2.6.2 - demand side policies Flashcards
What is the aim of the Monetary Policy Committee?
they set monetary policy in order to meet the 2% CPI inflation target rate, to sustain growth and employment
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
What are the aims of quantitative easing?
It aims to support the economy by encouraging people to save less and spend more.
How does quantitative easing work?
The Bank of England can create new money electronically, most of this money is used to buy government bonds. 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.
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 prices rise too fast, the Bank of England needs to slow down to slow down the rate of inflation. The government reduces its holdings of government bonds by not replacing any which the government repaid. They also began to actively sell bonds to investors.
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?
Helped to keep economic growth strong, wages high and unemployment low. However, it increase the prices of things such as shares and property, benefiting wealthier people who own assets, but younger people struggle to buy first homes and build up savings.
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
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
