2.6.2 Demand-side policies

Question 1

What are demand side policies?

Answer 1

Demand-side policies aim to shift aggregate demand (AD) in an economy.

Question 2

What are the two categories of demand-side policies?

Answer 2

Fiscal policy and monetary policy.

Question 3

What is fiscal policy?

Answer 3

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

Question 4

What is monetary policy?

Answer 4

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

Question 5

Who is responsible for setting up the fiscal policy?

Answer 5

The UK government each year when it delivers the Government budget.

Question 6

Who is responsible for setting up the monetary policy?

Answer 6

The Bank of England (UK central bank) is responsible for setting monetary policy. The Bank’s Monetary Policy Committee meets 8 times a year to set policy.

Question 7

What are the two main instruments of monetary policy?

Answer 7

/Incremental adjustments to the interest rate (usually not more than 0.25%)
/Quantitative easing which increases the supply of money in the economy

Question 8

What are the fiscal policy instruments?

Answer 8

Government spending includes direct expenditure, but not transfer payments.

Question 9

What is the main source of revenue for the government?

Answer 9

Taxation.

Question 10

What are direct taxes?

Answer 10

Direct taxes are taxes imposed on income and profits. They are paid directly to the government by the individual or firm.

Question 11

What are indirect taxes?

Answer 11

Indirect taxes are imposed on spending. The supplier is responsible for sending payment to the government, for example VAT 20% tax.

Question 12

What happens at the bank of England meeting?

Answer 12

At this meeting they set the Bank Rate and discuss if quantitative easing is required (or should continue). It is decided by a majority vote.

Question 13

What is the most important target for the bank of England?

Answer 13

The single most important consideration in their deliberations is the inflation target of 2% CPI.

Question 14

What factors influence the bank of England’s decisions?

Answer 14

/Rate of real GDP growth (output gaps?)
/Current level of CPI inflation
/Unemployment figures
/The exchange rates
/Global outlook
/Business and consumer confidence

Question 15

What are strengths of the monetary policy?

Answer 15

/The Bank of England operates independently from the Government (political process)
/Is able to consider the long-term outlook
/Targets inflation and maintains stable prices
/Depreciating the currency can increase exports

Question 16

What are the weaknesses of the monetary policy?

Answer 16

/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
/Cheaper credit can inflate asset prices in the long term
The interest rate has limitations on downward adjustment

Question 17

Strengths of the fiscal policy?

Answer 17

/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

Question 18

Weaknesses of fiscal policy?

Answer 18

/Policies can fluctuate significantly as governing parties’ change
Long term infrastructure projects 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