Real-world issue 2: How do governments manage their economy and how effective are their policies?
Conceptual understandings
Government intervention attempts to achieve macroeconomic objectives through a choice of policies.
Political, economic, social and environmental factors are interdependent and will influence the effectiveness of government policies.
Key concepts: scarcity, choice, efficiency, equity, economic well-being, sustainability, change, interdependence, intervention.
3.5 Demand management (demand-side policies)—monetary policy
Monetary policy
Control of money supply and interest rates by the central bank
Goals of monetary policy
Low and stable rate of inflation
Inflation targeting
Low unemployment
Reduce business cycle fluctuations
Promote a stable economic environment for long-term growth
External balance
The process of money creation by commercial banks (HL only)
Tools of monetary policy (HL only)
Open market operations
Minimum reserve requirements
Changes in the central bank minimum lending rate (base rate/discount rate/refinancing rate changes)
Quantitative easing
Demand and supply of money—determination of equilibrium interest rates (HL only)
Diagram (HL only): showing the determination of equilibrium interest rates
Real versus nominal interest rates
Calculation: real interest rates from given data
Expansionary and contractionary monetary policies to close deflationary/recessionary and inflationary gaps
Diagram: AD/AS curves showing expansionary and contractionary monetary policy
Effectiveness of monetary policy
Constraints on monetary policy, including:
limited scope of reducing interest rates, when close to zero
low consumer and business confidence
Strengths of monetary policy, including:
incremental, flexible and easily reversible
short time lags
Strengths and limitations in promoting growth, low unemployment, and low and stable rate of inflation
3.6 Demand management—fiscal policy
Fiscal policy
Sources of revenue—direct and indirect taxation, sale of goods and services from state-owned enterprises, sale of government assets
Expenditures—current expenditures, capital expenditures, transfer payments
Goals of fiscal policy
Low and stable inflation
Low unemployment
Promote a stable economic environment for long-term growth
Reduce business cycle fluctuations
Equitable distribution of income
External balance
Expansionary and contractionary fiscal policies in order to close deflationary/recessionary and inflationary gaps
Diagram: AD/AS curves showing expansionary and contractionary fiscal policy for both Keynesian and monetarist/new classical schools of thought
Keynesian multiplier (HL only)
MPC— marginal propensity to consume
MPS—marginal propensity to save
MPT—marginal propensity to tax
MPM—marginal propensity to import
Calculation (HL only): Keynesian multiplier
Calculation (HL only): the effect on GDP of a change in an injection in investment, government spending or exports, using the Keynesian multiplier
Effectiveness of fiscal policy
Constraints on fiscal policy, including:
political pressure
time lags
sustainable debt
crowding out (HL only)
Diagram (HL only): showing the crowding-out effect
Strengths of fiscal policy, including:
targeting of specific economic sectors
government spending effective in deep recession
Automatic stabilizers: progressive taxes, unemployment benefits (HL only)
Strengths and limitations in promoting growth, low unemployment, and low and stable rate of inflation
3.7 Supply-side policies
Goals of supply-side policies
Long-term growth by increasing the economy’s productive capacity
Improving competition and efficiency
Reducing labour costs and unemployment through labour market flexibility
Reducing inflation to improve international competitiveness
Increasing firms’ incentives to invest in innovation by reducing costs
Market-based policies, including:
policies to encourage competition, such as:
deregulation
privatization
trade liberalization
anti-monopoly regulation
labour market policies, such as:
reducing the power of labour unions
reducing unemployment benefits
abolishing minimum wages
incentive-related policies, such as:
personal income tax cuts
cuts in business tax and capital gains tax
Diagram: AD/AS model and LRAS curve to show the effect of supply-side policies
Diagram: showing minimum wage
Interventionist policies, including:
education, training
improving quality, quantity and access to health care
research and development
provision of infrastructure
industrial policies
Demand-side effects of supply-side policies
Supply-side effects of fiscal policies
Effectiveness of supply-side policies
Constraints on supply-side policies
Market based—equity issues, time lags, vested interests, environmental impact
Interventionist—costs, time lags
Strengths of supply-side policies
Market based—improved resource allocation, no burden on government budget
Interventionist—direct support of sectors important for growth
Strengths and limitations in promoting growth, low unemployment, and low and stable rate of inflation
Inquiry—possible areas to explore (not an exhaustive list)
The successes and constraints of fiscal policy in achieving low unemployment as a macroeconomic objective, for a chosen country.
The economic and social impacts on different stakeholders of monetary policy, for a chosen country.
Theory of knowledge questions
Can political beliefs and ideologies affect a person’s preference for one particular policy over another?
When evaluating economic policies, how important are cultural differences?
How much statistical data should economists use in determining the reliability of any economic policy result?
Economists and those who use economic theory may disagree with each other about the outcome of economic policies. On what basis might we make judgments about their relative conclusions?
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