2.6) macroeconomic policies and objectives

Question 1

why do governments intervene in an economy?

Answer 1

Governments intervene in the economy in an attempt to improve its economic performance.

Question 2

what are the 4 key macroeconomic objectives?

Answer 2

economic growth, low unemployment, low and stable inflation, balance of payment equilibrium on the current account

Question 3

what is the long run trend growth of the uk?

Answer 3

In the UK, the long run trend of economic growth is about 2.5%.

Question 4

what do governments aim to have as an unemployment rate?

Answer 4

they aim for a rate of 3% which includes the frictional unemployment ie unemployement between jobs

Question 5

what is the government target for inflation and what is the purpose of this?

Answer 5

In the UK, the government target is 2%, measured by

CPI. This aims to provide price stability for firms and consumers and will help them make decisions for the long run.

Question 6

what are demand side policies designed to do?

Answer 6

Demand side policies are policies designed to manipulate consumer demand.

Question 7

what is expansionary policy ?

Answer 7

Expansionary policy is aimed at increasing AD to bring about growth

Question 8

what is deflationary policy?

Answer 8

deflationary policy attempts to decrease AD to control inflation.

Question 9

what is monetary policy?

Answer 9

Monetary policy is where the central bank or regulatory authority attempts to control the level of AD by altering base interest rates or the amount of money in the economy.

Question 10

what is fiscal policy?

Answer 10

Fiscal policy is use of borrowing, government spending and taxation to manipulate the level of aggregate demand and improve macroeconomic performance.

Question 11

what is the repo rate?

Answer 11

the interest rate the bank of England lends short term loans out to other banks and financial institutions

Question 12

how does a increase in the repo rate affect overall borrowing by firms and consumers?

Answer 12

an increase in the repo rate will make it more expensive for the high street banks to borrow at, as result they will need to increase their own interest rate to account for the rise, making it more expensive for the regular consumers

Question 13

what are the four key mechanisms in which a rise in the interest rate causes a fall in AD?

Answer 13

increase the cost of borrowing and makes savings more attractive, fall in the price of assets, people will be less confident, value of the pound will rise

Question 14

how does the rise in the cost of borrowing affect the AD?

Answer 14

The rise in interest rates will increase the cost of borrowing for firms and consumers. This will lead to a fall in investment and consumption, reducing AD.

Question 15

what are the two areas where consumption will be greatly reduced when the interest rate rises?

Answer 15

Two particular areas of consumption that will decrease are consumer durables (cars, fridges etc. ) and houses.

Question 16

how does the increase in the interest rate affect the level of saving?

Answer 16

Higher interest rates require higher rates of return for investment. this makes savings more attractive, as the interest earnt on them will be higher, perhaps more the investment itself

Question 17

how does the rise in the interest rate affect asset prices and what is the effect on AD?

Answer 17

Since less people are borrowing and more are saving, there is a fall in demand for assets such as stocks, shares and government bonds. This leads to a fall in prices for these assets. Therefore, consumers will experience a negative wealth effect since the value of their assets fall, which will lead to a fall in consumption. Moreover, investment is less attractive since firms are likely to see lower profits if prices fall. AD falls because of the fall in consumption and investment.

Question 18

how does the rise in the interest rate affect the consumer confidence and what is the effect on AD?

Answer 18

People will become less confident about borrowing and spending if interest rates rise. The fall in consumer and business confidence leads to a fall in consumption and investment, causing a fall in AD

Question 19

how is the level of disposable income affected by the rise in the interest rate and what is its affect on AD?

Answer 19

other loans, such as mortgages, will become more expensive to repay and so consumers have to dedicate more of their income to paying back these debts. This means they have less income to spend on
goods and services, so consumption will fall, causing AD to fall.

Question 20

how does the rise in the interest rate affect the value of the pound and what is the effect on AD?

Answer 20

Higher rates will increase the incentive for foreigners to hold their money in British banks as they can see a higher rate of return. As a result, there will be increased demand for pounds and the value of the pound will rise . This means that imports will be cheaper, and exports will be more expensive. This decreases net trade and therefore AD.

Question 21

what are the 6 main issues with the methods of demand management?

Answer 21

exchange rate change may cause exports fall and imports rise significantly causing trade deficit . 2) changes in interest rate takes 2 years to have full effect. 3)interest rate may also be so low already that any other decrease wont stimulate demand. 4) range of interest rates that arent affected by the bank rate 5) lack of confidence may mean even if interest rate is low people still may not borrow 6) high interest rates in long run will discourage investment and decrease LRAS

Question 22

what is quantitative easing?

Answer 22

This is when the Bank of England buys assets in exchange for money in order to increase money supply and get money moving around the economy during times of very low demand.

Question 23

why is quantitative easing useful?

Answer 23

It can prevent the liquidity trap, where even low interest rates cannot stimulate AD.

Question 24

what are the two ways of the bank to do quantitative easing and which is most effective?

Answer 24

One way of buying assets is for the Bank of England to simply increase the size of banks’ accounts at the Bank of England, called the ‘reserves’, which encourages them to lend money. another way is for the bank to purchase securities or bonds from private sector institutions such as insurance companies, pension schemes and banks. buying securities is more effective due to the fact when banks are worried about people defaulting they wont lend out no matter the size of their accounts.

Question 25

what are the effects of quantitative easing ?

Answer 25

Quantitative easing has the effect of increasing consumption and investment, which increases AD and ensures the country meets its inflation target

Question 26

how does quantitative easing influence asset prices and its effect on consumption?

Answer 26

Since the bank is buying assets, there is a rise in demand and so asset prices rise. This causes a positive wealth effect since shares, houses etc. are worth more so people will increase their consumption. Moreover, the cost of borrowing will decrease as higher asset prices mean lower yields (money earnt from assets), making it cheaper for households and businesses to finance spending.

Question 27

how does quantitative easing influence the money supply and its effect on consumption?

Answer 27

the money supply increases . Private sector companies receive more money which they can spend on goods and services or other financial assets, which may increase investment or consumption and therefore increase AD. It may also push asset prices up further. Banks have higher reserves, meaning they can increase their lending to households and businesses so both consumption and investment increase as people can buy on credit.

Question 28

what is the effect of quantatitive easing on the interest rate?

Answer 28

Commercial banks may lower their interest rates as they are receiving so much money from the Bank of England and so can offer very low interest deals to their customers. The increased money supply will mean that the price of money falls; interest rates are the price of money. This will encourage borrowing, and therefore increase investment and consumption so increase AD. If many banks decide to lower their interest rates, the same mechanisms will apply as those following a reduction in the base rate.

Question 29

what are the 5 main problems with quantitative easing?

Answer 29

1)very risky, if not managed correctly could cause high inflation or hyper. 2)it may only lead to increased demand for second hand goods ( does not increase demand for new build houses, only pre existing) which pushes up price. 3)no guarantee that high asset prices lead to higher consumption (dependent on confidence). 4)large effect on housing market which could lead to bubbles, also increases share prices causing inequality as rich get richer,5) not a permanent solution however countries in eurozone becoming dependent on its use

Question 30

what is the fisher equation?

Answer 30

money supply x velocity of money= price level x quantity of goods sold

Question 31

what quantity in the fisher equation is assumed to be fixed?

Answer 31

the velocity of money

Question 32

what is the significance of the fisher equation in keeping prices stable?

Answer 32

as the velocity of money and the countrys output of goods are assumed to be constant, then any increase in the supply of money will just increase prices

Question 33

how can the central bank control the money supply?

Answer 33

the central bank can force banks to hold certain assets as a percentage of their total assets, known as reserve assets. this means they can control the amount of money loaned out. the central bank can also restrict the amount of money they lend out and who they lend too

Question 34

what is the role of the bank of england?

Answer 34

Monetary policy is controlled by the Bank of England rather than the government.

Question 35

what is the monetary policy committee (MPC)

Answer 35

The Monetary Policy Committee (MPC) makes the most important decisions, including the Bank of England base rate and the actions over quantitative easing.

Question 36

what is the main aim of the monetary policy committee?

Answer 36

Their main aim is keep inflation at 2% and if it goes below 1% or above 3% the governor of the Bank of England has to write a letter to the Chancellor of the
Exchequer explaining why this is happened and what the Bank of England is doing to bring it back to the target. They use CPI in order to see whether this target has been met.

Question 37

what is fiscal policy?

Answer 37

Fiscal policy refers to the use of government spending and tax policies to influence economic conditions, especially macroeconomic conditions, including aggregate demand for goods and services, employment, inflation, and economic growth.

Question 38

what are the two ways the government can increase AD using fiscal policy?

Answer 38

1) A rise in income tax will cause a fall in disposable income. This will lead to a reduction in consumption and thus decrease AD. Alternatively, a rise in corporation tax will decrease a firm’s post-tax profits. This will lead to a reduction in investment and thus decrease AD.
2) A rise in government spending will increase AD since it is one component.

Question 39

what is a budget defecit?

Answer 39

A budget deficit is when the government spends more money than they receive.

Question 40

what is a budget surplus?

Answer 40

A budget surplus is when the government receives more money than they spend.

Question 41

what are direct taxes?

Answer 41

Direct taxes are paid directly to the government by the individual taxpayer.

Question 42

what are indirect taxes?

Answer 42

An indirect tax is where the person charged with paying the money to the government is able to pass on the cost to someone else i.e. the supplier can pass on the burden of the indirect tax to the consumer

Question 43

what are the 4 highest revenue raising taxes for the government?

Answer 43

The four highest revenue raising taxes are income tax, national insurance, VAT and corporation tax .

Question 44

how much does income tax make up of total government revenue?

Answer 44

Income tax is a direct tax and is the biggest source of revenue for the government, around 25% of all taxation revenue.

Question 45

what is vat?

Answer 45

VAT is an indirect tax and the standard rate of VAT is 20%. Not all goods pay the standard rate, for example food and children clothes aren’t charged and domestic
fuel/power are charged 5%.

Question 46

what is austerity?

Answer 46

strict economic policies that a government imposes to control growing public debt, defined by increased frugality.

Question 47

what are the problems when evalutating fiscal policy?

Answer 47

1)Government spending also impacts LRAS. For example, by cutting government spending to reduce AD, the government may be reducing the quality of education or spending on research and technology. 2)Taxes and spending have an impact on inequality, so some decisions aimed to reduce/increase demand may increase income inequality. 3) political issues (raising taxes/cutting public spending are unpopular) 4)Expansionary fiscal policy is difficult to undertake during a period of austerity. 5) The impact of fiscal policy depends on the multiplier: the bigger the multiplier, the bigger the impact on AD.

Question 48

what do classical economists think about demand side policys?

Answer 48

Classical economists argue that any demand management, whether fiscal or monetary, will have no effect on long-run output so supply side policies should be used. They believe that increasing AD during a depression will have no effect other than to increase prices. If the economy is in short-run disequilibrium, it will quickly return to long run equilibrium.

Question 49

what do Keynesian economists think about demand side policys?

Answer 49

On a Keynesian LRAS, the impact of changes in AD depend on where the economy is operating : if the economy is at full employment then a rise in AD will
only lead to higher prices. However, if unemployment is very high, then a rise in AD will only lead to higher output.

Question 50

what is the biggest issue with demand side policies?

Answer 50

The biggest issue of demand-side policies is that, in most cases, an expansionary policy is inflationary whilst a deflationary policy brings unemployment. This
depends on the elasticity of the curve and the curve which you perceive to be correct (Keynesian or classical), but holds in most scenarios. Thus, through demand management, the government cannot bring about both low and stable inflation and high economic growth/low unemployment.

Question 51

what is a pro about using monetary policy rather than fiscal and what side of economists favour it and why?

Answer 51

Monetary policy is useful as the government is able to increase demand without having to increase their spending, which would result in a larger fiscal deficit.
Classicists argue that if demand management is going to be done only monetary policy should be used.

Question 52

what is a pro about using fiscal policy over monetary policy?

Answer 52

Fiscal policy can have significant impacts on the supply side of the economy, for example increases in spending on education to increase AD will also increase LRAS. Moreover, it is more effective at targeting specific groups and reduce poverty, for
example by increasing benefits it can increase AD and reduce inequality.

Question 53

what was the great depression?

Answer 53

In the 1930s, the world experienced a severe depression known as the Great Depression- in the UK, unemployment was over 15% and in the US it was almost 25%. The areas most affected in the UK were the primary industry and the manufacturing industry which relied on exports and so were impacted by the collapse of world trade.

Question 54

what caused the great depression?

Answer 54

1)wall street crash of 1929 2) loss of consumer confidence and buissness confidence 3) US banking system 4) protectionism 5) Gold standard

Question 55

what event set off the great depression?

Answer 55

The Great Depression was set off by the Wall Street Crash of 1929 when there was a sharp fall in share prices on the New York Stock Exchange

Question 56

why was the loss of consumer confidence and business confidence a cause of the great depression?

Answer 56

the loss of consumer and business confidence: shareholders lost money in the crash, others became worried about what would happen, and firms cut back investment which led to a downward spiral in
AD.

Question 57

why was the US banking system a cause of the great depression?

Answer 57

Banks had lent too much during the 1920s, which had created an unsustainable boom and the system
was unable to deal with issues following the crash. The government allowed banks to fail after the crash, which decreased confidence further and reduced loans to
businesses and consumers, causing a fall in AD.

Question 58

why was the protectionism a cause of the great depression?

Answer 58

protectionism reduced world trade which decreased AD and lowered confidence. Firms involved in
exports were no longer able to pay bank their loans, which caused bank failures in the USA. America introduced the Smoot-Hawley Tariff Act in 1930 which decreased imports to the USA. Countries which traded with America saw a reduction in exports which decreased in AD in their countries. American also suffered from a fall in exports as other countries retaliated.

Question 59

why was the gold standard a cause of the great depression?

Answer 59

The UK was also affected by its commitment to the gold standard, in which its currency was fixed to the value of gold and therefore fixed to other currencies. It left the gold standard in 1914 but re-joined in 1925 at the 1914 level and value, despite the fact the value of the pound had fallen. The rejoining of the gold standard meant the pound was appreciated rapidly and exports fell as they became more expensive.
The UK went into the Great Depression with an overvalued exchange rate.

Question 60

what was the UKs policys responses to the great depression?

Answer 60

The UK government believed that balancing the government budget was key to recovery and that borrowing money would prevent the private sector from doing so. they started austerity measure cutting public spending by 10% and raised income tax to 25%.. the uk was forced to leave the gold standard which reduced value of pound by 25% allowing BoE to cut interest rates by 2.5%.

Question 61

what was the US policy responses to the great depression?

Answer 61

franklin Roosevelt initiated his new deal which promised public sector investment, work schemes for the unemployed and fiscal stimulus. this was a Keynesian expansionary fiscal policy

Question 62

how was mortgage lending in the US a cause for the 2008 crisis?

Answer 62

In the early 2000s, relatively poor people were encouraged by the government and banks to take
out mortgages to buy their own homes. This was an example of moral hazard, as the bank workers saw higher bonuses for selling more mortgages. They were given low interest rates on the loan for the first few years, but many were no longer able to continue paying with the higher repayments. Houses were repossessed, demand fell, and prices fell meaning the value of the houses was now less than the mortgage of
the house. This is known as negative equity.

Question 63

how was the mixing of prime and sub prime mortgages a cause of the 2008 crisis?

Answer 63

banks had been grouping ‘prime’ mortgages (people who were likely to pay back their loans) and ‘sub-prime’ mortgages (those who weren’t) and selling packages to other banks and investors as if they were all prime mortgages. The aim was to reduce risk since it meant no bank was highly dependent on risky
mortgages. However, it increased risk as many were now holding assets worth less than they had paid for them; it spread the effects of the housing crash and the unpaid loans.

Question 64

how was the fall in confidence a cause of the 2008 crisis?

Answer 64

there was a fall in confidence and banks stopped lending between each other, fearing that they would lose money if the other bank were to collapse. Similar events occurred in the UK, Ireland, Spain and Portugal. Northern Rock Building Society was the first affected in the UK in 2007 with too many loans not being repaid, and savers beginning to withdraw their money. In 2008, Lehman Brothers, an investment bank, was allowed to fail. This caused panic as people believed bank after bank would be allowed to collapse, leading to losses for savers.

Question 65

what were the policy responses to the 2008 crisis?

Answer 65

governments were forced to nationalize banks and building societies and guarantee savers their money in order to prevent the chaos of a collapsed banking
system. They used expansionary monetary policies with record low interest rates and quantitative easing. The BoE said the QE led to lower unemployment and higher growth than would otherwise have been the case. the USA government had a more expansionary fiscal policy and this is perhaps why it recovered faster. In 2010, the UK prioritized reducing National Debt over providing a fiscal stimulus, but the USA did not make this decision until 2013.

Question 66

what are supply side policies?

Answer 66

Supply side policies are government policies aimed at increasing the productive potential of the economy and moving the supply curve to the right.

Question 67

what are market based policies?

Answer 67

Market based policies are policies which are designed to remove anything that prevents the free market system working efficiently, causing lower output and higher prices. These barriers include those which reduce willingness of workers to take jobs or lead to inefficient production, high prices or a lack of risk taking.

Question 68

what are interventionist policies?

Answer 68

Interventionist policies are policies designed to correct market failure, for example the free market under provides education and so the government provides it. Also, firms may only look into the short term and look to maximise short run profits to give to shareholders instead of investing, so governments may take actions to encourage investment.

Question 69

what type of policies do free market economists believe is best ?

Answer 69

they believe that market based policies are best as they believe the government should play a minimal role in the market.