2.6.2 - demand side policies

Question 1

What is the aim of the Monetary Policy Committee?

Answer 1

they set monetary policy in order to meet the 2% CPI inflation target rate, to sustain growth and employment

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

What are the aims of quantitative easing?

Answer 4

It aims to support the economy by encouraging people to save less and spend more.

Question 5

How does quantitative easing work?

Answer 5

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.

Question 6

What are government bonds?

Answer 6

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 7

How can quantitative easing increase business investors?

Answer 7

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 8

What is quantitative easing?

Answer 8

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.

Question 9

How does QE affect government borrowing?

Answer 9

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 10

What are the impacts of QE?

Answer 10

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.

Question 11

How does QE impact pensions?

Answer 11

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 12

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

Answer 12

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 13

what is the target CPI for the MPC?

Answer 13

CPI target at 2%, minus or plus 1%

Question 14

What is expansionary/loose/inflationary monetary policy?

Answer 14

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 15

What is contractionary/deflationary/tight monetary policy?

Answer 15

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

Question 16

What is government expenditure used for?

Answer 16

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 17

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

Answer 17

it allocates government spending and oversees collection of taxes.

Question 18

what is fiscal policy?

Answer 18

manipulation of g and t by the government to influence AD to stabilise the economy

Question 19

what is stabilisation policy?

Answer 19

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

Question 20

what are the two main types of fiscal policy?

Answer 20

discretionary stabilisers and automatic stabilisers

Question 21

what are discretionary stabilisers?

Answer 21

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

Question 22

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

Answer 22

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

Question 23

What are the main impacts of discretionary fiscal policy?

Answer 23

-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 24

what are automatic stabilisers?

Answer 24

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 25

what is fiscal stance?

Answer 25

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

Question 26

what is expansionary fiscal policy?

Answer 26

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

Question 27

how is expansionary fiscal policy used during a recession?

Answer 27

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

Question 28

what are the impacts of an increase in g?

Answer 28

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 29

what are the impacts of a decrease in t?

Answer 29

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 30

how do Keynesian economists view the use of fiscal policy?

Answer 30

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 31

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

Answer 31

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 32

how effective is the use of automatic stabilisers?

Answer 32

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 33

how can fiscal drag be defined?

Answer 33

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 34

why may discretionary fiscal policy may not be effective?

Answer 34

-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

Question 35

what is crowding out?

Answer 35

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 36

what is “fine-tuning”?

Answer 36

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