2.6.2 Demand side policies

Question 1

Demand side policies

Answer 1

Policies aimed at manipulating consumer demand.

Question 2

Expansionary/Deflationary policy

Answer 2

Expansionary:
Aimed at increasing AD to bring about growth
Deflationary:
Aimed at decreasing AD to control inflation

Question 3

Monetary policy

Answer 3

When the central bank attempts to control AD.
- Altering base interest rates
- (Or) the amount of money in the economy.

Question 4

Fiscal policy

Answer 4

When the government attempts to control AD.
-Borrowing
-Taxation
-Government spending

Question 5

1. Mechanism: Contractionary - Increase in cost of borrowing for firms and consumers

Answer 5

-> In particular, consumption will decrease for durable good which are often bought on credit, and house as mortgage.
-> for firms, higher interest require higher rates of return.
This will lead to a fall in consumption and investment, both components worth 75% of aggregate demand. So in theory, will shit AD1to AD2 dramatically.

Question 6

2. Mechanism: Contractionary - Decrease price of assets

Answer 6

Since less people are borrowing and more are saving, demand for assets fall. Assets can lose value meaning they are riskier. Investors will prefer saving their wealth in banks.
-> This may lead to a negative wealth effect. as the price of assets fall, consumers will be less confident in their spending of money, which will lead to a fall in consumption.
-> Investment is less attractive, as firms are more likely to see lower profits as prices fall.
This will lead to a fall in consumption and investment, both components worth 75% of aggregate demand. So in theory, will shit AD1to AD2 dramatically.

Question 7

3. Mechanism - low interest rates -

Answer 7

Mortgages will become more expensive to repay, so consumer have to dedicate more of their income to pay back these debts. This means they have less income to spend on goods and services, so consumption will fall, causing AD to fall.

Question 8

4. Mechanism - contractionary - appreciation in exchange rate

Answer 8

->Higher rates will increase the incentive for foreign consumers to hold their pounds in British banks as they see a higher rate of return. As a result demand increases for the pound causing it to rise.
->Imports become cheaper - exports more expensive. Decreasing net trade, and therefore AD.

Question 9

Problems with interest rates: Balance of trade deficit

Answer 9

The exchange rate may be affected so much that exports fall and imports rise significantly.

Question 10

Problems with interest rates:
Lower interest rates may not always boost spending

Answer 10

In a liquidity trap, interest rates may not increase spending because people are still paying back debts.
->n 2009, UK interest rates were cut to 0.5%, but spending remained subdued.

Question 11

Quantitative easing (monetary supply)

Answer 11

Central bank buys assets to inject liquidity in the economy (increase money supply).
-Central banks creates new money electronically.
-This money is used to buy financial assets - mainly government bonds
-More demand leads to higher prices on assets. E.g. rise in the price of bonds leads to a lower yield (%) on government bonds (i.e. lower interest rates)
-These lower interest rates feeds through to mortgage and corporate bonds.
-> lower interest rates and increased cash in banking system should stimulate AD through a rise in consumption and investment.

Question 12

1. Mechanism: Quantitative easing - increases price of assets

Answer 12

Since the bank is buying assets, there is a rise in demand and so asset prices rise.
-> This causes a positive wealth effect since shares, houses etc. are worth more.
-> Higher asset prices mean lower yields, this decreases the cost of borrowing making it cheaper for households and businesses to finance spending.
-> So people will increase their consumption and firms will increase their investment, leading AD to rise.

Question 13

Problems with quantitative easing: Hyperinflation

Question 14

Problems with quantitative easing: housing market

Answer 14

Following the Bank of England decision to use quantitative easing in 2009, it had a large impact on the housing market, stimulating demand leading to rapid prices in 2013.

Question 15

Problem with quantitative easing: widening income inequality

Answer 15

It leads to rising share prices, which only benefits those who own assets who are mainly in higher income groups. As Standard and Poor report in 2016, suggested that the value of financial assets has risen by £600bn but real wages have fallen by 6%.

Question 16

Fiscal policy instruments: Government spending

Answer 16

Government spending is a key component of AD - 25%.
-Recurring government spending - day in day out spending to provide public services. E.g. salaries of NHS workers
-Capital spending - spending that provides new public infrastructure, E.g. Flood defence schemes, construction of new motorways and bridges.

Question 17

(Fiscal) budget surplus/deficit

Answer 17

Surplus: government receives more than they spend.
Deficit: government spends more money than they receive.

Question 18

Problems with government spending: multiplier

Answer 18

-The impact of government spending depends on the size of the multiplier: the bigger the multiplier the bigger impact on AD. -Classical economists argue that the multiplier is zero, whereas, Keynesian economists argue that it can be large if targeted correctly.

Question 19

Fiscal policy instruments: Taxation

Answer 19

A rise in income tax will cause a fall in disposable income.
a rise in corporation tax will decrease a firms post-tax profits.
-Reduce AD as consumption and investment falls.

Question 20

Direct/Indirect taxes

Answer 20

Direct - tax levied on income, wealth and profit. (burden of the tax cannot be passed on)
Indirect - Tax on consumer expenditure. (burden of the tax can be passed on)
Top four highest revenue raising taxes:
1.Income tax (direct) - 25%
2.National insurance (direct)
3.VAT (indirect) - 20% standard rate (however, not all goods)
4. Corporation tax (direct) - 19% main rate

Question 21

Problems with taxation: Increases inequality

Answer 21

-VAT is a regressive tax, those on low income have to spend a greater proportion of their income on goods, than higher income individuals - rate of tax paid falls as incomes rise.

Question 22

Evaluation of demand side policies: Depends on where economy is operating

Question 23

Evaluation of demand side policies: Trade off

Answer 23

In most cases expansionary policy is inflationary, whilst a contractionary policy brings unemployment. Thus through demand management, there is a trade off. The government cannot bring about low and stable inflation and low unemployment.

Question 24

Evaluation of demand side policies: Elasticity

Answer 24

The impact of changes in AD depend on where the economy is operating: if the economy is at full employment than a rise in AD will only lead to higher prices.