2.6.2 - Role of Bank of England ; Demand - side policies used in GFC and Great Depression; Strengths and Weaknesses of Demand Side Policies

Question 1

Role of Bank of England

Answer 1

Monetary Policy is controlled by Bank of England rather than government

The Monetary Policy Committee (MPC) is part of the Bank of England and is responsible for decisions over base rate and actions of quantitative easing

Aims to keep inflation at 2% + -

Question 2

Great Depression (1930s)

Answer 2

. Caused by Wall Street Crash in 1929 after sharp fall in share prices.

Multiple Possible Causes of fall in share prices:

. US banking system lent too much creating unsustainable boom, which led to a fall in AD, consumer confidence and fall in borrowing, etc.

. Protectionism reduced world trade which decreased AD due to less exports and lowered consumer confidence, decreasing AD

UK response : Balanced budget to reduce debt by raising income tax and cutting public expenditure on wages and unemployment benefits, interest rates reduced,

US response : Balanced Budget to reduced debt by making cuts, expansionary fiscal policy

Question 3

Global Financial Crisis (2008/2009)

Answer 3

. Caused by subprime mortgages lent to relatively poor households

. Example of moral hazard, as workers saw higher bonuses for selling more mortgages

. Houses were repossessed when mortgages were not met. Demand and prices fell for houses meaning the value of the house was less the mortgage of the house; this is negative equity

. This led to a fall in confidence due to the wealth effect. This reduced consumer spending and led to a fall in AD

UK and USA response :

. Both government nationalised banks to guarantee savers their money to prevent collapsed banking system. E.g. UK government bought Lloyds Bank

. Expansionary monetary policy used - lower interest rates and quantitative easing

. USA used more expansionary fiscal policy

Question 4

Limitations of Monetary Policy

(Fiscal and monetary)

Answer 4

. Commercial banks may not pass the base rate onto consumers, which means even if the central bank changes the interest rate, it might not have the intended affect of increasing AD

. Even if cost of borrowing is low, consumers might be unable to borrow as banks are unwilling to lend. After the 2008 financial crisis, banks became more risk averse.

. Low interest rates will also be effective at stimulating spending and investment, when consumer and firm confidence is high. If consumers think that the economy is risky, they are less likely to spend, even if interest rates are low

. Demand - side policies have time lags. For example, it takes interest rates two years to have an impact on the wider economy. This means that in the short - run, the economic policy will not be as effective meaning a limited impact on AD

. Expansionary fiscal and monetary policy increases national debt as it leads to a budget deficit, which leads to taking out loans with interest payments over time. This can affect AD in the long run