2.6.2: Demand-Side Policies Flashcards
What is monetary policy?
Where governments control AD levels by altering monetary variables (e.g. amount of money in the economy).
What is fiscal policy?
The use of taxes & government expenditure to manipulate AD levels.
What are the monetary policy instruments?
-Interest rates.
-Quantitative easing.
What are interest rates?
The cost of borrowing/reward for saving (expressed as a percentage).
The Monetary Policy Committee (MPC) tries to ________ the base rate to cause a ________ in AD.
Reduce, rise.
What are the mechanisms of interest rates?
-Rise in C: Saving is less attractive (due to a lower rate of return).
-Rise in C & I: Lower costs of borrowing.
-Rise in (X-M): Lower interest rates de-incentivise investors to hold their money in British banks. The value of the pound will be weaker, but net trade will rise.
What are the limitations of interest rates?
-Changes take up to 2 years to have an effect.
-Lack of confidence will reduce the borrowing/lending rate no matter how low interest rates are.
What is quantitative easing?
Where a central bank (e.g. the Bank of England) buys assets in exchange for money to increase money supply for banks.
When is quantitative easing used?
When inflation is low & it isn’t possible to lower interest rates.
What is meant by buying assets in quantitative easing?
Increasing the size of banks’ accounts (reserves), which encourages banks to lend more money.
How does quantitative easing cause a positive wealth effect?
- Banks purchase assets through electronic money.
- Prices of assets rise, while interest adjust downwards.
- This encourages banks to rebalance their portfolios by increasing investment in other assets with a higher interest rate.
- Lower interest rates reduce borrowing costs for business (stimulus for borrowing/spending).
- Owners experience an increase in their wealth, confidence & spending.
- This positive effects of this may then spread out to the real economy.
What are the limitations of quantitative easing?
-Risky, and can cause inflation/hyperinflation. The flood of cash in the market may encourage reckless financial behavior and increase prices.
-QE can create asset bubbles, which are unsustainable increases in the prices of certain assets, such as stocks or housing, that can burst and cause financial instability.
-Causes a greater wealth inequality, as the owners of assets benefit from price rises.
What is government spending?
The expenditure of governments.
What does a rise in government spending result in?
A rise in AD.
The government can ________ the ________ of the circular flow of income.
Influence, size.
What are the limitations of government spending?
-Cutting government spending to reduce AD also reduces the quality of AS, due to a cut in investment costs.
-If the economy is close to full capacity, then higher government spending may cause inflationary pressures and little increase in real GDP.
What is a fiscal/budget deficit?
When the government spends more than they receive.
What is a fiscal/budget surplus?
When the government spends less than they receive.
What is taxation?
A financial contribution made to the government.
What can tax revenue be used for?
Government expenditure.
What are the limitations of taxation?
-Causes opposition.
-Reduces economic growth, as it reduces the incentives for work, investment, & entrepreneurship.
What is direct taxation?
Taxes payed directly by the taxpayer.
What is indirect taxation?
When the economic agent charged with the tax passes the tax onto someone else (e.g. firms can pass on the burden of indirect tax to the consumer).
What is an example of direct tax?
Income tax.
What is an example of indirect tax?
VAT.
What does AD1 -> AD2 mean for government spending?
Rise in fiscal/budget deficit due to an increase in government spending.
Expansionary fiscal/budget policy.
What does AD2 -> AD1 mean for government spending?
Fall in fiscal/budget deficit due to a decrease in government spending.
Contractionary fiscal/budget policy.
What was the Great Depression?
A global depression that initiated in 1929. By 1933, real GDP fell by 30%, and the unemployment rate rose by 25%. It lasted over a decade.
What were the causes of the Great Depression?
-Wall Street Crash: sharp fall in share prices on the New York Stock Exchange.
-US Banking System: lent too much in the 1920’s, creating an unsustainable boom.
-Loss In Confidence: decreasing consumption and investment.
-Protectionism [USA]: reducing world trade.
-Gold Standard [UK]: overvalued exchange rate, with exports reducing.
What was the USA response to the Great Depression?
-Roosevelt’s New Deal: work schemes for the unemployed and fiscal stimulus.
-WWII- The US employment rate fully recovered in 1943.
What was the UK response to the Great Depression?
-Balancing the budget: cut unemployment benefits and raised income tax.
-High interest rates: maintaining the pound (came under scrutiny).
-Leaving the Gold Standard: 1931 (also cut interest rates).
What was the Financial Crisis?
A global recession that initiated in 2008, also started in the USA, but was less severe than the Great Depression.
What were the causes for the Great Depression?
-Mortgage Lending: poor people were encouraged to take out mortgages (moral hazard, as mortgage sales saw bonuses for bank workers). They were given low interest rates that skyrocketed. Houses were repossessed and demand fell. Prices fell and house value was less than mortgage value.
-Grouping: ‘prime’ mortgages (pay back) and ‘sub-prime’ mortgages (struggle to pay back). Selling packages to banks and investors as if they were all ‘prime’ mortgages.
-Loss In Confidence: banks stopped lending. Lehman Brothers failed, and people withdrew from banks.
What was the USA & UK response to the Financial Crisis?
-Nationalisation: banks. They guaranteed savers their money to prevent a collapsed system.
-Expansionary monetary policy: low interest rates, quantitative easing.
-Expansionary fiscal policy [USA]: recovered faster.
What is the Classical evaluation of demand-side policies?
-Only causes inflation in the long run.
-Time lags.
-Ineffective if there is no spare capacity.
What is the Keynesian evaluation of demand-side policies?
+Only way to get the economy out of disequilibrium.
+Positive multiplier.
-Depends on spare capacity.
