June 2020 Econ P2 Planning

Essay 1

Explain possible causes of a falling budget deficit

Position in the economic cycle: In a boom, the government is likely to reduce government spending as AD no longer needs boosting. Furthermore, spending too much in a boom could lead to crowding out. This is where the government borrows in order to spend -> this drives up the interest rate, which makes the cost of borrowing higher, reducing the incentive for firms to invest. Furthermore in a boom, the government is likely to have more tax revenue as AD is higher.

Decrease in unemployment: A decrease in unemployment, will mean that more people are working. This will not only mean that AD shifts right -> more spending -> more tax revenue, but also, the government will not need to pay as much in welfare and JSA payments, which could cause a falling budget deficit.

Growth in the economy: As the economy grows (AD/LRAS diagram), the real gdp is greater, which means that the government has more tax revenue from VAT since there is more consumer spending.

To what extent do you agree that reducing the budget deficit is more important to the UK macro performance than the C/A deficit on the BoP

High budget deficit will mean a increase of the national debt, which not only will increase the opportunity cost of future years, but will mean that future generations pay for current spending. Reducing the budget deficit will decrease the burden on future generations and mean that in future taxes won't have to be raised to pay for the accumulated debt.

A C/A deficit may not be harmful to economy if the economy is growing (AD/AS), as the main impact of a C/A deficit is that net exports is negative, detracting from AD, however if consumer spending and other components are growing, this isn't a large issue, so in this case a budget deficit is more important.

Not reducing the budget deficit could mean that in future the cost of borrowing increases. This is because the more the UK government borrows, the less confidence bond-purchasers have in the UK government. Running a consistently high budget deficit could mean that in an economic shock, or recesssion, the government is not able to borrow when it is most needed. Government borrowing can be said to have an opportunity cost of borrowing in future. Borrowing too much can mean deeper recessions a greater impact on the economy than just reducing government spending initially. This suggests that reducing the budget deficit is more important than reducing the C/A deficit.

Crowding out.

C/A deficit could indicate that the UK only has a comparative advantage in very few small sectors. This means that a C/A deficit could indicate an issue with the structure of the UK economy, and that the UK needs to invest in more supply side policies to become more efficient. Once the UK becomes more efficient, its C/A balance should improve which will mean that the government has succeeded at improving the UK economy, which not only benefits the C/A balance, but also will have the result of reducing inflation, and lowering the cost of living and raising the standard of living for the UK due to a more efficient economy. This would make improving the C/A deficit a good indicator of macro-economic performance.

Trying to reduce the budget deficit could lead to government failure, as the government doesn't want to spend as it will be seen as failing its macro-economic objectives, even in a recession where higher government spending is needed. The budget deficit is more likely to follow booms/recessions rather than indicating whether the government is properly managing debt and its finances. This would make a budget deficit a poor indicator of macro-economic performance.

Reducing the C/A deficit will lead to increase in AD, as in order to reduce the C/A deficit, net exports must be increased. An increase in AD would lead to growth and a reduction in unemployment. Additionally, reducing C/A may involve creating trade deals with other countries, which may lead to trade creation, where the UK is able to switch from one more expensive country to a cheaper one, since tarrifs have now been removed. This would mean cheaper imports which could shift the AS curve right, leading to further growth.

Whether the budget deficit is more important as an objective depends upon whether they are used in conjunction with other objectives. Both objectives are subject to failure if relied upon solely. For example, a C/A deficit could be solved by a large devaluation of the exchange rate, but this would be a solution through the "second best" approach, and would not actually improve the competitiveness of performance of the UK economy. Similarly, reducing a budget deficit is only really desirable in a boom / normal economic times, and if governments don't increase spending during a recession this could lead to less growth and worse economic performance. If reducing the budget deficit is only a goal during a boom, then it is likely to be more important than reducing the C/A deficit, as the C/A deficit could simply be an indicator than the UK is a rich country and hence has a large number of luxury imports.

Essay 2

Explain how demand side and supply side shocks might increase unemployment in an economy

Evaluate the view that the main objectives of the UK government macroeconomic policy can be achieved without conflicting with eachother

Education and Training can increase the supply of skilled labour in an economy, (keynesian LRAS / AD), which increases the spare capacity in an economy, reducing the costs for firms and hence reducing inflation, increasing employment and increasing growth. Lower costs of production should also lead to

Infrastructure Investment can increase geographic mobility of labour, which will decrease costs for firms, shifting LRAS right (classical LRAS / AD diagram), which will reduce inflation, increase growth reduce unemployment.

Expansionary monetary policy such as decreasing the IR can lead to an increase in AD. If an economy has spare capacity, such as in a recession, then (keynesian LRAS / AD with spare capacity), then this will not cause inflation, increase growth and employment.

Supply side policies such as Education & Training cost a large amount of money and this money will have to come from somewhere -> Most likely this is through higher taxes, such as VAT, which are regressive. This means that the distribution of income will worsen when supply side policies are used. Furthermore, many of the most highly paid dodge tax, which means they are not paying for the supply side policies, instead the burden of tax ends up impacting the poorest most, further worsening the distribution of income.

Supply side policies such as education and training cause a large growth in government spending. If these are used correctly, they will be used when there is not much spare capacity in the economy. However, due to the large time lag of these investments, AD will shift right immediately, whereas LRAS will not shift for likely many years. This could lead to temporary demand-pull inflation.

Decreasing IR can lead to a reduction of saving and increase of spending, increasing AD. However, if IR are kept high for too long, this can lead to consumers have very little savings and borrowing large amounts. An economic shock such as a spike in oil prices could cause the BoE to increase IR, which could lead to consumers defaulting on their loans, including their mortgages. This could cause a recession and hence a fall in consumer confidence.