2.6.2 Demand-side policies

Question 1

What are the two different types of policies that a government can use?

Answer 1

• Demand-side policies
• Supply-side policies

Question 2

Aim of demand-side policies

Answer 2

To shift AD in an economy.

Question 3

Aim of demand-side policies

Answer 3

To shift AD in an economy.

Question 4

What are the two different types of demand-side policies?

Answer 4

• Fiscal Policy
• Monetary Policy

Question 5

Fiscal policy

Answer 5

Fiscal policy involves the use of government spending and taxation to influence AD.

• The government is responsible for setting fiscal policy.
• The UK government presents their fiscal policies to the country each year when it delivers the budget each year.

Question 6

Monetary policy

Answer 6

Monetary policy involves adjusting interest rates and the money supply to influence AD

• The Bank of England’s Monetary Policy Committee is responsible for setting monetary policy.

Question 7

Interest rates

Answer 7

The cost of borrowing / return for lending money.

Question 8

Monetary policy

Answer 8

Monetary policy involves making decisions about interest rates, the money supply and exchange rates.

Question 9

Is monetary policy a demand-side or supply-side policy?

Answer 9

Demand side policy, because it impacts AD.

Question 10

Most important tool of monetary policy

Answer 10

The ability to set interest rates.
- Changes to interest rates affect borrowing, saving, spending and investment.

Question 11

Types of monetary policy

Answer 11

• Contractionary (‘tight’)
• Expansionary (‘loose’)

Question 12

Contractionary monetary policy

Answer 12

Contractionary monetary policy involves reducing aggregate demand (AD) using high interest rates, restrictions on the money supply, and a strong exchange rate.

Question 13

Expansionary monetary policy

Answer 13

Expansionary monetary policy involves increasing aggregate demand (AD) using low interest rates, fewer restrictions on the money supply, and a weak exchange rate.

Question 14

Main aim of monetary policy in the UK

Answer 14

To ensure price stability – i.e. low inflation.

• It also aims to promote economic growth and reduce unemployment.

Question 15

Two main instruments of monetary policy

Answer 15

• Adjustments to interest rates
• Quantitative easing (which increases the supply of money in the economy)

Question 16

What happens if the UK misses the inflation target?

Answer 16

If the inflation rate misses the 2% target by more than 1% in either direction (i.e. if it’s less than 1% or more than 3%), then the governor of the Bank of England has to write to the Chancellor.

Question 17

What would the Bank of England do to interest rates if inflation increases?

Answer 17

They would likely increase interest rates, to reduce consumption in the economy. It would increase consumption.

If AD is lower, then demand-pull inflation will decrease.

Question 18

Benefit of the independence of the BoE

Answer 18

The Bank of England’s independence means that interest rates can’t be set by the government at a level that will win votes, but which might not be right for the economic circumstances at the time.

Question 19

How is the BoE accountable?

Answer 19

If the inflation rate is more than 1% away from the target rate (either above or below), then the Bank’s governor must write an open letter to the Chancellor explaining why, what action the MPC is going to take to deal with this, and when they expect inflation to be back to within 1% of the target.

Question 20

What data will the BoE’s MPC use to make a decision about interest rates?

Answer 20

• House prices
• The size of any output gaps
• The pound’s exchange rates
• The rate of any increases or decreases in average earnings

Question 21

Likely effects of an increase in interest rates

Answer 21

• Less borrowing
• Less consumer spending (less consumption)
• Less investment by firms
• Less confidence among consumers and firms
• More saving
• A decrease in exports
• An increase in imports

Question 22

Likely effects of an decrease in interest rates

Answer 22

• More borrowing
• More consumer spending (less consumption)
• More investment by firms
• More confidence among consumers and firms
• Less saving
• An increase in exports
• An decrease in imports

Question 23

What happens to monetary policy when consumer confidence is low?

Answer 23

It becomes ineffective - if consumer confidence is low, they will be less willing to spend in the economy or take out loans, despite changes to interest rates.

Question 24

Bank of England’s base rate

Answer 24

The lowest rate at which the Bake of England will lend to financial institutions. | This is not the rate of interest that you’d pay if you applied to a high-street bank for a loan or mortgage.

• If the base rate goes up, then that will usually lead to interest rates charged on mortgages and bank loans also increasing. The same happens in reverse if the base rate falls.
• Banks often need to borrow the money that they lend out to firms and consumers from other lenders. If lots of banks are trying to borrow money at the same time, then they’ll have to pay a higher rate of interest themselves, which will affect the cost of mortgages and loans they offer to consumers.

Question 25

How does QE affect the money supply?

Answer 25

QE increases the money supply, which will enable individuals and firms to spend more.

Question 26

How does QE work?

Answer 26

The Bank of England buys back treasury bonds and bills owned by financial institutions (such as mortgage companies or banks).

This improves the liqudity of these financial institutions as assets on their balance sheets become liquid money.

This was done with the hope of firms spending the money or lending it to other people to spend.

• QE was slow to work at first because the banks were still reluctant to lend money after the credit crunch. Instead they used it just to increase their reserves of money.
• Eventually these banks did begin to lend money to other firms and individuals – who used the money to, for example, invest in new machinery, start in new businesses or buy houses.
• All of this spending boosted AD and led to an increase in the rate of inflation.

Question 27

Danger of using QE

Answer 27

Financial institutions may initially use this ‘new money’ to pay out dividens to shareholders or increase their reserves, and only lend it out when the economy improves. This extra lending at a time when inflation may already be increasing can lead to demand-pull inflation becoming harder to control.

Question 28

Is monetary policy long-term or short-term?

Answer 28

Long term - it has a significant time lag.

In fact, the time lags between changes in the base rate and its effect on the economy can be very long term:
- The maximum effect on firms is usually felt after about one year.
- The maximum effect on consumers is usually felt after about two years.

Question 29

What are the two types of fiscal policy?

Answer 29

• Expansionary fiscal policy
• Contractionary fiscal policy

Question 30

Expansionary fiscal policy (sometimes called ‘reflationary’ or ‘loose’ fiscal policy)

Answer 30

Expansionary fiscal policy involves boosting AD by increasing government spending or lowering taxes. It is likely to involve a government having a budget deficit (government spending > revenue).

Question 31

Contractionary fiscal policy (sometimes called ‘deflationary’ or ‘tight’ fiscal policy)

Answer 31

Contractionary fiscal policy involves reducing AD by reducing government spending or increasing taxes. It’s likely to involve a government having a budget surplus (government spending < revenue).

Question 32

When is expansionary fiscal policy likely to be used?

Answer 32

During a recession or when there’s a negative output gap.

It will increase economic growth and reduce unemployment, but it’ll also increase inflation and** worsen the current account of the balance of payments** because as incomes increase, more is spent on imports.

Question 33

When is contractionary fiscal policy likely to be used?

Answer 33

During a boom or when there’s a positive output gap.

It will reduce economic growth and increase unemployment, but it’ll also reduce price levels (inflation) and improve the current account of the balance of payments because as incomes fall, less is spent on imports.

Question 34

What are the two types of fiscal policy?

Answer 34

• Discretionary policy
• Automatic stabilisers

Question 35

Discretionary policy

Answer 35

Where governments deliberately change their level of spending and tax.

At any given point a government might choose to spend on improving the country’s infrastructure or services, and increase taxes to pay for it.

On other occasions the government might take action because of the economic situation, e.g. during a recession the government might spend more and cut taxes to stimulate AD.

Question 36

Automatic stabilisers

Answer 36

Where a government’s fiscal policy automatically reacts to changes in the trade cycle.

During a recession, government spending will increase because the government will pay out more benefits.

The government will also receive less tax revenue (due to unemployment). These automatic stabilisers reduce the problems a recession causes, but at the expense of creating a budget deficit.

During a boom, the automatic stabilisers create a budget surplus as tax revenue increases and government spending on benefits fall.

Question 37

Austerity measures

Answer 37

Where governments raise taxes and reduce public spending to reduce the budget deficit.

Question 38

Strengths of Monetary Policy

Answer 38

• The Bank of England operates independently from the government (and the political process).
• The long-term outlook can be considered.
• Targets for inflation are set and it maintains a stable price.
• Depreciating the currency can increase exports.

Question 39

Weaknesses of Monetary Policy

Answer 39

• Conflicting goals. E.g. economic growth puts upward pressure on inflation.
• Time lags between policy and the desired impact (up to 2 years)
• Expansionary policy is less effective in negative output gaps than when used with positive output gaps. – consumers may not respond to lower interest rates when confidence is low.
• Cheaper credit can inflate asset prices in the long term.
• The interest rate has limitations on downward adjustment.

Question 40

Strengths of Fiscal Policy

Answer 40

• Spending can be targeted on specific industries
• Short time lag as compared with monetary policy
• Redistributes income through taxation
• Reduces negative externalities through taxation
• Increased consumption of merit/public goods.
• Short term government spending can lead to an increase in the LRAS. E.g. building a new airport immediately increases government spending and AD, but when it is built, the potential output will have increased.

Question 41

Weaknesses of Fiscal Policy

Answer 41

• Policies can change significantly as governing parties change, meaning long term infrastructure policies may lack follow-through.
• Increased government spending can create budget deficits. Repaying this debt may lead to austerity on future generations.
• Conflicts between objectives. E.g. cutting taxes to increase economic growth may cause inflation.