2.6.2 - demand side policies

Question 1

What is the role of the Bank of England’s Monetary Policy Committee?

Answer 1

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.

Question 2

What are the 3 ways the MPC can influence AD?

Answer 2

1. interest rates
2. the money supply
3. the exchange rate

Question 3

what is the main method used to control the money supply?

Answer 3

quantitative easing

Question 4

How does quantitative easing work?

Answer 4

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.

Question 5

What are government bonds?

Answer 5

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

Question 6

How can quantitative easing increase business investors?

Answer 6

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

Question 7

What is quantitative easing?

Answer 7

When the Bank of England buys assets in exchange for money to increase the money supply in times of low demand.

Question 8

How does QE affect government borrowing?

Answer 8

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.

Question 9

What are the impacts of QE?

Answer 9

• 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.

Question 10

How does QE impact pensions?

Answer 10

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.

Question 11

How is the exchange rate used as monetary policy (depreciation)?

Answer 11

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.

Question 12

what is the target CPI for the MPC?

Answer 12

CPI target at 2%, minus or plus 1%

Question 13

What is expansionary/loose/inflationary monetary policy?

Answer 13

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.

Question 14

What is contractionary/deflationary/tight monetary policy?

Answer 14

Reducing the base interest rate to reduce inflation. Increased saving, reduced consumption due to fall in purchasing power, reduced investment, etc.

Question 15

What is government expenditure used for?

Answer 15

1. spending on g/s for current use eg. health, education
2. capital expenditure = spending on infrastructure eg. roads, hospitals
3. transfer payments = provides benefits in cash/payments to poor and vulnerable households

Question 16

what is the role of the Treasury (fiscal policy)?

Answer 16

it allocates government spending and oversees collection of taxes.

Question 17

what is fiscal policy?

Answer 17

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.

Question 18

what is stabilisation policy?

Answer 18

the government has a responsibility to smooth out the peaks and troughs of the business cycle.

Question 19

what are the two main types of fiscal policy?

Answer 19

discretionary stabilisers and automatic stabilisers

Question 20

what are discretionary stabilisers?

Answer 20

the government actively adjusts fiscal policy in response to a boom or downturn.

Question 21

how would the government use discretionary stabilisers when the economy is overheating?

Answer 21

the government may increase tax to temper aggregate demand. this would likely be amplified by the multiplier effect

Question 22

What are the main impacts of discretionary fiscal policy?

Answer 22

-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

Question 23

what are automatic stabilisers?

Answer 23

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.

Question 24

what is fiscal stance?

Answer 24

refers to whether the government is pursuing an expansionary (loose or inflationary) or contractionary (deflationary or tight) fiscal policy

Question 25

what is expansionary fiscal policy?

Answer 25

increase of g and reduction in t increasing the budget deficit/reducing a budget surplus

Question 26

how is expansionary fiscal policy used during a recession?

Answer 26

the government stimulates AD by boosting government spending or cutting taxes, affecting components of AD.

Question 27

what are the impacts of an increase in g?

Answer 27

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.

Question 28

what are the impacts of a decrease in t?

Answer 28

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

Question 29

how do Keynesian economists view the use of fiscal policy?

Answer 29

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.

Question 30

how do other economists (non-Keynesian) view fiscal policy use?

Answer 30

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.

Question 31

how effective is the use of automatic stabilisers?

Answer 31

1. they merely reduce the magnitude of fluctuations in the business cycle 2. they have adverse supply-side effects eg. higher taxes create a disincentive reducing employment, benefits create an unemployment trap 3. 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

Question 32

how can fiscal drag be defined?

Answer 32

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

Question 33

why may discretionary fiscal policy may not be effective?

Answer 33

-crowding out -difficult to predict actual impact on consumption and savings following t and g changes -size of the multiplier is determined by mpc, mps, mpm, mpt, 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

Question 34

what is crowding out?

Answer 34

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.

Question 35

what is "fine-tuning"?

Answer 35

the government's main responsibility is to smooth out the peaks and troughs of the business cycle

Question 36

What is the difference between monetary and fiscal policy?

Answer 36

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.

Question 37

How are interest rates used as monetary policy?

Answer 37

The MPC can change the base rate to tackle inflation. This affects the market rates offered by banks to consumers and businesses.

Question 38

How does a rise in interest rates cause a fall in AD?

Answer 38

- 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.

Question 39

What are some problems with using interest rates as a method of monetary policy?

Answer 39

- 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

Question 40

What are the problems of using quantitative easing as a method of monetary policy?

Answer 40

- 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

Question 41

What is the difference between a budget surplus and a budget deficit?

Answer 41

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.

Question 42

What is direct taxation?

Answer 42

Direct taxes are paid directly to the government by the taxpayer from income eg. income tax, national insurance

Question 43

What is indirect taxation?

Answer 43

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

Question 44

What are some problems of fiscal policy?

Answer 44

- 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

Question 45

Evaluation of demand-side policies?

Answer 45

- 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.

Question 46

Evaluation of monetary policy v fiscal policy

Answer 46

- 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