2.6.2 Demand-side policies Flashcards
What are the two different types of policies that a government can use?
- Demand-side policies
- Supply-side policies
Aim of demand-side policies
To shift AD in an economy.
Aim of demand-side policies
To shift AD in an economy.
What are the two different types of demand-side policies?
- Fiscal Policy
- Monetary Policy
Fiscal policy
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.
Monetary policy
Monetary policy involves adjusting interest rates and using quantitative easing to influence AD
- The Bank of England’s Monetary Policy Committee is responsible for setting monetary policy.
Interest rates
The cost of borrowing / return for saving
Economic effects of higher interest rates
- Consumer spending→ reduces effective disposable income
- Household saving → return on saving rises so higher MPS
- Investment → borrowing more expensive, less investment
- Exchange rates → appreciation of domestic currency due to hot money inflows , SPICED, decreases AD as spending on foreign goods rises
- Asset prices → fall in value, negative wealth effect, confidence falls
Factors considered when setting bank rate
- Rate of growth of Real GDP & estimated size of output gap
- Inflation forecasts
- Growth of business costs & wages
- Exchange rate
- Rate of asset price growth
- Confidence
- External factors → energy prices, inflation abroad
- Financial market conditions
Monetary policy
Monetary policy involves making decisions about interest rates, the money supply and exchange rates.
Is monetary policy a demand-side or supply-side policy?
Demand side policy, because it impacts AD.
Most important tool of monetary policy
The ability to set interest rates.
- Changes to interest rates affect borrowing, saving, spending and investment.
Types of monetary policy
- Contractionary (‘tight’)
- Expansionary (‘loose’)
Contractionary monetary policy
Contractionary monetary policy involves reducing aggregate demand (AD) using high interest rates, restrictions on the money supply, and a strong exchange rate.
Expansionary monetary policy
Expansionary monetary policy involves increasing aggregate demand (AD) using low interest rates, fewer restrictions on the money supply, and a weak exchange rate.
Main aim of monetary policy in the UK
To ensure price stability – i.e. low inflation.
- It also aims to promote economic growth and reduce unemployment.
Two main instruments of monetary policy
- Adjustments to interest rates
- Quantitative easing (which increases the supply of money in the economy)
What happens if the UK misses the inflation target?
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.
What would the Bank of England do to interest rates if inflation increases?
They would likely increase interest rates, to reduce consumption in the economy. It would decrease consumption.
If AD is lower, then demand-pull inflation will decrease.
Benefit of the independence of the BoE
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.
How is the BoE accountable?
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.
What data will the BoE’s MPC use to make a decision about interest rates?
- House prices
- The size of any output gaps
- The pound’s exchange rates
- The rate of any increases or decreases in average earnings
Likely effects of an increase in interest rates
- 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
- Hot money inflows currency appreciates
Likely effects of an decrease in interest rates
- More borrowing
- More consumer spending (more consumption)
- More investment by firms
- More confidence among consumers and firms
- Less saving
- An increase in exports
- An decrease in imports
What happens to monetary policy when consumer confidence is low?
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.
Bank of England’s base rate
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.
How does QE affect the money supply?
QE increases the money supply, which will enable individuals and firms to spend more.
How does quantitative easing work (2)
- QE is a way of increasing liquidity by increasing supply of money.
- BOE artificially create money.
- use money to buy government debt in form of bonds.
- Government now owe BOE
- increases the supply of mount decreases cost of borrowing
- incentives forms/ consumers to borrow - Increases consumption and investment both components of AD.
Danger of using QE
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.
Is monetary policy long-term or short-term?
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.
What are the two types of fiscal policy?
- Expansionary fiscal policy
- Contractionary fiscal policy
Expansionary fiscal policy (sometimes called ‘reflationary’ or ‘loose’ fiscal policy)
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).
Contractionary fiscal policy (sometimes called ‘deflationary’ or ‘tight’ fiscal policy)
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).
When is expansionary fiscal policy likely to be used?
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.
When is contractionary fiscal policy likely to be used?
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.
What are the two types of fiscal policy?
- Discretionary policy
- Automatic stabilisers
Discretionary policy
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.
Automatic stabilisers
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.
Austerity measures
Where governments raise taxes and reduce public spending to reduce the budget deficit.
Strengths of Monetary Policy
- 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.
Weaknesses of Monetary Policy
- 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.
Strengths of Fiscal Policy
- 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.
Weaknesses of Fiscal Policy
- 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.
- It depends on the size of the multiplier. If the multiplier effect is large, then changes in government spending will have a bigger effect on overall demand.
Different types of taxes in the UK
Income tax, Council tax, Capital gains tax, National insurance contributions,
Excise duties on (Alcohol, Tobacco, Gambling and hydrocarbon fuels) meant to discourage demerit activities/ goods.
Uk’s different tax rates
over £12,500 - 20%
over £50,000 - 40%
over £125,000. - 45%
