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IB Economics > 3.5 Demand Management - Monetary Policy > Flashcards

3.5 Demand Management - Monetary Policy Flashcards

1
Q

What is a “government budget”?

A

“Planned inflows and outflows of government funds over a time period”.

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2
Q

What happens when Taxes > Spending?

A

Budget Surplus –> National debt falls

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3
Q

What happens when Taxes < Spending?

A

Budget Deficit –> National debt increases

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4
Q

What happens when Taxes = Spending?

A

Budget Balance –> National debt stays the same

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5
Q

What are some of the goals of “fiscal policy”?

A
  • 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)
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6
Q

Why does a government make transfer payments?

A

To redistribute income from one person/group to another. They do not in themselves result in the production and purchase of goods and services.

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7
Q

Why are automatic stabilizers used?

A

Because they can reduce the severity of the business cycle

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8
Q

What are two examples of automatic stabilizers?

A
  1. Progressive tax
  2. Unemployment benefit
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9
Q

How does “progressive tax” operate as an automatic stabilizer during the expansionary fase?

A
  • 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
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10
Q

How does “progressive tax” operate as an automatic stabilizer during the contractionary fase?

A
  • 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
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11
Q

How do “unemployment benefits” operate as an automatic stabilizer during the expansionary fase?

A
  • Income increases
  • Unemployment falls
  • Unemployment benefits decreases
  • AD is again kept in check
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12
Q

How do “unemployment benefits” operate as an automatic stabilizer during the contractionary fase?

A
  • Income decreases
  • Unemployment increases
  • Unemployment benefits increase
  • AD is again kept in check
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13
Q

What is “crowding out”?

A
  • 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
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14
Q

What are some benefits of “fiscal policy”?

A
  • Fix deep recessions
  • Fight inflation
  • Targeted effects
  • Impact on potential output (LRAS)
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15
Q

What are some limitations of “fiscal policy”?

A
  • Inability to address Supply shocks, particularly cost-push inflation
  • Political constraints
  • Time lags
  • How much public debt can an economy bear
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16
Q

What are “monetary policies”?

A

Policies set by the Central Bank which involve changing the money supply and interest rates to create price stability

17
Q

What is the “discount rate”?

A

The rate at which central banks lend to other commercial/ deposit banks

18
Q

What are “bonds”?

A

Debt that the government takes from within the economy

19
Q

What happens with an expansionary monetary policy?

A

Bank rate cut –> AD shifts outwards

  1. Price Level increases
  2. Real output increases
20
Q

What happens with a contractionary monetary policy?

A

Bank rate rise –> AD shifts inwards

  1. Price Level decreases
  2. Real output decreases
21
Q

What are the 4 monetary policies?

A
  1. Discount rate
  2. Open Market Operations
  3. Quantitative Easing
  4. CRRC (Credit Reserve Ratio)
22
Q

How does the “discount rate” monetary policy work?

A

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
23
Q

How does the “Open Market Operations (OMO)” monetary policy work?

A
  • 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
24
Q

How does the “Quantitative easing (QE)” monetary policy work?

A

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
25
Q

How does the “Credit Reserve Ratio (CRRC)” monetary policy work?

A

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

26
Q

How does an Expansionary Monetary Policy affect output and prices?

A
  • Increase money supply
  • Interest rate falls
  • Lower interest rate boosts consumption and investment spending
  • AD increases, deflationary gap reduced/ closed
27
Q

How does a Contractionary Monetary Policy affect output and prices?

A
  • Reduce money supply
  • interest rate rises
  • higher interest rate discourages consumers and investors
  • AD decreases –> Inflationary gap reduced/ closed
28
Q

How can Expansionary vs Contractionary Monetary policies be drawn as a diagram?

A

-

29
Q

What are some reasons for monetary policies?

A
  • 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
30
Q

What are some against for monetary policies?

A
  • 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%.

IB Economics (41 decks)

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