2.6.2 - Demand-side policies

Question 1

A) Distinction between monetary and fiscal policy

Answer 1

● Monetary Policy:
Involves adjusting Interest rates and the money supply to influence AD. The Bank of England (UK central bank) is responsible for setting monetary policy.

● Fiscal Policy:
involves the use of government spending and taxation to influence AD
The government is responsible for setting fiscal policy.

Question 2

C - Monetary Policy: Impact of Interest rates on firms

Answer 2

● Increase in interest rates Is likely to lead to a fall in planned capital spending by businesses.

This is because loans to finance investment projects are likely to become more expensive.

This will then lead to a fall in the expected real rate of return on capital investment. Some businesses may decide to postpone projects.

Additionally the cost of the loans they have previously taken out has increased as a result of higher interest rates, and so the costs of their existing debts will also increase. Therefore, assuming that revenue for the firms stay the same then there will be a decrease in profits for them as their costs have gone up. As a result there will be a decrease in their profits and so they will be less willing to invest back into their business.

Question 3

C - Monetary Policy: Impact of Interest rates on consumers.

Answer 3

● As Interest rates increase consumption decreases this is because people will be more incentivised to save. As the reward for saving increases and if people were borrowing e.g overdraft, loans and mortgage payments then they will have to pay back more then they initially took out.

● An increase in interest rates less people are borrowing and more people are saving, this will decrease the demand for these assets such as shares and government bonds. Therefore consumers will experience a negative wealth effect since the value of their assets fall, which will lead to a fall in consumption.

● On top of this, other loans, such as mortgages, will
become more expensive to repay and so consumers have to dedicate more of their income to paying back these debts. This means they have less income to spend on goods and services, so consumption will fall.

● An increase in the price of houses or stocks will cause an increase in consumer spending for those who have either/both of those assets. This is due to the positive wealth effect whereby a rise in asset prices can increase a consumers/firms wealth increasing their confidence and therefore their willingness to spend/invest. Furthermore, high confidence levels will also affect consumer spending and investment. If consumer and business confidence is high then there will be increased consumer spending and business investment.

Question 4

C- Monetary Policy: Impact of Interest rates on exchange rates.

Answer 4

● An increase in Interest rates will incentives foreigners to store their money in Uk banks as they can see a higher rate of return. As a result there will be an increase demand for the pound which will increase the value of the pound (appreciation of the pound).
SPICED (explain it) This means that imports will be cheaper and exports will become more expensive. This decrease the net trade and therefore AD decreases.

vice visa for a decrease in interest rates.

Question 5

Monetary Policy Summary

Answer 5

Question 6

Expansionary Monetary Policy

Answer 6

● Expansionary Monetary Policy - cutting interest rates in an effort to increase economic growth

If the Bank of England cuts interest rates, it will tend to increase overall demand in the economy :

● Lower interest rates make it cheaper to borrow; this encourages firms to invest and consumers to spend.
● Lower interest rates reduce the cost of mortgage interest repayments. This gives households greater disposable income and encourages spending.
● Lower interest rates reduce the incentive to save.
● Lower interest rates reduce the value of the Pound, making exports cheaper and increase export demand.

Question 7

Problems with monetary policy.

Answer 7

● Time lag - Changes in interest rates take up to 1 years to have their full effect.
● Confidence - A lack of business and consumer confidence in the economy may mean that no matter how low interest rates are consumers and businesses do not want to borrow or banks do not want to lend to them.
● Sometimes, interest rates are so low that they cannot be decreased any further to
stimulate demand. So they may need to use quantitative easing instead.
● The exchange rate may be affected so much that exports fall significantly and
imports rise significantly, causing a balance of trade deficit.(trade offs).
● If confidence is very high, people may continue to borrow and spend, despite higher interest rates.
If there is cost-push inflation (e.g. rising oil prices), tight monetary policy may lead to lower economic growth.
Tight monetary policy also conflicts with other macro-economic objectives. The cost of higher interest rates is a fall in economic growth and possible unemployment.
●

Question 9

Quantitative easing

Answer 9

1. The Central bank prints money digitally in the form of ‘central bank reserves’,
2. These reserves are used to buy bonds. Bonds are essentially IOUs issued by the government and businesses as a means of borrowing money.
3. As a result of this, the demand for government bonds increases. This increases the price of these bonds and creates money in the banking system.
4. As a consequence, a wide range of interest rates fall and loans become cheaper.
5. As a result, consumption and investment receive a boost.
6. Higher consumption and more investment support economic growth and job creation.

link - BOfE

link - Econplusdal

Question 10

Fiscal Policy
- Summary

Answer 10

Question 11

Expansionary Fiscal Policy

Answer 11

• Increased government spending and reducing taxes to stimulate economic growth.

Question 12

Contractionary fiscal policy

Answer 12

• Decreased government spending and increased government taxation**

Question 13

Blurt everything you know about Government budget (fiscal) deficit.

Answer 13

A government budget deficit occurs when government expenditure exceed government revenue.

Question 14

Blurt everything you know about Government budget (fiscal) surplus.

Answer 14

A government budget deficit occurs when government revenue exceed government expenditure.

Question 15

What are demand side policies ?

Answer 15

Polices that are used to either increase Aggregate demand - Expansionary demand side polices. Expansionary demand side policies are used in times of low/negative economic growth e.g. a recession.

Polices that are used to decrease Aggregate demand - Contractionary demand side policies. contractionary demand side policies are used in times of high economic growth e.g. a boom.

Question 16

What is the role of the Bank of England ?

Answer 16

In the UK, the Monetary Policy Committee (MPC) alters interest rates to control the supply of money

Question 17

Why do we use quantitative easing ?

Answer 17

An example of expansionary monetary policy to increase AD leading to economic growth

Question 18

Blurt everything you know about the great depression

Answer 18

• 1929 - 1941
• By 1932 In the USA the unemployment rate was around 25%
• led to a huge loss in consumer and business confidence, decreasing
  consumption and investment
• More than 9,000b banks closed
• world wide trade went down by 33%
• In the UK, unemployment doubled and exports halved leading to a major recession

link

Question 19

What was the USA’s response to the great depression

Answer 19

• The new deal (an example of expansionary fiscal policy)- explain what happens to the economy with that policy

Question 20

Strengths of demand side polices

Answer 20

• Time lag : Intrest rates takes at least 1 year to have an effect on the economy
• Confliction with other

Question 21

Strengths of demand side polices

Answer 21

• Helps to achieve the macroecnomic obehctive of reduced inequality as Government spending on social programs, subsidies, or tax cuts for low- and middle-income earners helps reduce income inequality, as lower-income households generally spend a larger proportion of their income, further boosting aggregate demand.
• Helps to achive low unepolymet as demand-side policies can boost business confidence, encouraging more investment and consumption.
  This confidence can translate into more hiring, lending, and business expansion, creating a more resilient economy. So more tax rev for gov.
  -

Question 22

Weakness of demand side polices

Answer 22

Conflicting with other macroeconomic objectives
- Demand pull inflation, This is particularly problematic if the economy is already close to full capacity, as excessive demand can lead to overheating. Which is bad because As an economy overheats, domestic prices rise, making exports less competitive internationally and increasing imports, worsening the trade balance.
This can lead to a trade deficit, weakening the national currency and impacting the global economic standing of the country.
-** Time lag** : Interest rates takes at least 1 year to have an effect on the economy
- Ineffectiveness at Full Employment
Once an economy is near or at full employment, further demand-side intervention will not reduce unemployment and may only result in inflation. At this stage, only supply-side policies can enhance long-term growth and productivity.
- Crowding out effect : Increase gov borrowing, increase intrest rates, lower demand for loans, private invtesment decrease.