2.6.2 - demand side policies Flashcards
What is the role of the Bank of England’s Monetary Policy Committee?
Their main aim is for inflation to remain at 2% (CPI). They make decisions about the base rate and quantitative easing. The MPC is made up of nine people, they meet on a monthly basis to set the base rate and QE.
What are the 3 ways the MPC can influence AD?
- interest rates
- the money supply
- the exchange rate
what is the main method used to control the money supply?
quantitative easing
How does quantitative easing work?
The Bank of England can create new money electronically, most of this money is used to buy government bonds and assets. Commercial banks receive cash, increasing liquidity, stimulating lending = increased consumption and investment. Buying lots of bonds pushes the price up, interest rates on loans are affected by the price of bonds. If prices go up, interest rates should go down - easier to borrow and spend money. The currency depreciates, increasing net exports. Positive wealth effect created. Quantitative easing increases consumption and investment, increasing AD and ensuring the country meets its inflation target.
What are government bonds?
A type of investment where you lend money to the government and in return it promises to pay back a certain sum of money in the future with interest
How can quantitative easing increase business investors?
Many investors buy bonds as a safe place to put their money. If the prices of those bonds increases, their safety becomes more expensive so investors are encouraged to buy shares or lend money to business again instead, supporting the economy
What is quantitative easing?
When the Bank of England buys assets in exchange for money to increase the money supply in times of low demand.
How does QE affect government borrowing?
It helped the government to borrow money to cover a budget deficit. The government pays less interest on bonds owned by the Bank of England than other investors, taking further pressure off public finances.
What are the impacts of QE?
- the bank buys assets so there is a rise in demand and asset prices rise, causing a positive wealth effect, so that people increase their consumption. Cost of borrowing will decrease as higher asset prices means lower yields, so it is cheaper for consumers and businesses to finance spending.
- the money supply will increase. private sector firms receive more money to spend on goods/services, increasing investment and consumption, leading to higher AD. It may push asset prices up further. Banks have more reserves, so they can increase lending to consumers and firms, increasing consumption and investment.
- commercial banks may lower interest rates are they receive money from BofE, and can offer low interest deals to consumers. Increased money supply means prices of money falls, encouraging borrowing, increasing investment and consumption, leading to a rise in AD.
How does QE impact pensions?
Bond prices are used to estimate how much it will cost to provide pensions in the future. Increased bond prices means cost of providing future pensions rises so firms were obliged to make bigger payments into their pensions, reducing possible investment money.
How is the exchange rate used as monetary policy (depreciation)?
The sale of pounds to depreciate the value of Sterling. Exports are cheaper and imports expensive, increasing net exports and AD. However, this increases cost of production as imported FOPs are more expensive.
what is the target CPI for the MPC?
CPI target at 2%, minus or plus 1%
What is expansionary/loose/inflationary monetary policy?
Reducing the base interest rate, increasing consumption. Reduced mps as opportunity cost of spending falls, expansion in borrowing (cheaper), increased demand for g/s, increased purchasing power via wealth effect, increased investment etc.
What is contractionary/deflationary/tight monetary policy?
Reducing the base interest rate to reduce inflation. Increased saving, reduced consumption due to fall in purchasing power, reduced investment, etc.
What is government expenditure used for?
- spending on g/s for current use eg. health, education
- capital expenditure = spending on infrastructure eg. roads, hospitals
- transfer payments = provides benefits in cash/payments to poor and vulnerable households
what is the role of the Treasury (fiscal policy)?
it allocates government spending and oversees collection of taxes.
what is fiscal policy?
Manipulation of g and t by the government to influence AD to stabilise the economy. Increased taxation will reduce disposable income, reducing consumption and AD, reducing inflationary pressure. Increased government spending increases AD, stimulating economic growth.
what is stabilisation policy?
the government has a responsibility to smooth out the peaks and troughs of the business cycle.
what are the two main types of fiscal policy?
discretionary stabilisers and automatic stabilisers
what are discretionary stabilisers?
the government actively adjusts fiscal policy in response to a boom or downturn.
how would the government use discretionary stabilisers when the economy is overheating?
the government may increase tax to temper aggregate demand. this would likely be amplified by the multiplier effect
What are the main impacts of discretionary fiscal policy?
-alters AD level
-effects LRAS - tax changes provide incentives, encourage investment and improve human capital
-influences distribution of income
-determines size of the state relative to the private sector
what are automatic stabilisers?
this reduces fluctuations of national income without deliberate action by the government. a natural fiscal response to a slowdown or recovery in economic activity. inherent cyclical adjustments in the level of tax revenue and government expenditure through the business cycle.
what is fiscal stance?
refers to whether the government is pursuing an expansionary (loose or inflationary) or contractionary (deflationary or tight) fiscal policy
what is expansionary fiscal policy?
increase of g and reduction in t increasing the budget deficit/reducing a budget surplus
how is expansionary fiscal policy used during a recession?
the government stimulates AD by boosting government spending or cutting taxes, affecting components of AD.
what are the impacts of an increase in g?
government spending generates demand for goods and services which may encourage firms to employ more people. there may be a multiplier effect causing increased national income.
what are the impacts of a decrease in t?
cutting taxes can help to stimulate AD. income tax reduction increases disposable income levels and therefore consumption. reductions in VAT rate reduces business costs and prices for consumers, stimulating consumption. this creates demand induced investment to offset potential shortages (the accelerator effect) - causes economic expansion
how do Keynesian economists view the use of fiscal policy?
they believe the government has a vital role in stabilising the macroeconomy, because there is no automatic mechanism through which the economy can recover from a recession.
how do other economists (non-Keynesian) view fiscal policy use?
they believe the government should leave the private sector alone - it is government intervention that prevents the private sector from bringing about full employment equilibrium.
how effective is the use of automatic stabilisers?
- they merely reduce the magnitude of fluctuations in the business cycle
- they have adverse supply-side effects eg. higher taxes create a disincentive reducing employment, benefits create an unemployment trap
- fiscal drag - as the economy starts to recover automatic stabilisers act as a drag on expansion, they reduce the size of the multiplier and jeopardise the magnitude of the economy
how can fiscal drag be defined?
the deflationary effect of a progressive taxation system on a country’s economy. as wages rise, a higher proportion of income is paid in tax
why may discretionary fiscal policy may not be effective?
-crowding out
-difficult to predict actual impact on consumption and savings following t and g changes
-size of the multiplier is is determined by mpc, mps, mpm, mpt, mpi, mpi, mpg and depends on consumer and business confidence
-random shocks = unpredictable events eg. external supply side shocks seriously derail fiscal policy
-time lags in stabilisation policy = difficult to influence the business cycle appropriately
-cost push inflation = increase in expenditure and corporation tax passed onto consumers as higher prices = higher wage claims
-welfare and distributive effects = cuts in g and increases in taxation fall on low income households
-disincentive effects
-borrowing and debt
what is crowding out?
the idea that government spending may squeeze out consumption and investment by the private sector, so that growth in AD from increased g is offset by a fall in C/I. also, a increase in g is usually followed by a rise in taxes - households may offset the gain and increase their savings, reducing consumption. government borrowing may also crowd out private investment - if they issue too many bonds, it may have to increase interest rates reducing the level of private investment.
what is “fine-tuning”?
the government’s main responsibility is to smooth out the peaks and troughs of the business cycle
What is the difference between monetary and fiscal policy?
Monetary policy is used by the government to control money supply in the economy, by interest rates and quantitative easing. This is done by the Bank of England.
Fiscal policy uses government spending and taxation to influence AD. This is done by the government.
How are interest rates used as monetary policy?
The MPC can change the base rate to tackle inflation. This affects the market rates offered by banks to consumers and businesses.
How does a rise in interest rates cause a fall in AD?
- Increased interest rates increases the cost of borrowing for firms and consumers. This leads to a fall in investment and consumption, reducing AD. It makes saving more attractive as there will be a higher amount of interest earned.
- If less people are borrowing, there will be a fall in demand for assets such as stocks, shares and bonds. This leads to a fall in asset prices, consumers experience a negative wealth effect, leading to a fall in consumption. Investment becomes less attractive, as firms will likely see lower profits due to falling prices, therefore AD will fall due to reduced consumption and investment.
- People are less confident about borrowing and spending when interest rates rise. A fall in consumer and business confidence leads to reduced consumption and investment, and a fall in AD. Loans will become more expensive to repay, so consumers dedicate more income to paying this. They have reduced income to spend on goods/services, reducing consumption and AD.
- Higher rates increase incentives for foreigners to hold their money in British banks due to higher rate of return. There will be increased demand for pounds and the value of the pound will rise. This means imports are cheaper and exports more expensive, leading to negative net trade and a fall in AD.
What are some problems with using interest rates as a method of monetary policy?
- exchange rate may be affected so much that exports fall and imports rise, causing a balance of trade deficit
- changes in interest rates take 2 years to have full effect, small changes may have no impact
- sometimes, interest rates are so low that they can’t be decreased further to stimulate demand
- not all interest rates are affected by the BofE base rate
- lack of confidence in the economy may mean that low interest rates may not encourage consumers and businesses to borrow, banks may not be willing to lend
- high interest rates over time discourage investment and decrease LRAS
What are the problems of using quantitative easing as a method of monetary policy?
- very risky, could cause high inflation
- may only lead to increased demand for second-hand goods, pushing up prices but not increasing aggregate demand
- no guarantee that higher asset prices lead to higher consumption through the wealth effect, especially if confidence remains low
- may lead to rapid price rises in the housing market, worsening issues of geographical immobility. leads to rising share prices, increasing wealth inequality
- economies may become too dependent on quantitative easing
What is the difference between a budget surplus and a budget deficit?
A budget deficit is when the government spends more money than they receive. A budget surplus is when they receive more money in tax revenues than they spend.
What is direct taxation?
Direct taxes are paid directly to the government by the taxpayer from income eg. income tax, national insurance
What is indirect taxation?
Where the person charged with paying the money to the government is able to pass on the cost to someone else eg. suppliers can pass on an indirect tax to consumers eg. excise duty, VAT
What are some problems of fiscal policy?
- government spending also impacts LRAS eg. by cutting government spending to reduce AD, the quality of education or research may be reduced
- taxes and spending impact inequality, high taxes may reduce incentives to work
- government also has to worry about political issues, they may not want to raise taxes as they could be voted out of the government
- expansionary fiscal policy is difficult during time of austerity
- impact of fiscal policy depends on the multiplier
Evaluation of demand-side policies?
- classical economists argue that policies will have no effect on long-run output, increasing AD during a depression has no impact, other than increasing prices
- on a Keynesian LRAS, impact of AD changes depends on where the economy is operating. If the economy is at full employment, increase AD only causes higher prices. However, it unemployment is high, a rise in AD leads to higher output
- there are significant time lags
- in most cases, expansionary policy is inflationary and deflationary policy causes unemployment. This depends on elasticity of the curve. Therefore, the government can’t achieve both low inflation and low unemployment.
Evaluation of monetary policy v fiscal policy
- monetary policy is useful as the government can increase demand without increasing spending, reducing fiscal deficit
- fiscal policy can significantly impact the supply side of the economy eg. increased spending on education increases AD and LRAS. It is more effective at targeting specific groups and reducing poverty eg. by increasing benefits it can increase AD and reduce inequality
