Real-world issue 2

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)

  • $\frac{\text{1}}{\text{1-MPC}}$ or
  • $\frac{\text{1}}{\text{MPS+MPT+MPM}}$
  • 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?