2.6.2: Demand-Side Policies

Question 1

What is monetary policy?

Answer 1

Where governments control AD levels by altering monetary variables (e.g. amount of money in the economy).

Question 2

What is fiscal policy?

Answer 2

The use of taxes & government expenditure to manipulate AD levels.

Question 3

What are the monetary policy instruments?

Answer 3

-Interest rates.
-Quantitative easing.

Question 4

What are interest rates?

Answer 4

The cost of borrowing/reward for saving (expressed as a percentage).

Question 5

The Monetary Policy Committee (MPC) tries to ________ the base rate to cause a ________ in AD.

Answer 5

Reduce, rise.

Question 6

What are the mechanisms of interest rates?

Answer 6

-Rise in C: Saving is less attractive (due to a lower rate of return).
-Rise in C & I: Lower costs of borrowing.
-Rise in (X-M): Lower interest rates de-incentivise investors to hold their money in British banks. The value of the pound will be weaker, but net trade will rise.

Question 7

What are the limitations of interest rates?

Answer 7

-Changes take up to 2 years to have an effect.
-Lack of confidence will reduce the borrowing/lending rate no matter how low interest rates are.

Question 8

What is quantitative easing?

Answer 8

Where a central bank (e.g. the Bank of England) buys assets in exchange for money to increase money supply for banks.

Question 9

When is quantitative easing used?

Answer 9

When inflation is low & it isn’t possible to lower interest rates.

Question 10

What is meant by buying assets in quantitative easing?

Answer 10

Increasing the size of banks’ accounts (reserves), which encourages banks to lend more money.

Question 11

How does quantitative easing cause a positive wealth effect?

Answer 11

1. Banks purchase assets through electronic money.
2. Prices of assets rise, while interest adjust downwards.
3. This encourages banks to rebalance their portfolios by increasing investment in other assets with a higher interest rate.
4. Lower interest rates reduce borrowing costs for business (stimulus for borrowing/spending).
5. Owners experience an increase in their wealth, confidence & spending.
6. This positive effects of this may then spread out to the real economy.

Question 12

What are the limitations of quantitative easing?

Answer 12

-Risky, and can cause inflation/hyperinflation. The flood of cash in the market may encourage reckless financial behavior and increase prices.
-QE can create asset bubbles, which are unsustainable increases in the prices of certain assets, such as stocks or housing, that can burst and cause financial instability.
-Causes a greater wealth inequality, as the owners of assets benefit from price rises.

Question 13

What is government spending?

Answer 13

The expenditure of governments.

Question 14

What does a rise in government spending result in?

Answer 14

A rise in AD.

Question 15

The government can ________ the ________ of the circular flow of income.

Answer 15

Influence, size.

Question 16

What are the limitations of government spending?

Answer 16

-Cutting government spending to reduce AD also reduces the quality of AS, due to a cut in investment costs.
-If the economy is close to full capacity, then higher government spending may cause inflationary pressures and little increase in real GDP.

Question 17

What is a fiscal/budget deficit?

Answer 17

When the government spends more than they receive.

Question 18

What is a fiscal/budget surplus?

Answer 18

When the government spends less than they receive.

Question 19

What is taxation?

Answer 19

A financial contribution made to the government.

Question 20

What can tax revenue be used for?

Answer 20

Government expenditure.

Question 21

What are the limitations of taxation?

Answer 21

-Causes opposition.
-Reduces economic growth, as it reduces the incentives for work, investment, & entrepreneurship.

Question 22

What is direct taxation?

Answer 22

Taxes payed directly by the taxpayer.

Question 23

What is indirect taxation?

Answer 23

When the economic agent charged with the tax passes the tax onto someone else (e.g. firms can pass on the burden of indirect tax to the consumer).

Question 24

What is an example of direct tax?

Answer 24

Income tax.

Question 25

What is an example of indirect tax?

Answer 25

VAT.

Question 26

What does AD1 -> AD2 mean for government spending?

Answer 26

Rise in fiscal/budget deficit due to an increase in government spending.
Expansionary fiscal/budget policy.

Question 27

What does AD2 -> AD1 mean for government spending?

Answer 27

Fall in fiscal/budget deficit due to a decrease in government spending.
Contractionary fiscal/budget policy.

Question 28

What was the Great Depression?

Answer 28

A global depression that initiated in 1929. By 1933, real GDP fell by 30%, and the unemployment rate rose by 25%. It lasted over a decade.

Question 29

What were the causes of the Great Depression?

Answer 29

-Wall Street Crash: sharp fall in share prices on the New York Stock Exchange.
-US Banking System: lent too much in the 1920’s, creating an unsustainable boom.
-Loss In Confidence: decreasing consumption and investment.
-Protectionism [USA]: reducing world trade.
-Gold Standard [UK]: overvalued exchange rate, with exports reducing.

Question 30

What was the USA response to the Great Depression?

Answer 30

-Roosevelt’s New Deal: work schemes for the unemployed and fiscal stimulus.
-WWII- The US employment rate fully recovered in 1943.

Question 31

What was the UK response to the Great Depression?

Answer 31

-Balancing the budget: cut unemployment benefits and raised income tax.
-High interest rates: maintaining the pound (came under scrutiny).
-Leaving the Gold Standard: 1931 (also cut interest rates).

Question 32

What was the Financial Crisis?

Answer 32

A global recession that initiated in 2008, also started in the USA, but was less severe than the Great Depression.

Question 33

What were the causes for the Great Depression?

Answer 33

-Mortgage Lending: poor people were encouraged to take out mortgages (moral hazard, as mortgage sales saw bonuses for bank workers). They were given low interest rates that skyrocketed. Houses were repossessed and demand fell. Prices fell and house value was less than mortgage value.
-Grouping: ‘prime’ mortgages (pay back) and ‘sub-prime’ mortgages (struggle to pay back). Selling packages to banks and investors as if they were all ‘prime’ mortgages.
-Loss In Confidence: banks stopped lending. Lehman Brothers failed, and people withdrew from banks.

Question 34

What was the USA & UK response to the Financial Crisis?

Answer 34

-Nationalisation: banks. They guaranteed savers their money to prevent a collapsed system.
-Expansionary monetary policy: low interest rates, quantitative easing.
-Expansionary fiscal policy [USA]: recovered faster.

Question 35

What is the Classical evaluation of demand-side policies?

Answer 35

-Only causes inflation in the long run.
-Time lags.
-Ineffective if there is no spare capacity.

Question 36

What is the Keynesian evaluation of demand-side policies?

Answer 36

+Only way to get the economy out of disequilibrium.
+Positive multiplier.
-Depends on spare capacity.