2.6.2 Demand-side Policies Flashcards
What are the three types of policies
Which are demand-side and which are supply-side
Demand-side: Fiscal and Monetary Policy
Supply Side policies
What is Fiscal Policy
Policies that include Gov Spending, Taxation and/or borrowing to affect AD
What is monetary policy
Policies relating to interest rates, money supply and/or the exchange rate
What is supply-side policy
Policies that increase the productive potential of an economy, usually in relation to increase in quantity/quality of an economy’s factors or production
What is expansionary fiscal policy used for
- To boost economic growth
- Reduce (cyclic) unemployement
- Increased demand-pull inflation
- Redistribution of income
What is contractionary fiscal policy used for
- Reduce inflation - demand pull
- Reduce budget deficit/national debt
- Redistribution of income
- Reduce current account deficit
Gives examples of how expansionary fiscal policy works
- Reduction in income tax (in particular on lower income)
- Reduction of Corporation Tax
- Increase in Gov spending (reducing regressive taxes may have a bigger effect because lower income households have a higher MPC)
How would you show expansionary fiscal policy on a Keynesian AD/AS diagram
Expansion in AD outwards
What can expansionary fiscal policy also have an effect on
LRAS
lower taxes could move more economically active into employment = increased productivity
lower cooperation tax = higher investment, increasing the economy stock in capital
What are automatic stabilisers
Fiscal Policy tools to influence GDP and counter fluctuations in the economic cycles
It used:
1) Progressive Income tax
2) Welfare benefits
How do automatic stabilisers work in a boom
To cushion demand
- Increased income, pushes workers into higher tax bands, increasing average rate of tax, slowing down the rate of consumption
- Unemployment will be lower = less Gov spending on welfare benefits
How do Automatic stabilisers work in a recession
Support output
- Income falls, pushes workers into lower tax bands, decreasing the average rate of tax return, preventing a drop in consumption
- Increased welfare spending
What is discretionary fiscal policy
Deflationary policy onto of automatic stabilisers
What are the two biggest sources of Government revenue
Income tax
VAT
What is direct tax
is levied on income, wealth and profits
It includes income tax, inheritance tax, national insurance capital gains, and cooperation tax
This burden of tax cannot be passed on
What is indirect tax
examples: exercise duties on fuels, cigarettes, and alcohol and VAT
Producers may be able to pass on all tax depending on elasticity
UK income tax is progressive or regressive?
What is the tax-free allowance on income?
What are the rates on tax
prgressive
££12,570
20%, 40%, 45%
What is the standard rate of VAT
Which products have a reduced rate
Which products are VAT free
20% since 2011
domestic fuel + power, children’s cars seats, have a 5% rate
Food, house construction, books have a 0% VAT
What is monetary policy
Changes in interest rates, money supply and the exchange rates by central banks in order to influence AD
What is the use of expansionary monetary policy
- Increase demand-pull inflation
- Economic growth
- Reduced unemployment
What is the use of contractionary Monetary policy
- Reduced inflation
- Prevent excessive house price growth and credit in the economy
- Reduced excess debt + promote saving
- Reduce current account deficit = less income spent on imports
What is the transmission mechanisms
various channels affecting variables in AD
Describe the expansionary monetary policy transmission mechanism
- Decreased credit card interest rates = increased consumer spending
- Decreased saving rates = increased consumption
- Decreased Mortgage rates = increased consumption
- Decreased rates of business loans = increased investment
- Weaker exchange rate = increasing exports
Describe a graph for expansionary monetary policy
Expansion on AD
What can expansionary monetary policy also have an effect on
(besides AD)
LRAS
Increased Investment through lowered interest rates
Leads through increased long-run economic growth by increasing Net stock in capital
Evaluate expansionary monetary policy
- Demand pull inflation
- Current account deficit
- Interest rates have a lower band before they have no effect (liquidity trap)
- Negative impact on savers
- Time lag (18-24 months)
What does the effectiveness of monetary policy depend on
Depends on size of output gap (spare capacity)
Consumer + Business confidence
Banks are willing to lend or change in base vs interest rates
Size of rate cut
What is Quantitative easing (QE)
Involves the introduction of new money into the national supply by a central bank
The new electronic money is used to buy assets (mainly bonds) from financial institutions such as insurance, pensions and commercial banks
Where has QE been used
UK
USA
EU
Describe the transmission mechanism of QE
- New electronic money is created by the central banks
- This is used to buy assets e.g. bonds from financial institutions
- This increases price of bonds
- Causes interest rates to fall
- Increases liquidity in financial sector
- Incentives to lend more
- Causes a positive wealth effect, from rise in asset prices
What is the overall purpose of QE
to increase AD
What is the wealth effect
lower yield (interest) rates leads to higher share + bond prices
Leading to people feeling wealthier and therefore spending more
What is the borrowing cost effect
QE lowers interest rates on long term debt = Gov bonds and mortgages
What is the lending effect
QE increases the liquidity of banks, increases income and spending in the economy
What is the currency effect
lower interest rates have a side effect of causing the exchange rates to weaken = more competitive exports
Why would you use QE
In normal circumstance, you would just reduce interest rates
However liquidity trap means that interest rates are too low, they have no effect
A QE of £120Bn cut interest rates by
1%
Problems with QE
QE is not meant to be permanent
What happens if the reverse of QE happens
What policies were used after the 2008 Financial Crisis
Demand side
What were the key origins of the 2008 recession
- Sub-prime lending - leading to high risk home buyers
- Financial Innovations - e.g credit default swaps
- Asset Price bubbles - excessive asset growth in house pricing
- Regulator capture - failure of credit rating industries
What was the central Government response to the 2008 crisis
- Lower interest rates (expansionary monetary policy)
- QE
- Bank bailouts
- Financial Stimulus
Arguments in favour (expansionary) policies
- Prevent depression - strong fiscal + monetary stimulus to increase demand
- Create jobs - labor-intensive infrastructure having a positive multiplier effect
- Avoid price deflation = price + wages falling
- Support confidence - investment + consumption
Weakness/limits to the 2008 stimulus
- Keynesian liquidity trap
- Moral Hazard - bailing banks may allow them to become risker
- Savers - adverse effect of savers e.g. pensioners
- Rising property prices - wealth effect from QE and lower interest rates
