2.6.2 Demand Side Policies

Question 1

What are the two demand side policies?

Answer 1

• fiscal policy
• monetary policy

Question 2

Significance of fiscal policy in a recession?

Answer 2

• recession = two consecutive quarters of negative growth
• often average incomes are falling + there is a lack of AD, negative output gap, cyclical unemployment
• expansionary fiscal policy aims to increase AD = increasing govt spending on infrastructure+ lowering tax

Question 3

How does fiscal policy solve a negative output gap?

Answer 3

• decrease taxes = leads to more disposable income = consumption increase + firms may increase investment to meet demand
• firms may also hire more workers which boosts national income
• increase government spending e.g. health, education, infrastructure increases national income through the multiplier effect
• increase in an injection (G) leads to further rounds of spending which increases national income by more than the original increase in govt spending

Question 4

What does the success of a expansionary fiscal policy depend on?

Answer 4

• the effectiveness of the policy may depend upon the size of the multiplier
• the multiplier will be bigger the more the additional spending is spent on UK produce goods + services
• the higher the withdrawals = lower the value of the multiplier

Question 5

Expansionary fiscal EVALUATION

Answer 5

• may lead to demand pull inflation if the AD increases too much
• increased govt spending + cut on tax may mean the govt have to increase borrowing = budget deficit
• therefore, in the longer run if borrowing increases govts are likely to raise taxation or cut back on spending in other areas (opportunity cost)
• deterioration of the current account - increased disposable income may cause an increase in demand for imports = UK has a high marginal propensity to import —> AD will also not increase as much if X-M is negative

Question 6

When would a contractionary fiscal policy be used?

Answer 6

• reduce govt borrowing
• reduce demand pull inflation
• reduce spending on imports

Question 7

Example of a contractionary fiscal policy

Answer 7

• increase in income tax
• reduced disposable income = fall in consumption + firms may cut back on investment if there is less consumer demand
• lowers AD = could lower demand pull inflation depending on level of spare capacity in the economy
• less disposable income will lower demand for imports (marginal propensity to import) so other things being equal the trade balance will improve

Question 8

Contractionary fiscal policy EVALUATION

Answer 8

• could lead to an increase in cyclical unemployment
• could lead to a fall in real GDP
• not always the case that an increase in tax will increase tax revenue - Laffer curve

Question 9

What does the success of a contractionary fiscal policy depend on?

Answer 9

• size of increase in tax
• level of spare capacity in the economy
• whether it is an increase in the basic rate of income tax

Question 10

What does the laffer curve suggest?

Answer 10

• as taxes increase, tax revenue collected by the govt increases
• BUT after a certain point a further increase in tax will cause people to not work as hard or not at all due to high income tax acting as a disincentive
• therefore, tax revenue begins to decline

Question 11

What will the impact of an income tax increase depend on?

Answer 11

• if the basic rate increases the income tax structure becomes less progressive = distribution of income made more unequal
• however, an increase in the higher rate will be more progressive + reduce income inequality BUT it may lower incentives to take higher paid work or increase the incentive for tax avoidance

Question 12

What does a monetary policy involve?

Answer 12

• changes to bank rate set by the MPC
• if inflation increases, interest rates are lowered
• the MPC are tasked with achieving inflation of 2% +/- 1%

Question 13

Impact of an increase in interest rates on AD

Answer 13

• higher cost of borrowing = fall in consumption + fall in investment by firms
• higher cost of borrowing means households have higher mortgage repayments on variable rate mortgages, so there is a fall in disposable income, reducing consumption
• increases in the interest rates attracts ‘hot money’ into the UK - capital inflows increase to get a better return
• this increases the demand for pounds + the exchange rate gets stronger

Question 14

Impact of an increase in interest rates on the exchange rate

Answer 14

• attracts ‘hot money’ into the UK - capital inflows increase to get a better return
• hot money is short term speculative flows —> increased demand for the pound + exchange rate gets stronger
• higher valued currency = exports more expensive + imports cheaper
• net exports deteriorates (X-M) = AD falls

Question 15

How can a strong exchange rate reduce cost push inflation?

Answer 15

• if imported goods are cheaper this will help lower inflation
• if raw materials are cheaper there I’ll be lower cost push inflation = SRAS shifts to the right

Question 16

What policy is quantitate easing?

Answer 16

• expansionary monetary policy = increases AD
• govt wants to stimulate economy - the central bank buys bonds from financial institutions (e.g. banks, insurance companies etc.)
• this increases money supply as the sellers of bonds have liquidated their bonds (converted to cash) + banks therefore have more capital
• this may lead to increased lending to firms + households = increases AD

Question 17

Impact of QE on interest rates?

Answer 17

• there is an inverse relationship between bond prices + interest rates
• QE increases demand for bonds
• this increase the price of bonds in the secondary bond market
• this has a knock on effect of lowering interest rates = increase in AD

Question 18

Disadvantages of monetary policy?

Answer 18

• interest rate changes subject to time lags - impact takes 18 months
• interest rate inelastic loans = if interest PED is inelastic then monetary policy is less effective

Question 19

Impact of a depreciation of exchange rates?

Answer 19

• exports cheaper + imports more expensive
• increased demand for exports = trade balance improves = increase in AD
• could lead to demand pull inflation if trade balance improves

Question 20

Impact of a depreciation of exchange rates? EVALUATION

Answer 20

• if demand for exports is inelastic, in the short term, demand will increase but by a small %
• the Marshall Lerner condition states following a depreciation of the currency a country’s current account balance will only improve if the PED for imports + exports sums to greater than 1
• therefore, in the short term the PED is inelastic so the current account balance may deteriorate before it gets better