2.6.2 - Demand Side Policies - Monetary Policy

Question 1

Name two types of Demand Side Policies

Answer 1

. Fiscal Policy

. Monetary Policy

Question 2

Purpose of Demand Sides Policies (Fiscal and Monetary)

Answer 2

. To achieve macroeconomic and microeconomic objectives

Macroeconomic objectives ⁠— economic growth, low stable inflation, low unemployment, etc.

Microeconomic objective ⁠— reducing market failure such as environmental externalities

Question 3

Define Monetary Policies

Answer 3

. Refers to the use of monetary variables, such as interest rates and quantitative easing in order to achieve government objectives and influence AD

. It is controlling the money supply of an economy to achieve government objectives

Question 4

Two types of monetary Policy

Answer 4

1.) Expansionary Monetary Policy — intended to increase AD and economic growth.

Involves decreasing interest rates or increasing quantitative easing . It results in inflation and decreased unemployment

2.) Contractionary Monetary Policy — intended to reduced AD and reduce economic growth.

Involves raising interest rates or reducing quantitative easing. It results in increased unemployment, reduced inflation and improves current account positions of balance of payment

Question 5

Explain how a cut in interest rates affect the economy

(Expansionary Monetary Policy)

Answer 5

• The affects mentioned below are expansionary monetary policy examples. The opposite of this is contractionary monetary policy

1.) Cut in interest rate will reduce the cost of borrowing, making it cheaper for consumer to borrow, hence reducing the opportunity cost of doing so.

Disposable income of consumers increases allowing them to spend on goods and services. MPC increasing, thus increasing consumption so AD shifts from AD1 to AD2

2.) Cut in interest rates reduces the rate of savings as the rate of returns fall. This decreases the marginal propensity to save, thus decreasing saving in the economy.

As a consequence, the savings ratio in the economy will decrease, with most consumer spending taking place. This increase consumption in the AD equation shifting AD to the right from AD1 to AD2

3. ) Cut in interest rates will reduce the monthly payments for those with variable mortgages. These homeowners will receive a boost for their disposable income in the economy. This increases consumption in the AD equation shifting AD to the right from AD1 to AD1
4. ) A cut in interest rates reduces the cost of borrowing for firms, reducing the opportunity cost of doing so. This increases the marginal propensity for firms to invest thus increasing investment in the AD equation, shifting AD to the right from AD1 to AD2.

5.) A fall in interest rate will lead to a fall in the value of the domestic currency (exchange rate), due to a lack of hot money flows by foreign investors due to a lower rate of return on savings.

This results in imports becoming dearer and exports becoming cheaper. This means that the demand and therefore expenditure on imports decrease, whereas the revenue and demand for exports increase. This increases the value of (X-M), leading to AD shifting to the right.

6.) Low interest rates (caused by quantitative easing or MPC reducing it) increases demand for assets such as houses in the economy. This increases the prices of homes, which increases consumer confidence due to the wealth effect, which increase the MPC, thus consumption

[Can be used as evaluation to demand - pull inflation]

However, increased wealth for those with assets can lead to wealth inequality [Another evaluation]

Question 6

Define Quantitative Easing

Answer 6

. An expansionary monetary policy where the central bank electronically creates money to buy financial assets (e.g. bonds ) from financial institutions in exchange for money

. The objective of the central bank is to increase money available for borrowing and lending by buying financial assets

Question 7

Explain Process of Quantitative Easing

Answer 7

1.) Central bank creates money electronically to buy financial assets (mainly bonds) from financial institutions such as banks, government or pension funds in exchange for money

2.) This drives up the prices of bonds and reduces their yield

3.) This means commercials banks have more money and less bonds

4.) With all this additional money received by commercial banks, the banks can lower interest rates in order to attract borrowers

5.) More businesses and individuals are willing to borrow due to cheaper cost of borrowing

6. ) There will be an increase in consumption from consumers due to more disposable income increasing marginal propensity to consume. There will be more investment from firms, for example on factors of production such as land, labour and capital
7. ) This increases AD, shifting AD from AD1 to AD2.

Question 8

Disadvantage of Quantitative Easing

Answer 8

1.) If the money supply increases too quickly, quantitative easing can lead to higher rates of inflation. This is due to the fact there is still a fixed amount of goods for sale when more money is now available in the economy. There will be higher levels of borrowing from firms due to lower costs of borrowing, hence increasing AD. There will be demand pull inflation, as AD exceeds AS, putting more pressure on factors of production, resulting in price of goods and services to increase

2. ) QE can reduce the value of currency, due to higher inflation or due to bond prices and hot money flows.

If interest rates fall, then this may lead to an outflow of ‘hot money’, as investors switch their founds into other currencies, which are offering a higher rate of return

3.) Quantitative easing increases wealth inequality. This is because when institutions replace assets for cash from the central bank, this money will go into buying share, bounds or house driving up the prices of these forms of wealth. Consequently, owners of theses assets will see a large rise in their wealth widening the gap between themselves and those who lack ownership of such assets

4.) When bond prices are driven up, those who have saved in government bonds will receive a lower return.

Furthermore, as long term interest rates are driven down in the economy, ordinary savers will receive rates of interest and thus lower return, discoursing savers.

5.) Low consumer confidence will reduce borrowing even if interest rates have been borrowed. This affects the marginal propensity to consume and affect AD

Question 9

Alternative to QE

Answer 9

. Helicopter money is an alternative monetary policy tool

. Involves the central bank printing money and directly distributing the money to the public

. The idea aims to boost consumer demand and therefore increasing spending

. Benefit of helicopter money is that in comparison to QE method that it will immediately increase aggregate demand and spending, whereas QE will take much longer to come in effect.

. However, it results in high demand - pull inflation and possible hyperinflation

Question 10

Define Bond

Answer 10

. Bonds are issued by governments and corporations when they want to raise money

. By buying a bond, you’re giving the issuer a loan, and they agree to pay you back the face value of the loan on a specific date, and to pay you periodic interest payments

Question 11

Define Bond Yield

Answer 11

the return to an investor from the bond’s interest