12.5 Evaluating Government Policies: Important Important

12.
5 Evaluating Government Policies
important
Evaluating Government Policies
Cyclical Unemployment
Arguments for Fiscal Policy
• Pull an economy out of deep recession, SS policy ineffective
• Direct impact of government spending on AD
• Multiplier effect
• Firms confidence is increased
• Can target regions if needed
• Automatic Stabilizers (fiscal boost) soften recessions
• LRAS may benefit if the G is capital spending rather than
current spending
Arguments against Fiscal Policy
• Time lags, problem - implement - wait
• Political constraints
• Budget deficits can lead to crowding out
• Tax cuts not as effective as government spending because
some increase in S
• Inability to fine-tune the economy, don’t know value of K
• Accelerator weak due to excess capacity
• Can’t deal with stagflation
Natural Rate Unemployment
Fiscal Policy not effective in long-run as it only
leads to inflationary gap
Demand-Pull Inflation
• Good at dealing with rapid and escalating inflation thru
impact on C
• Direct impact of less G on AD
• Downward multiplier effect of budget surplus
Cost-Push Inflation
Depending on the exact cause could be:
• Deals with wage-push spirals, reduce expected inflation by not
indexing excise duties. Full indexing can add 1% to CPI, so not
indexing lowers expected rate of inflation, wage claims will moderate
• If big public sector, govt. could choose not to raise prices in line with
inflation. CPI could be lower
• Lower corporation tax, could break cost-push spiral but would need
to cut G too if trying to control inflation as may lead to DP
• Reduce real public sector pay. Keep pay rises below inflation, added
bonus of setting example for private sector to follow
• Lower VAT lowers CPI
Cost-Push Inflation
Arguments for Monetary Policy
• Quick implementation (monthly)
• Fine tune due to incremental adjustment of interest rates
• Central bank independence and no political constraints
• No danger of crowding out
• Increase in I (especially if elastic MEI)
• More C, “money burns a hole in your pocket” real assets
purchased not bonds, AD increases
Arguments against Monetary Policy
• many home-owners are on fixed rate mortgages
• people in rented property see no direct effects of interest rate changes
• credit-card lenders may not change rates immediately
• if businesses are operating with spare capacity, a fall in rates will not necessarily lead to higher
planned investment
• lower interest rates causes a fall in the effective disposable income of people with net savings
• up to 18 months time lags
• MEI maybe interest inelastic, firms may not increase investment as have spare capacity
• firms lack confidence, many sources of funding for capital spending are at fixed rates of interest
• firms looking for govt. lead before they invest i.e want to see changes in G&T
• may not stimulate AD if in deep recession, banks unwilling to lend
• imported cost-push pressures (ER depreciates)
• liquidity trap “It is as useful as pushing on a piece of string”
Natural Rate Unemployment
Monetary Policy not effective in long-run as it
only leads to inflationary gap
• higher mortgage rates will reduce the amount of money available for other purchases
• higher mortgages will also reduce the demand for houses house price fall causing a fall in C due to the wealth
effect
• lower house prices will reduce activity in the housing market, less people moving home, less spending on DIY
goods and services, carpets and curtains, etc.
• higher rates will encourage savings, higher opportunity cost of not saving
• high interest rates can cause share and bond prices to fall, and thus effect consumption through the wealth
effect.
• increased costs of existing borrowing, less profits for investment
• increased costs for future investment, investment discouraged especially if MEI is elastic
• expected lower consumer demand, less investment, lack of confidence
• higher exchange rates, reducing international competitiveness, less exports, lower profits, less investment
• higher exchange rates will lower the costs of imported raw materials, downward pressure on cost-push inflation
• independence of the central bank from the political process
• quickly implemented
• can fine tune better than fiscal due to small % increments available
• mortgage interest rates do not always follow interest rate changes
• many home-owners are on fixed rate mortgages
• people in rented property see no direct effects of interest rate changes
• credit-card lenders may not change rates immediately
• up to 18 months time lags
• uneven impact on different industries / sectors due variations in the interest
elasticity of demand for different goods and services (e.g. consumer durables v
basic foods)
• impact on the traded goods sector through the exchange rate, BoP deteriorates
• Impact on the regional economy (some regions are more dependent on export
demand)
Cost-Push Inflation
• Higher interest rates, higher exchange rates, lowers cost of

imported raw materials and semi-finished goods, lowers PPI,
lower pressure on CPI
Cost-Push Inflation
• Higher interest rates, higher exchange rates, higher cost of

exports, loss of international competitiveness, worsening of
BoP, possible increase in unemployment in export industries
Arguments for Supply Side Policy
• None
Arguments against Supply Side Policy
• Doesn’t deal with problem of lack of AD
Natural Rate of Unemployment
• Lowering personal income taxes – expectation of increased income
will encourage people to work longer hours and to enter the
workforce (increase LRAS)
• Lower state benefits increases incentive for people to look for work
• Increased tax revenue (Laffer Curve)
• Abolishing minimum wage, firms hire more labour
• Training and retraining (direct & indirect), regional policies, improve
job information, reduces NRU, without loss of job security or
increase in inequalities
Natural Rate of Unemployment
• Lowering personal income taxes – substitution effect may not be
greater than income effect, less tax revenue (Laffer Curve)
• Increased inequalities
• Less protection for low-income groups
• Less job security
• Opportunity cost of government spending
• Larger budget deficit
• Time lags
• Reduced automatic stabilizers (both fiscal boost and fiscal drag)
• None.
• However possibility in the very long run of
increasing trend rate of growth (new economic
paradigm) and so limit demand-pull pressure
in the future
• Ineffective at dealing with inflationary gaps in
the short-run
• Interventionist SS policies may lead to
inflationary pressure in short run
Cost-Push Inflation
• Restricting monopoly power, more competition; greater efficiency;

lower costs of production
• Encouraging competition, prices fall, more choice, more consumer
surplus
• BoP may improve due to increased international competitiveness
• Shifting AS to the right will cause a lower price level. By making
the economy more efficient supply side policies will help reduce
cost-push inflation
Cost-Push Inflation
• There is the argument that businesses will need less workers if they
invest in more technology/machines (Technological unemployment)
• Supply side economics is a LONG TERM policy - Its takes TIME – to

improve literacy & numeracy skills, time to complete an apprentice or
a degree
• Greater freedom from industry may result in damage to the

environment. Without planning controls there would be a divergence
of MPC from MSC leading to a misallocation of resources.
Fisca Monetary
Fisc
Poli
Fisc
Poli
l Policy
cy
cy
al
al
Polic
y
Sustainable Economic
Growth
Balanced Balance of Tinbergen Low & Stable Inflation

Payments
Low Unemployment
Exchange Fisc
Rate Supply – Side
Policy Policy

12.5 Evaluating Government Policies: Important Important

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12.

5 Evaluating Government Policies

• Higher interest rates, higher exchange rates, lowers cost of

• Higher interest rates, higher exchange rates, higher cost of

• Restricting monopoly power, more competition; greater efficiency;

• Supply side economics is a LONG TERM policy - Its takes TIME – to

• Greater freedom from industry may result in damage to the

Balanced Balance of Tinbergen Low & Stable Inflation

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