Macroeconomics-IB

The circular flow of income model

Income going into the flow is called injections and income going out of the flow is known as
leakages.

Injections = G + I + X

Leakages = T + S + M

Equilibrium of national income is reached when (planned) Injections = (planned) Leakages.

The income in the circular flow is always equal to the national income, however this
equilibrium does not necessarily mean the economy is at full employment.
The business cycle

The business cycle also known as the trade cycle shows growth of an economy around the
long term trend (dashed line) measured by changes in GDP.

4 facts to know about the business cycle:

1. Boom/Peak is at point B:
o Rapidly rising inflation
o Shortage of factors of production (most probably labour)
o Rising property values
2. Trough is at points A and C:
o High unemployment
3. Recovery takes place after troughs right when GDP starts growing again:
o Falling unemployment
o Growing consumption/investment
o Possible rise in inflation
o Growing tax revenue (possibly falling government expenditure on e.g.
unemployment benefits)
4. Recession occurs when GDP falls for at least two consecutive quarters, hence takes
place shortly after booms/peaks (right when GDP begins decreasing):
o Rising unemployment
o Falling consumption and investment
o Increasing government expenditure and shrinking tax revenue
o Possible businesses’ bankruptcies
You must also know the distinction between a decrease in GDP and a decrease in GDP
growth. Decrease in GDP means that output of an economy is actually falling. Decrease in
GDP growth means that the output of an economy is still growing but at a slower rate.

2.1 Measures of economic activity (GDP; GNP;

GNI)
Definitions:

 GDP – Gross Domestic Product is the value of total output produced in an economy
over a period of time.
 GNI – Gross National Income is the value of total output produced in an economy
over a period of time and net income from abroad taken into account. (GNI = GDP +
net income from abroad)
 GNP – Gross National Product is the value of total output produced in an economy
over a period of time, net income from abroad taken into account and depreciation
(also known as capital consumption) taken away. (GNP = GNI – depreciation)
 “Green” GDP – Gross Domestic Products that takes into account the monetary value
of loss of biodiversity, damage done (costs) to the environment. (Green GDP = GDP –
costs to the environment)

3 methods to calculate GDP:

1. Income: Wages + Rent + Interest + Profit

2. Output: sum of 1st, 2nd, 3rd sectors’ outputs
3. Expenditure: C + I + G + (X – M) (see below)

Higher level students need to know how to calculate the national income using the
expenditure approach:

GDP = C + I + G + (X – M), where:

C – Consumption
I – Investment
G – Government expenditure
X – Exports
M – Imports

This will give you GDP at market prices. To get GDP at factor costs you add subsidies and
take away taxes:

Factor costs = market prices + subsidies – taxes (indirect e.g. VAT)

Problems with using GDP as a measure for economic activity:

 GDP does not take into account negative effects on the environment such as
pollution or use of natural resources
  Shadow economy (also known as black markets) is not taken into account including
those working illegally
 People who are doing unpaid work (volunteering or within a family) are not included
 Everything that is produced and consumed by people themselves is not included in
GDP (e.g. potatoes grown by Smith and consumed by his family are left unrecorded)
 Improvements in the quality of output produced are not considered

2.2 Aggregate demand

Aggregate demand consists of Consumption (C), Investment (I), Government spending (G),
Exports (X) and Imports (M)

AD = C + I + G + (X – M)

Definition: Aggregate demand is the total demand for goods and services in an economy at
different price levels.

Explanation of
why AD is downward sloping:

 As prices rise, demand for economy’s goods and services decreases. Goods become
less competitive internationally and people’s real income falls.

AD will shift if any of its components (C, I, G, X, M) change.

Consumption is affected by:

 Consumer Confidence
 Interest rates
  Personal Income taxes
 Household indebtedness
 Wealth

Investment is affected by:

 Interest rates
 Business confidence
 Technology
 Business taxes
 Level of corporate indebtedness

Government spending is affected by political and economic priorities.

Exports and Imports are affected by:

 Income of trading partners

 Exchange rates
 Changes in the level of protectionism
 Relative inflation rates

2.2 Aggregate supply

Definition: Aggregate supply is the total value of goods and services produced in an
economy over a given period of time.

Short Run Aggregate Supply (SRAS)

 SRAS slopes upwards
because as prices increase, it becomes more profitable for firms to increase their
output and new firms start producing.

Reasons why Short Run Aggregate Supply shifts:

 Changes in resource prices (labor, raw materials, etc.)

 Changes in business (corporate) taxes and subsidies
 Supply shocks

Long Run Aggregate Supply (LRAS)

 LRAS is vertical because the
economy is at its full capacity. It is impossible to increase production in response to growing
aggregate demand.

Monetarist/New Classical view: LRAS is vertical at full employment level of output at full
capacity and potential output. Potential output is based on factors of production quantity
and quality, hence the price level does not affect the Long Run Aggregate Supply.

Keynesian view: an economy has 3 different sections on the AS curve:

1. 0 to Y1 – enough spare capacity in the economy to increase production without

increasing costs.
2. Y1 to Y2 – also known as the “bottleneck” – the economy is approaching full capacity,
hence costs for hiring the scarce resources begin to rise.
3. Y2 – the economy is at full employment (in LR at full capacity), therefore attempts to
increase production will only cause price level to rise.
Reasons why Long Run Aggregate Supply shifts:

 Changes in the stock of resources (labor, land, etc.)

 Changes in technology
 Changes in quality of factors of production (leading to improvements
in efficiency/productivity)
 Institutional changes

2.2 Equilibrium
Equilibrium in the monetarist/new classical model

The diagram illustrates what takes place in an economy according to a monetarist when
aggregate demand increases. Assume the economy is in equilibrium at Y1P1, where AD1 =
SRAS1 = LRAS. AD shifts AD1 -> AD2. Firms respond to this increase in demand by increasing
their output (GDP Y1 -> Y2). Since the economy was already at full employment level of
income, the only way for firms to produce more is to make the existing factors of production
work overtime (e.g. ask for workers to come work on weekends). That requires to pay them
more, increasing costs of production and therefore raising the price level in the economy P1
-> P2. At P2Y2, where AD2 = SRAS1 short-run equilibrium is reached. The distance between
Y2 and Y1 is the inflationary gap that opened. It occurs when the real output of an
economy is above the potential output of the economy.

Monetarists believe that this situation is unsustainable and the economy will always come
back to full employment level of GDP. Eventually, people will figure out that even though
they are getting paid more to work overtime, the price level in an economy also rose. They
understand their real wage did not increase and the so called “money illusion” fades away.
That leads to short-run aggregate supply shifting SRAS1 -> SRAS2. Then a long-run
equilibrium at P3Y1 where AD2 = SRAS2 = LRAS is reached.

Changes in the long-run equilibrium can only occur when LRAS shifts. Long-run aggregate
supply shifts as a result of Supply-side policies implemented by the government and
reasons which can be found here.

Equilibrium in the Keynesian model

In the Keynesian model equilibrium can be at any level of income, where AD = AS. In the
previous (monetarist) model we saw that increases in AD result in inflationary gaps. In the
Keynesian model, increases in aggregate demand need not be inflationary. AD1 -> AD2 GDP
increased. However, the price level did not increase. As long as there is spare capacity in the
economy (e.g. unemployed workers) according to Keynesians increases in AD will not lead to
rising inflation (one does not need to offer higher wages for workers to come work). Yet,
when the economy approaches its full employment level of income (“bottleneck” and the
vertical part of the AS) then increases in AD will result in an inflationary gap. That will
happen because there will be little to none spare capacity (e.g. workers) left. Firms then
offer higher wages than their competitors to hire employees. Hence, production costs
increase and the price level in an economy rises P1 -> P2.
2.3 Macroeconomic objectives – Low
Unemployment
Definition: Unemployment – situation when people who are willing, able and available for
work are unable to find work.

Unemployment rate formula: (Number of unemployed people / Labour force) * 100%

Difficulties in measuring unemployment:

 Hidden unemployment (working people who are excluded from the measure of
unemployment because of the definition of unemployment)
 Underemployment (people want full-time jobs, yet are only able to get part-time
jobs)
 Regional, gender, age and ethnic disparities are not taken into account as it is an
average

Consequences of unemployment:

 Loss of GDP
 Loss of government revenue (tax)
 Cost to the government in the form of unemployment benefits
 Greater disparities in income distribution
 Various social problems (growing unemployment-related crime rates; higher stress
levels; homelessness)

Types of unemployment:

 Frictional – people are switching jobs

 Structural – people are out of job because their skills are no longer required (e.g.
technology improved and machinery replaced humans or consumer preferences
changed and a service/good is no longer produced)
 Seasonal – people are out of job because their workplace only operates seasonally
(e.g. skiing resorts)
 Cyclical (also known as Demand Deficient) – because of weak demand for various
goods and services, firms decrease their output and fire workers
 (Real-wage unemployment)

Cyclical unemployment can be seen here:

As aggregate demand falls from AD1 to AD2, unemployment increases by the amount Y1-Y2.
That is demand deficient unemployment.

On the Labour force diagram, cyclical (demand deficient) unemployment can be shown as
follows:

As individual firm’s demand falls, the firm decreases its output. Hence, the demand for
labour decreases D1 -> D2. Because wages do not fall, there appears an unemployment of
amount Q1-Q2 (the distance between D1 and D2 at wage W1).
Cures for frictional and seasonal unemployments:

 Cutting unemployment benefits – becomes less beneficial to stay unemployed

 Improving information – making it easier to find jobs

Cures for structural unemployment:

 Training schemes and education – help people re-specialise and gain skills which are
demanded
 Relocation – providing incentives to move to places where person’s skills are
required

Cures for cyclical unemployment:

 Expansionary fiscal and/or monetary policies aimed at increasing aggregate demand

—————————————————

There is also Natural Rate of Unemployment – it is also known as the equilibrium

rate. Mainly used by Monetarists and is referred to as the rate which exists at the full
employment level of income where the AS is vertical. Cure: Supply-Side Policies which would
shift the LRAS (Monetarist view) and the vertical AS part (Keynesian view) to the right.

The diagram above illustrates the Natural Rate of Unemployment, it is the Q2-Q1 (distance
between S and LF at wage W1). LF in this diagram is the Labour Force – people who are able
to work, however are unwilling at a given wage. It is converging to the Supply of labour,
because as wage increases people will eventually start to work. In theory, there must be a
wage at which everyone who is able to work will be willing to work.

2.3 Macroeconomic objectives – Inflation

Another macroeconomic objective is low and stable rate of inflation.

Definitions:

 Inflation is persistent increase in the price level of an economy over a period of

time.
 Disinflation is fall in the rate of inflation.
 Deflation – decrease in the price level of an economy over a period of time.
 Core or underlying rate of inflation – this measurement eliminates the effect of
volatile swings in the prices of e.g. food or oil.

Inflation is mostly measured using the CPI – Consumer Price Index. It measures the changes
in prices of a basket of goods and services consumed by an average household.

Weaknesses of the CPI:

 There is no such thing as an “average” household – different consumption patterns

lead to different CPIs
 Quality of goods/services provided is not taken into account

PPI or the Producer Price Index measures the changes in prices of factors of production
(capital, raw materials, etc.) and can be useful in predicting future inflation.

Consequences of inflation:

 Greater uncertainty that could lead to falling investment and consumption

 Redistributive effect – high inflation rate for savers means that the real interest rate
they are getting on their money placed in a bank is smaller; high inflation rate for
borrowers means the real interest rate they are paying because of their loan is
smaller
 Export competitiveness falls (provided other exporting countries do not experience
same or higher rate of inflation)
 Loss of purchasing power
 Shoe-leather costs (cost of searching for the best price)
 Menu costs (cost of constantly changing your goods’/services’ prices)

Even though students tend to remember shoe-leather and menu costs very well as negative
consequences of inflation, they should not be the main priority in any exam question. Leave
these small points for the last minutes of your exam when you are trying to squeeze out a
couple of extra points.

Consequences of deflation:

 High levels of cyclical unemployment and bankruptcies – when people see falling
prices, they believe they will keep falling and therefore, deter their spending. As a
 result, consumption falls and aggregate demand decreases, increasing demand
deficient unemployment and eventually causing firms to go out of business.

There are two types of inflation: cost-push and demand-pull.

Causes of demand-pull inflation:

 Lower tax rates

 Growing government spending
 Lower interest rates
 Growing consumer confidence
 Economic growth in other countries (leading to growing exports, hence increasing
AD)
 Depreciation of a country’s currency (leading to growing exports, hence increasing
AD)

The diagram above illustrates demand-pull inflation. You have to know the explanation of
why the price level starts rising as economy approaches the level of income of full
employment. It could be because of for example there being not enough labour anymore. A
firm wants to hire a worker however, is unable to because there aren’t any left. What does it
do? Offers a higher wage than the one he is already getting at another firm. That increases
the costs of production and so prices of goods and services (price level) rise P1 to P2.

Causes of cost-push inflation:

 Rising costs of production (capital, raw material and labour costs)

 Increased indirect taxation (e.g. VAT)
 Currency depreciation (leading to rising costs of production)
The causes mentioned above are illustrated in the diagram. Aggregate Supply falls meaning
it shifts up and price level increases P1 to P2.

Curing inflation
To cure inflation, governments can use contractionary fiscal (cutting government
expenditure and/or increasing direct taxes) and/or contractionary monetary policies
(raising the interest rates) to decrease aggregate demand. Also, supply-side policies could be
used. However, those mostly affect the economy in the (very) long-run. Therefore, there
would be little-to-none instant effect on the price level.

2.3 Macroeconomic objectives – Economic growth

One of the macroeconomic objectives is economic growth.

Definitions:

Economic growth is the realised increase in potential GDP of an economy over a period of
time. – it is important to know that there are a number of definition of what economic
growth is. Therefore, if exam question asks you to talk about economic growth, be very
careful how you define it.

This definition connects both of those below.

Actual growth which takes place when an economy is below full employment level of
income and moves towards its potential level of GDP (by employing more of its resources).

Potential growth occurs in the long-run and it is associated with the increase in quantity
and/or quality of factors of production (this shifts the vertical part of the Keynesian AS
curve; the vertical LRAS curve in a Monetarist diagram).
Also, see the diagram as you are required to know how to demonstrate economic growth
using a PPC (Production Possibilities Curve).

Actual growth is from point A to point B.

Potential growth is the shift of the PPC curve PPC1 to PPC2.

The definition of economic growth given above would be from point C to point D (“…realised
increase in potential…”)

Consequences of economic growth (which depend on the definition

chosen):
Positive:

 Higher living standards

 Government budget improvements
 Falling unemployment
 Growing income and consumption

Negative:

 Possible inflation
 Negative externalities (overall damage to the environment)
 Possible increase in current account deficit
 Rising Gini coefficient
2.3 Macroeconomic objectives – Equity in the
distribution of income
Due to unequal distribution of factors of production it is hardly possible for the market
system to result in equitable distribution of income. Even though inequality does provide
incentives for businesses to research and improve, the popular opinion is that
income/wealth should be redistributed from the rich to the poor. There are different ways
this can be done each having its pros and cons. That is the main discussion topic between
policy makers – ways and the amount of redistribution.

Indicators of income equality/inequality

Definitions:

 Lorenz curve – shows proportion of a population’s income that is earned by a given

percentage of the population.
 Gini coefficient – numerical measure of income inequality.

Lorenz curve above – the more the curve is bent the more unequal distribution of income.
The 45 degree curve shows complete equality – 1% of population receives 1% of
population’s income; 10% receives 10% and so on.

Gini coefficient’s formula: A / (A+B)

Gini coefficient values are between 0 and 1 (as can be seen from the formula above). The
lower the value of the coeffcieint the lower the inequality. The higher the value of Gini’s
coefficient the higher the inequality.

Promoting equity
The most popular way of redistributing income is taxation (and transfer payments). There
are 2 types of taxes:

 Direct taxes are those placed on people’s incomes and wealth

 Indirect taxes are those placed on producers (goods/services) who then attempt to
pass it onto consumers in the form of a higher price (e.g. VAT)

Taxes are:

 Progressive – the average rate of tax rises as the person’s income rises (e.g. most
income taxes, because of tax-brackets)
 Regressive – the average rate of tax decreases as the person’s income rises (e.g. tax
on fuel)
 Proportionate – the average rate of tax is constant

Taxes are the first step in the redistribution of income. The second step is for governments
to pass on the collected taxes to the poor. That is done using transfer payments which are
transfers of incomes from one person to another with no production taking place. Examples
of transfer payments include unemployment benefits, old age pensions, child allowances,
etc.

Governments can also use the collected taxes to provide socially desirable goods such as
free healthcare or free education, infrastructure including sanitation and clean water. That
makes those goods/services accessible to low income people which is also promotion of
equity.

Poverty
Absolute poverty – when a household’s income is below the poverty line (official World
Bank’s poverty line – 1.25$ a day).

Relative poverty – standard defined by the average income (required for a lifestyle in a
typical society) in a certain country.

Causes of poverty:

 Low incomes
 Lack of human capital
 Unemployment

Consequences of poverty:

 Low living standards (leading to higher levels of diseases, child mortality rates, etc.)
 Lack of access to healthcare
  Lack of access to education
 Poverty-related social problems

Higher level students:

You have to know how to calculate the marginal rate of tax and the average rate of tax from
a given set of data.

2.4 Fiscal Policy – The Government Budget

Sources of government revenue:
 Taxes:
o Direct taxes, such as income tax or corporate taxes
o Indirect taxes, for example – VAT
 Profit from state-owned enterprises which sell goods and/or services. For
example, public transportation in some countries is nationalised. Hence, the
earnings go to the government budget. (However, a lot of state-owned firms could
be (and usually are) very inefficient. Therefore, government might actually need to
draw from the government budget to keep those firms running.)
 Selling (privatising) state-owned enterprises. Government budget increases in the
short-run, but possible long-term earnings are given up.

Types of government expenditures:

 Current expenditures are those spent on goods/services and paying for factors of
production. E.g. wages, drugs for national health system, etc.
 Capital expenditures are those spent on assets and capital. E.g. building roads,
power stations, etc.
 Transfer payments are used for income redistribution. Examples of these include
unemployment benefits, pensions, etc.

The government budget outcome:

 Budget deficit is when the government expenditure is larger than the government
revenue. Budget deficits increase the public (government) debt.
 Budget surplus is when the government expenditure is smaller than the
government revenue. Budget surpluses decrease the size of the public (government)
debt.
 Balanced budget is when the government expenditure is equal to the government
revenue.
2.4 Fiscal Policy – The Role Of Fiscal Policy
See the previous revision notes on 2.4 Fiscal Policy – The government budget here.

Fiscal policy and short-term demand management

Fiscal policy – it is the use of government expenditure and tax rates to influence aggregate
demand.

Expansionary fiscal policy – increasing government expenditure and/or decreasing

taxes to increase aggregate demand. Used in attempts to close deflationary (recessionary)
gaps.

Contractionary fiscal policy – decreasing government expenditure and/or increasing taxes

to decrease aggregate demand. Used in attempt to close inflationary gaps.

Automatic stabilisers
Most economies have built-in stabilisers like unemployment benefits and progressive taxes.
When GDP grows, unemployment falls and wages rise. Lower unemployment means less
government spending on unemployment benefits and higher wages (as well as more
working people who pay taxes) mean more government income from progressive taxes. As
GDP falls, governments increase their spending on unemployment benefits and tax revenue
falls (because of falling wages and growing number of unemployed workers).

Fiscal policy and its impact on potential output

Fiscal policy can be used to create an environment for long-term economic growth:

 Investing in infrastructure (government-owned capital necessary for economic

activity to take place) e.g. roads, power stations, etc.
 Preparing the economy: liberalising laws for setting up business or hiring/firing
workers. That makes private firms more likely to invest and set up business in the
country.
 Providing incentives for firms to invest: for example, lower corporate tax rate is the
obvious incentive.

Evaluation of fiscal policy

Strengths of the fiscal policy:
  It can target certain sectors of the economy
 Government expenditure is a direct impact on the AD (it changes, various
determinants only influence the size of the effect)
 It is highly effective in a recession
 Small time lags (e.g. taxes are decreased, workers have more disposable income the
very next payday -> consume more right away.) Yet, this point is debatable!

Weaknesses of the fiscal policy:

 Political influence: where the government expenditure goes and taxes can be used
by politicians for electoral purposes
 “Crowding out” – governments borrow to increase their expenditure and offer a high
interest rate on their bonds. Private sector, in order to compete with the
government, increases its interest rate, thus discouraging private investment. This is
how government spending “crowds out” private investment.
 If taxes are decreased, people might start saving the extra income and the
expansionary fiscal policy does not work (or its effect is smaller). That might happen
because of belief that in the future taxes might go even higher than before, to
compensate for possible losses now.
2.5 Monetary Policy
Definitions:

 Monetary policy – it is the use of the interest rates (via manipulating the money
supply) to influence aggregate demand.
 Interest rates – rates at which borrowers are charged or lenders paid for their loan.
Typically expressed as an annual percentage.

Interest rate determination and the role of a central bank

The role of a central bank:

 Regulate the commercial banks

 Banker to the government – e.g. could issue bonds to finance government spending
 Usually responsible for interest rate determination (to achieve macroeconomic
objectives)
 Responsible for exchange rates (holds foreign currency reserves)

Interest rate determination:

Interest rates are determined by the supply and demand for money. Central banks are able
to manipulate the money supply and this way control the interest rate. In the given diagram,
the central bank increased the money supply S1 -> S2. We see that the final outcome was
falling interest rates r1 -> r2. If they had decreased the money supply, the interest rate
would have gone up.

The role of monetary policy

Monetary policy and short-term demand management

Expansionary monetary policy – decreasing interest rates in an attempt to increase
consumption and/or investment and thus, increase aggregate demand. Used to close
deflationary (recessionary) gaps.

Contractionary monetary policy – increasing interest rates in an attempt to lower

consumption and/or investment and thus, decrease aggregate demand. Used to close
inflationary gaps.

Monetary policy and inflation targeting

Most countries have a target inflation rate and reaching that target might be the main
macroeconomic objective (rather than full employment for example). Then the main
monetary policy objective is reaching and maintaining that inflation rate. For example, in
Eurozone, the target inflation rate is below but close to 2%.

Evaluation of monetary policy

Strengths of the monetary policy:

 Independence of the central bank means politicians are unable to influence its
decisions (e.g. before elections they might like to decrease interest rates to inflate
growth figures and take the credit)
 Interest rates can be adjusted incrementally
 Small time lag (especially in countries where the use of credit cards is high. The
interest rate on your credit card falls/increases and that might change your
consumption right away.) However, this point is highly debatable!
 Small time lags in the sense that central banks can change the interest rates quickly –
without the approval of government officials (whereas changing taxes requires
approval of the government). This point is also connected to the independence of
the central banks.

Weaknesses of the monetary policy:

 Consumption/Investment might be interest inelastic (even though interest rates

change by a large amount, consumption and/or investment does not respond by
that much)
 Conflicting government objectives – falling growth might require
expansionary monetary policy, however, high inflation could suggest contractionary
monetary policy is needed.
 Limited effectiveness when the economy is in a recession – instead of borrowing,
firms and consumers might simply repay the debts
2.6 Supply-Side Policies
The role of supply-side policies
Definition:

 Supply-side policies – are government policies aimed at increasing productivity and

shifting the LRAS curve to the right (increase the economy’s productive potential).
The aims of the supply-side policies are to positively affect the production side of the
economy by improving the institutional framework and the capacity (quality and quantity of
factors of production) to produce. Thus, supply-side policies shift the Long Run Aggregate
Supply curve (or the vertical part of the supply curve in the Keynesian model) to the right.

There are two types of supply-side policies:

1. Market based
2. Interventionist

Interventionist supply-side policies

1. Investment in human capital

Governments might invest in education and training of people. Improve the level of schools
or make education free. Also, provide various training schemes. In the short run, such
policies increase aggregate demand, but importantly – shift the LRAS curve to the right. This
happens because people’s skills improve. Hence, productivity increases.

2. Investment in new technology

Governments could invest in research and development of new technologies. Again, that
would increase aggregate demand in the short run, however, in the long run LRAS would
increase. That happens because new technology can increase productivity: e.g. 3D printers
made modelling or even production of various products quicker than ever.

3. Investment in infrastructure
Government expenditure might go towards infrastructure. Simple example – improving
logistics could decrease transfer times and costs in turn increasing productivity and shifting
the LRAS to the right. Remember the short term effect on AD!

4. Industrial policies
Governments might target specific economic areas through tax cuts, tax allowances and
subsidised borrowing which would promote growth of those areas. E.g. Useful startups
which could improve the efficiency of other areas of the economy.

Market-based supply-side policies

1. Policies to encourage competition

 Deregulation
 Privatisation
 Trade liberalisation
 Anti-monopoly regulation

2. Labour market reforms

  Reducing the power of labour unions
 Reducing unemployment benefits
 Removing minimum wages

All these reforms aim at making the labour market more flexible. E.g. When it is easier
and/or cheaper for firms to hire and fire workers, they will be more likely to hire.

3. Incentive-related policies
 Cutting the income tax – the idea is that your leisure becomes more expensive after
the tax cut and so you start working more. Refer to the Laffer curve and Substitution
vs Income effects.
 Cutting the business (corporate) tax – firms get to keep more of their profit, that is an
incentive to (take the risk) invest, find more efficient ways of production.

Evaluation of supply-side policies

All supply-side policies mentioned above can be evaluated in terms of:

 Time lags – some supply-side policies can take years to take effect (e.g. investing in
human capital), others – much shorter.
 Ability to create employment – think whether a certain policy creates employment.
E.g. investing in new technology can actually lead to technology substituting workers.
 Reducing inflationary pressure – can a certain policy help deal with high inflation? Try
not to make a rather unrealistic argument that “governments could invest in better
education and that would lead to higher productivity and eventually lower prices“. To see
the effects of that investment on inflation can take up to 15 years, so does it really
deal with inflation? Maybe in the very-very-long-run it does…
 Impact on economic growth – how certain policies can affect growth, which affect
growth more than others and why.
 Impact on the government budget – some policies may be very costly (investing in
infrastructure). However, privatisation might lead to short-term budget
improvements (but remember that possible long term benefits were given up!).
 Effect on equity – how will a certain policy affect the distribution of income? Think
about removing or changing the minimum wages, unemployment benefits.
 Effect on the environment – could deregulation lead to higher pollution or overall
quicker degradation of the natural environment? Think about policies which could
lead to increasing negative externalities.
Definitions
Economic Growth: Refers to increases in real GDP over time.