MACROECONOMICS – FISCAL, MONETARY & SUPPLY-SIDE POLICY ANALYSIS CHAINS

This is one of the MOST IMPORTANT Paper 4 chapters.

Examiners LOVE asking:

• effectiveness of policies

• policy conflicts

• inflation vs unemployment

• fiscal policy vs monetary policy

• short-run vs long-run

Your marks depend on:

• development chains

• evaluation

• policy limitations

NOT definitions.

EXPANSIONARY FISCAL POLICY CHAIN

• Government increases spending/cuts taxes

• Aggregate demand rises

• AD curve shifts right

• Output rises

• Employment rises

• Household incomes rise

• Consumption rises further

• Economic growth strengthens

Evaluation:

• depends on multiplier size

• may increase inflation

• government debt may rise

• crowding out possible

CONTRACTIONARY FISCAL POLICY CHAIN

• Government cuts spending/raises taxes

• Aggregate demand falls

• Inflationary pressure decreases

• Output may fall

• Unemployment may rise

• Economic growth slows

Evaluation:

• effectiveness depends on confidence

• may worsen recession

• time lags exist

Written and Compiled By Sir Hunain Zia (AYLOTI), World Record Holder With 154 Total A Grades, 11 World Records and 7 Distinctions, Educate A Change.

GOVERNMENT SPENDING INCREASE CHAIN

• Government spending rises

• AD increases directly

• Firms gain higher revenue

• Output expands

• Employment rises

• Multiplier effect occurs

• National income rises further

Evaluation:

• leakages reduce multiplier

• inefficient spending possible

• inflationary pressure may occur

TAX CUT CHAIN

• Disposable income rises

• Consumption increases

• Aggregate demand rises

• Output and employment rise

• Economic growth improves

Evaluation:

• consumers may save instead

• depends on MPC

• inflationary pressure possible

INDIRECT TAX INCREASE CHAIN

• Product prices rise

• Consumption falls

• Aggregate demand decreases

• Inflationary pressure may reduce

• Government revenue rises

Evaluation:

• regressive impact possible

• may worsen inequality

• black markets possible

BUDGET DEFICIT CHAIN

• Government spending exceeds revenue

• Borrowing increases

• National debt rises

• Interest payments rise

• Future taxation may increase

Evaluation:

• borrowing may stimulate growth

• sustainable if GDP grows faster than debt

CROWDING OUT CHAIN

• Government borrowing rises

• Demand for loanable funds rises

• Interest rates increase

• Private investment falls

• Long-run growth may weaken

Evaluation:

• unlikely during recession

• depends on spare capacity

AUTOMATIC STABILISERS CHAIN

• Recession occurs

• Tax revenue falls automatically

• Welfare payments rise

• Disposable income supported

• Fall in AD reduced

• Recession softened

Evaluation:

• may worsen budget deficit

• effectiveness limited during severe recession

MONETARY POLICY – INTEREST RATE CUT CHAIN

• Central bank cuts interest rates

• Borrowing becomes cheaper

• Consumption and investment rise

• Aggregate demand increases

• Output and employment rise

• Economic growth improves

Evaluation:

• depends on confidence

• liquidity trap possible

• inflation may rise

MONETARY POLICY – INTEREST RATE RISE CHAIN

• Interest rates increase

• Borrowing becomes expensive

• Consumption and investment fall

• Aggregate demand decreases

• Inflationary pressure falls

Evaluation:

• may worsen unemployment

• mortgage holders heavily affected

• exchange rate may appreciate

Written and Compiled By Sir Hunain Zia (AYLOTI), World Record Holder With 154 Total A Grades, 11 World Records and 7 Distinctions, Educate A Change.

QUANTITATIVE EASING CHAIN

• Central bank purchases bonds

• Money supply increases

• Interest rates fall

• Bank lending rises

• Consumption and investment increase

• Aggregate demand rises

Evaluation:

• banks may still not lend

• inflation risk exists

• asset price bubbles possible

LIQUIDITY TRAP CHAIN

• Interest rates already very low

• Consumers/firms still avoid borrowing

• Monetary policy becomes ineffective

• AD remains weak

• Recession continues

Evaluation:

• fiscal policy may work better

• confidence critical

EXCHANGE RATE APPRECIATION CHAIN

• Currency value rises

• Exports become expensive

• Export demand falls

• Imports become cheaper

• Trade balance may worsen

• Aggregate demand may fall

Evaluation:

• inflationary pressure decreases

• depends on PEDX and PEDM

EXCHANGE RATE DEPRECIATION CHAIN

• Currency value falls

• Exports become cheaper

• Export demand rises

• Imports become expensive

• Aggregate demand rises

• Economic growth may increase

Evaluation:

• imported inflation possible

• Marshall-Lerner condition important

• J-curve effect possible

SUPPLY-SIDE POLICY – EDUCATION CHAIN

• Government improves education/training

• Worker skills rise

• Productivity increases

• LRAS shifts right

• Sustainable growth rises

• Inflationary pressure reduces

Evaluation:

• expensive

• long time lag

• depends on education quality

SUPPLY-SIDE POLICY – INFRASTRUCTURE CHAIN

• Government improves infrastructure

• Transport efficiency rises

• Business costs fall

• Productivity increases

• Competitiveness improves

• LRAS rises

Evaluation:

• costly projects

• long implementation period

• environmental damage possible

SUPPLY-SIDE POLICY – DEREGULATION CHAIN

• Government reduces regulation

• Firms operate more flexibly

• Competition increases

• Efficiency improves

• Productivity rises

Evaluation:

• worker protection may weaken

• market failure risk increases

SUPPLY-SIDE POLICY – PRIVATISATION CHAIN

• State industries sold to private sector

• Profit motive increases

• Efficiency improves

• Costs may fall

• Consumer choice may increase

Evaluation:

• monopoly power may develop

• public welfare may worsen

• profit prioritised over accessibility

Written and Compiled By Sir Hunain Zia (AYLOTI), World Record Holder With 154 Total A Grades, 11 World Records and 7 Distinctions, Educate A Change.

SUPPLY-SIDE POLICY – LOWER CORPORATION TAX CHAIN

• Corporation tax reduced

• Firms retain more profit

• Investment increases

• Productivity rises

• LRAS shifts right

• Long-run growth improves

Evaluation:

• government revenue falls

• firms may not invest extra profits

SUPPLY-SIDE POLICY – LABOUR MARKET REFORM CHAIN

• Labour market becomes flexible

• Hiring/firing easier

• Structural unemployment may fall

• Efficiency improves

• Productivity rises

Evaluation:

• job insecurity increases

• inequality may worsen

ANTI-INFLATION POLICY CHAIN

• Government uses contractionary policy

• AD decreases

• Inflationary pressure reduces

• Price stability improves

Evaluation:

• unemployment may rise

• economic growth slows

ANTI-UNEMPLOYMENT POLICY CHAIN

• Government uses expansionary policy

• AD rises

• Output expands

• Labour demand rises

• Unemployment falls

Evaluation:

• inflation may increase

• effectiveness depends on confidence

POLICY CONFLICT CHAIN

• Government tries reducing inflation

• Contractionary policy used

• Unemployment rises

• Economic growth slows

• Policy trade-off occurs

Evaluation:

• supply-side policy may reduce conflict

• depends on severity of inflation

STAGFLATION POLICY CHAIN

• Inflation and unemployment rise together

• Contractionary policy reduces inflation but worsens unemployment

• Expansionary policy reduces unemployment but worsens inflation

• Policy dilemma occurs

Evaluation:

• supply-side policy often preferred long-run

• time lag significant

COMMON PAPER 4 EVALUATION POINTS FOR POLICY ESSAYS

Always use:

• time lags

• confidence

• multiplier size

• inflationary pressure

• spare capacity

• government debt

• crowding out

• political difficulty

• opportunity cost

• effectiveness short-run vs long-run

Written and Compiled By Sir Hunain Zia (AYLOTI), World Record Holder With 154 Total A Grades, 11 World Records and 7 Distinctions, Educate A Change.

PERFECT POLICY ANALYSIS FORMULA

POLICY CHANGE
→ AD/SRAS/LRAS EFFECT
→ OUTPUT CHANGE
→ EMPLOYMENT CHANGE
→ INFLATION/GROWTH EFFECT
→ LONG-RUN CONSEQUENCES
→ EVALUATION

ULTRA IMPORTANT EXAM CHAIN

Interest rates fall
→ borrowing becomes cheaper
→ firms invest more
→ AD rises
→ output and employment rise
→ economic growth improves

Evaluation:

• depends on confidence

• banks may restrict lending

• inflationary pressure may occur

BIGGEST POLICY ESSAY MISTAKE

Students only explain what the policy DOES.

Weak:
“Fiscal policy increases AD.”

Strong:
“Expansionary fiscal policy increases AD through higher government spending and lower taxation, raising output and employment via the multiplier effect, although the effectiveness depends on spare capacity, consumer confidence and the size of leakages.”

THAT is top-band Paper 4 analysis.