2.6.2 - demand-side policies

Question 1

What is monetary policy?

Answer 1

The use of interest rates, quantitive easing/tightening and exchange rates in order to achieve government objectives; use expansionary or contractionary monetary policy.

Question 2

What is a central bank?

Answer 2

The monetary authority and major regulatory bank in a country. It is responsible for operating monetary policy and maintains financial stability.

Question 3

Who decides the base rate of interest in the UK?

Answer 3

The Bank of England’s Monetary Policy Committee.

Question 4

What factors does the Bank of England use to predict future inflation?

Answer 4

Global conditions, domestic activity, the labour market, wage growth and inflation expectations.

Question 5

What is the base interest rate (bank rate)?

Answer 5

The main interest rate set by a nation’s central bank, which is the rate of interest charged to commercial banks if they must borrow from the central bank when short of liquidity.

Question 6

How is the real interest rate calculated?

Answer 6

Real interest rate = nominal interest rate - inflation rate.

Question 7

What is the interest rate transition mechanism?

Answer 7

A form of monetary policy which can achieve government objectives in certain ways.

Question 8

How do rising interest rates reduce borrowing?

Answer 8

Borrowing becomes more expensive meaning fewer loans taken out, decreasing consumption and investment, decreasing AD and general price level.

Question 9

What does the effectiveness of reduced borrowing depend on?

Answer 9

The rationality of borrowers in anticipating rate changes and how much existing debt.

Question 10

How do rising interest rates increase savings?

Answer 10

Increases return on savings, encourages savings (MPS) and decreases consumption (MPC), decreasing AD and general price level.

Question 11

What does the effect of increased savings depend on?

Answer 11

Population structure (age, income distribution) and behaviour of institutions.

Question 12

How do rising interest rates cause hot money inflows?

Answer 12

Increases demand for the pound, appreciation of currency which doesn’t attract foreign capital so imports more valuable than exports, decreasing AD and general price level.

Question 13

What factors influence hot money inflows?

Answer 13

Interest rates in other countries, PED of imports and exports and the extent at which the economy is operating.

Question 14

How does an increased cost of mortgage affect consumption?

Answer 14

Decreases demand for houses causing fall in prices, negative wealth effect, reducing consumer confidence and consumption, decreasing AD and general price level. Also, higher mortgage repayments reduce disposable income.

Question 15

What does the effect of mortgage cost increases depend on?

Answer 15

Proportion of population who already own a house and with mortgage, and the proportion of those with a fixed or variable mortgage.

Question 16

What is quantitative easing?

Answer 16

When the central bank purchases bonds or assets from commercial banks, lending them money which they have to pay interest (yield) on the full amount (principal) at a later date.

Question 17

Why did the central bank shift quantitative easing to private sector institutions during a financial crisis?

Answer 17

Commercial banks preferred to keep money in reserves rather than lending, so buying from them was ineffective.

Question 18

How does QE increase loan availability and lending?

Answer 18

Commercial banks have increase in liquid assets, meaning loans are more available, increasing consumption and investment, increasing AD and general price level.

Question 19

How does QE affect bond yields and interest rates?

Answer 19

Increased bond demand raises prices, lowering yields and decreasing commercial bank interest rates, decreasing cost of borrowing, increasing consumption and investment, increasing AD and general price level.

Question 20

How does QE influence the wealth effect?

Answer 20

Increase in asset prices encourages positive wealth effect, increasing consumption and investment, increasing AD and general price level.

Question 21

What is fiscal policy?

Answer 21

The use of government spending and taxation in order to change aggregate demand; use expansionary or contractionary fiscal policy.

Question 22

How does the government finance a fiscal deficit?

Answer 22

Through borrowing by issuing government bonds.

Question 23

What is the national debt?

Answer 23

The total amount of money owed by the UK government, accumulated over many years.

Question 24

What is the tax burden?

Answer 24

The total amount of taxes collected by the government as a percentage of GDP.

Question 25

What is current government spending?

Answer 25

Providing public services, e.g. NHS salaries, drugs in healthcare, road maintenance budget and army logistics supplies.

Question 26

What is capital government spending?

Answer 26

New public infrastructure, e.g. construction of new motorways and bridges, new equipment used in NHS, defence equipment and flood defence schemes.

Question 27

What are the types of taxation?

Answer 27

Direct and indirect.

Question 28

What is income tax?

Answer 28

Levied as a percentage of income.

Question 29

What is corporation tax?

Answer 29

Paid by businesses as levied on their products.

Question 30

What is VAT in the UK?

Answer 30

20% of the price of the good, included in the price of most goods.

Question 31

What caused the Global Financial Crisis of 2008?

Answer 31

Mortgage lending in US as grouping ‘prime’ mortgages with ‘sub-prime’ mortgages, and loss of consumer and business confidence.

Question 32

What caused the Great Depression of the 1930s?

Answer 32

Sharp fall in share prices on the NY Stock Exchange, loss of confidence, excessive US bank lending in 1920s, and protectionism reducing trade.

Question 33

What were UK policies during the Global Financial Crisis?

Answer 33

Bank Rescue Packages, fiscal stimulus (VAT reduction and increased spending), increasing AD and general price level.

Question 34

What were UK policies during the Great Depression?

Answer 34

Initially austerity and balanced budgets; later abandoned Gold Standard for flexible monetary policy, and introduced limited public works.

Question 35

What were US policies during the Global Financial Crisis?

Answer 35

Stimulus package creating jobs and boosting activity, fiscal stimulus (tax cuts and spending on infrastructure, education and health), increasing AD and general price level.

Question 36

What were US policies during the Great Depression?

Answer 36

New Deal: job creation through public works, unemployment benefits, pensions, and government spending to increase AD and general price level.

Question 37

What are strengths of demand-side policies?

Answer 37

Only way to reduce demand-deficient unemployment/stagnation short-term, large multiplier impact, spare capacity supports growth, control demand-pull inflation.

Question 38

What are weaknesses of demand-side policies?

Answer 38

Long-term inflation from expansionary policies, low multiplier may reduce effectiveness, lack of spare capacity requires supply-side solutions, can cause budget deficit and rising national debt, time lags.