3.5 Demand Management - Monetary Policy Flashcards
What is a “government budget”?
“Planned inflows and outflows of government funds over a time period”.
What happens when Taxes > Spending?
Budget Surplus –> National debt falls
What happens when Taxes < Spending?
Budget Deficit –> National debt increases
What happens when Taxes = Spending?
Budget Balance –> National debt stays the same
What are some of the goals of “fiscal policy”?
- Reduce business cycle fluctuations
- Low unemployment
- Promote a stable economic environment for long-term growth
- Equitable distribution of income
- Low and stable inflation
- External balance - Trade balance (X - M)
Why does a government make transfer payments?
To redistribute income from one person/group to another. They do not in themselves result in the production and purchase of goods and services.
Why are automatic stabilizers used?
Because they can reduce the severity of the business cycle
What are two examples of automatic stabilizers?
- Progressive tax
- Unemployment benefit
How does “progressive tax” operate as an automatic stabilizer during the expansionary fase?
- Income increases
- Tax payments increase
- Firms and Households might end up in high tax bands
- Avg tax paid increases
- Disposable income and retained profit decreases
- Reduces AD
- Reduced business cycle fluctuation
How does “progressive tax” operate as an automatic stabilizer during the contractionary fase?
- Income Decreases
- Tax payments decrease
- More Firms and Households in lower tax bands
- Avg tax paid decreases
- Disposable income increases and retained profit increases
- Increases AD
- Reduced business cycle fluctuation
How do “unemployment benefits” operate as an automatic stabilizer during the expansionary fase?
- Income increases
- Unemployment falls
- Unemployment benefits decreases
- AD is again kept in check
How do “unemployment benefits” operate as an automatic stabilizer during the contractionary fase?
- Income decreases
- Unemployment increases
- Unemployment benefits increase
- AD is again kept in check
What is “crowding out”?
- if governments need to borrow money to fund increased government spending during a recession (9 ‘deficit financing’), the ensuing increased demand for money will drive up interest rates
- This in turn will discourage private sector borrowing — particularly by firms, so that private Investment (l), and to a lesser extent consumption spending (C) will fall
- This reduction in private sector spending may partially or even completely nullify the impact on AD of higher public spending
What are some benefits of “fiscal policy”?
- Fix deep recessions
- Fight inflation
- Targeted effects
- Impact on potential output (LRAS)
What are some limitations of “fiscal policy”?
- Inability to address Supply shocks, particularly cost-push inflation
- Political constraints
- Time lags
- How much public debt can an economy bear
What are “monetary policies”?
Policies set by the Central Bank which involve changing the money supply and interest rates to create price stability
What is the “discount rate”?
The rate at which central banks lend to other commercial/ deposit banks
What are “bonds”?
Debt that the government takes from within the economy
What happens with an expansionary monetary policy?
Bank rate cut –> AD shifts outwards
- Price Level increases
- Real output increases
What happens with a contractionary monetary policy?
Bank rate rise –> AD shifts inwards
- Price Level decreases
- Real output decreases
What are the 4 monetary policies?
- Discount rate
- Open Market Operations
- Quantitative Easing
- CRRC (Credit Reserve Ratio)
How does the “discount rate” monetary policy work?
The lower this rate means decrease in the cost of borrowing by banks. They will further pass on this reduced interest to attract more customers to borrow loans.
- -> This increases consumption and investment (as interest rates fall)
- -> AD increases
How does the “Open Market Operations (OMO)” monetary policy work?
- When government sells the bonds, the money supply in the economy falls
- AD falls –> less money –> less spending
- -> Contractionary monetary policy
- If government buys back bonds, money supply in economy increases
- AD increases –> more money –> more spending
- -> Expansionary monetary policy
How does the “Quantitative easing (QE)” monetary policy work?
Quantitative easing is an Extension of Open Market Operations (OMO), it is used during times of economic crisis during Covid-19 and Aims to reduce long term interest rates.
- Buying bonds on a very large scale and long term bond with long maturity periods (5 years, 10 years)
- Focus at increasing level of confidence amongst households and firms
How does the “Credit Reserve Ratio (CRRC)” monetary policy work?
This refers to the % of the deposits that the commercial banks must keep with the central bank. This money can not be used for making/ giving out loans.
- If CRRC increases from 6% to 7%
–> decreases money supply as more money from commercial banks has to be kept as reserve with the central bank
–> less money for loans
–> C + I decrease, AD shifts inwards
CONTRACTIONARY monetary policy
How does an Expansionary Monetary Policy affect output and prices?
- Increase money supply
- Interest rate falls
- Lower interest rate boosts consumption and investment spending
- AD increases, deflationary gap reduced/ closed
How does a Contractionary Monetary Policy affect output and prices?
- Reduce money supply
- interest rate rises
- higher interest rate discourages consumers and investors
- AD decreases –> Inflationary gap reduced/ closed
How can Expansionary vs Contractionary Monetary policies be drawn as a diagram?
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What are some reasons for monetary policies?
- Politically independent CB can implement policy changes quickly and with credibility
- Independent CB free to take long-term view (again: no politics)
- No (direct) impact on public finances
- No crowding out
What are some against for monetary policies?
- Time lags (impact of change on AD takes several months at least)
- Risk of conflicting objectives
- Cannot address supply shocks/ stagflation
- What if IR is already at/ near to 0%.
