Economics help blog – Page 53

Policies for Economic Growth

25 May 20215 December 2020 by Tejvan Pettinger

Government policies to increase economic growth are focused on trying to increase aggregate demand (demand side policies) or increase aggregate supply/productivity (supply side policies)

Demand side policies include:
- Fiscal policy (cutting taxes/increasing government spending)
- Monetary policy (cutting interest rates)
Supply side policies include:
- Privatisation, deregulation, tax cuts, free trade agreements (free market supply side policies)
- Improved education and training, improved infrastructure. (interventionist supply side policies)

Demand side policies are important during a recession or period of economic stagnation. Supply side policies are relevant for improving the long run growth in productivity.

policies-for-economic-growth

Demand side policies

Demand side policies aim to increase aggregate demand (AD). This needs to be done during a recession or a period of below-trend growth. If there is spare capacity (negative output gap) then demand-side policies can play a role in increasing the rate of economic growth. However, if the economy is already close to full capacity (trend rate of growth) a further increase in AD will mainly cause inflation.

In this case, the economy at Y1 has spare capacity. Therefore an increase in AD leads to a rise in real GDP.

Monetary Policy

Monetary policy is the most common tool for influencing economic activity. To boost AD, the Central Bank (or government) can cut interest rates. Lower interest rates reduce the cost of borrowing, encouraging investment and consumer spending. Lower interest rates also reduce the incentive to save, making spending more attractive instead. Lower interest rates will also reduce mortgage interest payments, increasing disposable income for consumers.

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In 2009, base rates were cut to 0.5% to try and stimulate economic growth in the UK.

More detail on the effect of lower interest rates.

Evaluation of Monetary Policy

Lower interest rates may not always boost spending. In a liquidity trap, lower interest rates may not increase spending because people are trying to pay back debts. In 2009, UK interest rates were cut to 0.5%, but spending remained subdued. Banks were unwilling to lend because of liquidity shortages. Therefore, although in theory, it was cheap to borrow, it was hard to actually create credit. Therefore, this shows monetary policy can be ineffective in boosting economic growth

Another criticism of monetary policy is that cutting interest rates very low could distort future economic activity. For example, the US cut interest rates following the economic uncertainty of 9/11. These low-interest rates encouraged people to take on ambitious loans and mortgages; this was a factor behind the US housing bubble. Therefore cutting interest rates, at the wrong time, can contribute to a future housing and asset bubble which will destabilise economic growth. However, in 2009-12, the depth of the financial crisis means there is no immediate danger of a housing bubble, so it was appropriate to keep interest rates at zero.

2. Quantitative Easing

In a liquidity trap, where lower interest rates fail to boost demand, the Central Bank may need to pursue more unconventional types of monetary policy. Quantitative easing involves increasing the money supply and buying bonds to keep bond rates low. The hope is that the increase in the money supply and lower interest rates will boost investment and economic activity. The fear is that increasing the money supply could cause inflation. Though evidence from 2009-12 suggests that the inflationary impact was minimal. Without quantitative easing, the recession was likely to be deeper, though QE alone failed to return the economy back to a normal growth projection.

Carbon Tax – Pros and Cons

25 May 20211 December 2020 by Tejvan Pettinger

A carbon tax aims to make individuals and firms pay the full social cost of carbon pollution. In theory, the tax will reduce pollution and encourage more environmentally friendly alternatives. However, critics argue a tax on carbon will increase costs for business and reduce levels of investment and economic growth. The purpose of a carbon …

What does the government spend its money on?

1 July 202324 November 2020 by Tejvan Pettinger

Readers Question: What does the Government spend its money on?

The government spends money for a variety of reasons:

Reduce inequality (welfare payments like unemployment benefit).
Provide public goods (fire, police, national defence)
Provide important public services like education and health (merit goods)
Debt interest payments.
Transport
Military spending

UK public sector spending 2023-24

government-spending-by-dept-all-900

In the UK, the biggest department for public money is social security. This takes almost a quarter of all public spending. It goes on financing a variety of benefits (State pensions, public sector pensions, housing benefits, income support, disability/incapacity benefits, unemployment benefits).

EU spending is £14.7bn (2014). Net spending £9.9bn. See more at the cost of EU

Main areas of Government Spending 2015

Public Pensions £150 billion
- Sickness and disability £40bn
- Old age pensions £107bn
National Health Care + £133 billion
State Education + £90 billion
- Secondary education – £25bn
- University education – £11bn
- local education spending – £48bn
Defence + £46 billion
Social Security + £110 billion
State Protection + £30 billion
Transport + £20 billion
- Railway – £5.2bn
- Roads – £3bn
- Local transport – £9bn
General Government + £14 billion
- Executive and legislative – £5.9bn
Other Public Services + £86 billion
- Social housing – £1.2bn
- Waste management – £9bn
Public Sector Interest + £52 billion

Cost of EU

Gross payment to EU – £17.2bn
Net payment to EU – £8.6bn
FT – EU cost

Total Spending = £731 billion

Source: UK Public Spending

Examples of economic problems

23 September 202120 November 2020 by Tejvan Pettinger

The fundamental economic problem is the issue of scarcity but unlimited wants. Scarcity implies there is only a limited quantity of resources, e.g. finite fossil fuels. Because of scarcity, there is a constant opportunity cost – if you use resources to consume one good, you cannot consume another. Therefore, an underlying feature of economics is …

Factors that affect population size and growth

26 November 202119 November 2020 by Tejvan Pettinger

Readers question: Explain the main factors which affect population size and growth? Population growth is determined by fertility rates (the number of children per adult) – fatality rates. Birth rates and mortality rates are, in turn, determined by a combination of factors. Often economic growth and economic development have led to a decline in population …

How is Inflation Calculated?

3 January 202216 November 2020 by Tejvan Pettinger

Inflation, in the UK, is calculated through measuring changes in the cost of living. The official method is the CPI – Consumer Price Index. CPI Measures the annual % change in price level. Steps for Calculating Inflation Firstly, the government (through ONS) undertake the Family Expenditure Survey (FES). The FES is a voluntary survey of …

Increasing the Money Supply

27 July 202215 November 2020 by Tejvan Pettinger

Readers Question: I’d like to ask you about routine ways (apart from so called “printing new money”) by which the total volume of money in the economy grows.

The money supply measures the stock of money in the economy.

A narrow definition of money (M0) includes the stock of notes/coins and operational deposits at Bank of England
A broad definition of money (M4) is notes and coins + deposits in bank accounts + other liquid assets.

Ways to increase the money supply

Print more money – usually, this is done by the Central Bank, though in some countries governments can dictate the money supply. For example in Zimbabwe 2000s – the government printed more money to pay wages.
Reducing interest rates. Lower interest rates reduce the cost of borrowing. This makes investment relatively more profitable, and so encourages economic activity. Consumers will also see cheaper mortgage payments leading to higher disposable income. Read more – effect of cutting interest rates
Quantitative easing The Central Bank can also electronically create money. Under a policy of quantitative easing, they decide to increase their bank reserves ‘effectively create money out of thin air’. The created money can be used to buy assets; the idea is to increase cash reserves of banks.
Reduce the reserve ratio for lending. The reserve ratio is the percentage of deposits that bank keeps in cash reserves. If the reserve ratio is reduced, then the bank will lend more and due to the money multiplier, we will see a rise in bank lending. Central Banks can set a minimum reserve ratio. Reducing this ratio
Increase confidence in the banking system. If banks have confidence in the financial system, then they will be more willing to lend. In the credit crisis, it was necessary for the government to guarantee bank deposits and nationalise struggling banks
Central Bank buying government securities. The Central Bank pays investors holding bonds. If the Central Bank buy Government securities (or corporate bonds) people who were holding the bonds have more money to spend. Banks see illiquid assets become liquid. Therefore, in certain circumstances, this can lead to an increase in the money supply. However, it depends on whether the bond purchases are sterilised or ‘unsterilised’. Unsterilised means they create money to buy bonds.
Expansionary fiscal policy. In a recession, there is often a ‘paradox of thrift’ business and consumers want to increase savings – and this leads to a fall in spending and investment. If the government borrows from the private sector and spends on public work investment schemes then this will start a multiplier effect where households gain wages to spend and encourage private sector investment.

Collusion – meaning and examples

7 May 202413 November 2020 by Tejvan Pettinger

Collusion occurs when rival firms agree to work together – e.g. setting higher prices in order to make greater profits. Collusion is a way for firms to make higher profits at the expense of consumers and reduces the competitiveness of the market. In the above example, a competitive industry will have price P1 and Q …