve, but the government makes no attempt to regulate prices directly. If prices are sufficiently flexible, the pressure of excess supply or excess demand will quickly bid prices in a free market to their equilibrium level. Markets will not be free when effective price controls exist.
Price controls are government rules or laws that forbid the adjustment of prices to clear markets
Price controls may be floor prices (minimum prices) or ceiling prices (maximum prices)
Price ceilings make it illegal for sellers to charge more than a specific maximum price and are typically introduced when a shortage of a commodity threatens to raise its price by a substantial amount. High prices are the device by which a free market rations goods in scarce supply. Although high prices are one way to solve the allocation problem, ensuring that only a small quantity of the scarce commodity will be demanded, they may lead to a solution that society believes to be unfair, a normative value judgement. For example, high food prices mean considerable hardship for the poor. Faced with a national food shortage, a government might impose a price ceiling on food so that poor people can continue to buy adequate quantities of food
In a situation perhaps where war has erupted and the import of food is disrupted , the price ceiling strategy would create a shortage of supply relative to demand by holding food prices below their equilibrium level
The ceiling price allows some of the poor to buy food they could not otherwise have afforded. However, it has reduced total food supplied. Furthermore, since there is excess demand at the ceiling price, some form of rationing must be used to decide which potential buyers are actually supplied . This rationing system could be highly arbitrary.
Holding down the price of food might not help the poor after all. For this reason, the imposition of ceiling prices may be accompanied by government-organised rationing by quota, to ensure that available supply is shared out fairly, independent of ability to pay
Where price controls are maintained for many years they may have further repercussions. Many countries have imposed rent controls limiting the rent a landlord can charge tenants for accommodation. Intended to provide cheap housing for the poor, such legislation may have perverse effects
As time elapses some landlords respond to lower rents by converting their property for their own use or for sale to purchasers who wish to own their own home. This will lead to a large reduction in the quantity of rental accommodation supplied. Shortages increase and less and less housing is available for the poor who cannot afford to buy their own houses
Whereas the aim of a ceiling price is to reduce the price for consumers, the aim of a floor price is to raise the price for suppliers. One example of a floor price is a national minimum wage . If the free market equilibrium price for labour is set at e g £3 per hr . A minimum wage set below this will be irrelevant since the free market equilibrium can still be attained. Suppose in an effort to help workers, the government impose a minimum wage of £4 per hr. Firm will have to pay off some workers and cut hrs worked by remaining staff in order to keep down costs and there will be excess supply of labour. The lucky workers who manage to sell as much labour as they wish will be better off than before, but some workers will be worse off as they may find them selves unemployed or working less hrs
Many countries set floor prices for agricultural products. In previous examples we have assumed that the quantity traded would be the smaller of quantity supplied and quantity demanded at the controlled price since private individuals cannot be forced to participate in a market. There is, however, another possibility: the government may intervene not only to set the control price but also to buy or sell quantities of the good to supplement private purchases and sales ( the EEC common agricultural policy is an example of this).
Because many European agricultural products prices are set above the free market equilibrium price huge mountains of unsaleable produce have been created( e g wine, butte, milk, beef). European governments have been forced to purchase massive stocks of these products which would otherwise have been unsold at the controlled price
This in my opinion is an insane policy devised by land owners in Brussels( who benefit greatly by receiving the enormous subsidies European farmers receive ) .These subsidies create a massive distortion in world trade by producing cheap food for the Europeans (this may not really be the case as the taxes of European citizens needed to fund these subsidies will possibly be greater than the saving citizens make on purchasing these subsidised items, although if the subsidies were stopped there would be no obvious benefit to the tax payer as the EEC commissioners would soon find another way of wasting any savings made). This makes the rest of the world mainly developing countries unable to produce these products competitively and find themselves with no market for their goods. This contributes to the poverty and deprivation experienced by those countries. The only obvious winners due to this policy is the usually wealthy landowners who are quite willing to produce unsaleable products as long as the subsidies keep rolling in. The U S pursues the same policy.
The Japanese latest attempt at world domination through economic means, who armed with a workforce prepared to work all hours and be completely loyal and a monetary policy which allowed the banks to lend as much as they liked with very little criteria for borrowers to meet and very generous payback terms, proceeded to flood the world with goods whose price western manufacturers who are disadvantaged with all the rules and regulations associated with western economic practices could not match. World consumers benefited by this situation by cheaper prices, but the Japanese economy grew at a phenomenal rate at the expense of western economies. The Japanese departure from sound economic principles is now coming home to roost, with workers demanding higher wages and overproduction to name but a few of their problems their economy is approaching meltdown. The western firms who have had to slim down all unnecessary costs in order to try to compete with them should be in a better position now to improve their market share
The Americans pursue these policies to a certain extent but mainly for self protectionist purposes
Pricing non-market goods
Market prices may not be available . This occurs with:
. Community and public goods: where "free riders" cannot be excluded(e g street-lighting, land, radio programmes) or where it is decided to make no charge (e g public parks ,bridges) here the cost is covered by taxation which is unlikely to reflect true willingness to pay
2. Intangible externalities, e g noise and congestion cost , human lives saved, the pleasure derived from a walk in the park
Since both enter into C.B.A. (cost-benefit analysis) calculations, it is necessary to ascribe "shadow prices" to them so that benefits and costs can be quantified in money term . Such an exercise, however faces formidable difficulties e g what price do you put on a human life
With merit goods in particular, it may be desirable to recognise the uneven distribution of income when considering charges. For instance, charges for essential education would be highly regressive on low income families with children of school age. Alternatively, the regressive impact of charges can be modified by price discrimination. Thus low income families are given housing benefits, while persons over the retirement age do not pay prescription charges
Where demand for a public service is not likely to be to high at zero price, the choice between tax financing and user charging could reasonably rest on the question, who benefits from the service?. Where the community as a whole benefits- e g street lighting and by-pass roads- tax financing is appropriate. In contrast, if certain individuals benefit, the cost is best covered by individual fees(e g public tennis courts and swimming pools) or if a particular group benefits, a special levy can be imposed e g for street making charges. User-charges levied on this principle are generally accepted as being fair in that the direct beneficiary pays
For goods other than community goods, the choice between charges, taxation or a combination of both is governed by technical, economic and political considerations. Thus while motorways could be financed by toll charges, the effect on the traffic flow has led the UK to adopt the principle of paying for them from general taxation, both central and local. However users contribute heavily through motor vehicle licences and petrol duties, while charges are imposed on motorists in minor matters, such as parking fees. On the other hand , while public transport could be financed from taxation, economic factors favour charges, for elasticity of demand is such that, at zero price (financed wholly through taxation), demand would be so high that a misallocation of resources would result. This applies to many other services e g postal services, National Health prescriptions, dental treatment, sight testing and spectacles.
One other advantage of charges is that they can throw up a valuable guideline for investment. For example, metered water charges reveal demand at the current price and thus providing a datum line from which future demand can be estimated.
In practice, the choice between charges and taxation is likely to be politically motivated, especially where income redistribution figures prominently. But there are economic constraints on charging less than the free market price for an extended demand may impose a heavy burden on taxation generally, especially as consumers who benefit most press for extension of the service, as with subsidised public transport and housing. The result of this constraint on taxation is that some form of administrative rationing according to need may have to be imposed, e g the points system for allocating council dwellings. More seriously, hidden rationing may prevail through depreciation of the quality of service provided, e g State medical services and education
Even when it has been decided to cover the cost of a service by charges difficulties may arise where there are relatively high fixed costs, e g as with public transport, electricity, and natural gas, for supply by competing firms would mean that no one firm could be financially viable. In any case, for technical reasons, a monopoly may be necessary. For instance, only one firm can be given the right to acquire land for laying a gas main or for running a water pipe under the roads, while, for public transport, competing firms cannot be allowed to skim the profitable commuter traffic with none providing a service at other times or on other routes
The necessity of having to create a monopoly because of decreasing costs or of special technical conditions of supply has strengthened the case for the provision of certain services by local authorities, e g passenger transport, or by nationalised industries
The government has relatively recently denationalised or thrown open to competition most of these services e g trains, buses electricity supply, gas supply it remains to be seen the best system but if monopolies end up being created the government may have to step in to curb there worst excesses
Governments usually aim not for complete price stability but for a low and stable rate of inflation, The Labour Government of the UK, elected in May 1997, set the Bank of England the target of achieving an underlying rate of inflation of 2.5% with a margin of one percentage point each way.
Complete price stability or zero inflation would mean that the general price level is not changing . In practice in a dynamic, growing economy the general price level is likely to rise by between 1% and 2% per year. This rise will reflect the buoyant level of demand and the fact that the quality of goods tends to rise
If the rate of inflation is equal to or below rival countries, the country can at least maintain its international price competitiveness. If it is stable then firms do not have to encounter costs in estimating its future rate and workers do not have to guess what wage claims to make to maintain their real wages
However, high and accelerating inflation is clearly undesirable. It can reduce a countries international price competitiveness, reduce the real income of some groups, create uncertainty, make it difficult for firms to plan and thereby may discourage investment. Very high levels of inflation can cause the economic and political system of a country to break down
I havn,t covered thing's we have gone over previously like supply and demand charts, elasticity of demand charts, monopolies .
