Sunday, October 19, 2014

Macroeconomic Logic-What Textbook Doesn't Tell You (Important for CIE/ CAL AS Economics) (Part 3)

This is a continuation from the previous post on Macroeconomic Logic. Another problem with our CIE AS curriculum is that students are not told that expenditure-dampening policies to correct/ reduce current account deficit are actually contractionary fiscal and monetary policy themselves. In short, they are macroeconomic policies designed to reduce the level of national income so that the people have lesser income to spend on imports, which is where the name of EXPENDITURE-DAMPENING comes from-dampening the ability to consume imports. Knowing this underlying concept or fact is so important to avoid the confusion with EXPENDITURE-SWITCHING

Let me explain further:
Expenditure dampening policies: They are macroeconomic policies to reduce the level of national income so that people generally have lesser money to spend onto foreign goods and services and hence the reduction in the size of current account deficit

Fiscal policy: It is the manipulation of government spending and level of taxation in order to influence the movement of AD and overall level of economic activities

Contractionary fiscal policies as expenditure-dampening measures
1. Cut in government spending to fix current account deficit. When the public sector reduces spending into the economy, this will cause the AD curve to shift leftward. This is because government expenditure (G) is one of the components of AD. As a result, the level of output/ real GDP (as explained in earlier posting) will equally decline. Fall in output is almost always followed by a decline in national income. This implies lesser income to spend on imports. Assuming exports constant, current account deficit should decline

In case if you still don’t see how a cut in public sector spending can reduce average income, this is another version of explanation. When the government reduces public sector spending, it may imply that lesser jobs are created. It can also be the case where private firms are awarded with fewer projects than before and hence dampen the ability to spend into the domestic economy (yes, G can influence C and I)

2. A rise in direct taxation. When individuals pay more income tax, this means that their disposable income will fall. With lesser money than before, obviously they can afford fewer imports. Lesser outflows of money help to reduce the size of current account deficit. Another one is raising the level of corporate tax rate. As firms pay more tax, their retained profits will fall. This implies fewer capital goods can be imported from abroad. Less money flows out of the country and again, current account deficit may shrink

Monetary policy: It is the manipulation of interest rate or money supply in order to influence the movement of AD and overall level of economic activities

Contractionary monetary policy as expenditure dampening policies
1. Higher interest rate. The Bank of England may raise the base rate/ repo rate/ overnight rate to dampen the level of economic activities. Higher rate will encourage savings. Also more expensive borrowing will discourage household consumption on credit. These two will lead to an overall fall in consumption (C) into the economy. As AD shifts leftward, real output/ real GDP will fall. A decline in income per capita/ per person will reduce ability to consume imports

Another way to look into this is, higher rate of interest may be extended onto the usage of credit cards. As the cost of borrowing increases, people will tend to spend less using their credit cards. Less imports will be purchased and hence the improvement in current account deficit

2. Reducing the money supply. When money supply is cut, financial institutions will generally be less able to extend credit. Fall in the ability to generate new loans will lead to a decline in overall level of economic activities. Fewer people will go shopping, travelling domestically, buy houses and others. This explains why national income will fall hence reducing the ability to consume imports

Another way to look into this is, the credit card limit can be reduced. This means a fall in the maximum amount of money a credit card holder can spend. As a result, fewer imports can be afforded and hence a fall in current account deficit

What you should know in addition?
Contractionary fiscal policy. Since national income falls, that also implies that more people will be unemployed. Government finances may worsen eventually as more money will need to be spend to address rising unemployment e.g. Job Seeker’s Allowance. On top of that it also allows the economy to reduce demand-pull inflation

Contractionary monetary policy. National income will fall and current account deficit will shrink. But it is also worth noting that unemployment will rise, demand-pull inflation may reduce and government finances will probably worsen due to more benefits paid but lesser tax revenue collected

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