4: The UK Economy - Policies

Question 1

Possible government objectives

Answer 1

1. Sustainable economic growth - aims for sustainability environmentally and promoting long-term growth to avoid busts
2. Price stability - keep inflation + rate of interest low and stable. Measured by CPI. Inflation target = 2%
3. Low unemployment
4. Sustainable fiscal deficit and national debt - fiscal deficit - government spends more than it receives in tax revenue -> leads to borrwing. If interest on national debt is too high = high opportunity cost i.e. could be spent on education or healthcare
5. Low income inequality and poverty - if this is high leads to social unrest + lower standard of living. Measured by gini coefficient
6. Stable current account - try to improve international competitveness -> exports are promoted

Question 2

What do banks and other institutions use as a guide for interest rates?

Answer 2

The Monerary Policy Committee’s ‘base rate’

Question 3

What is the impact of interest rate change?

Answer 3

Central bank tries to achieve the inflation target by manipulating interest rates and quantative easing (when the central bank introduces new money into the money supply

Question 4

The effect of lowering the base rate

Answer 4

If base rate is lowered -> lower the rate commercial bamks lend/borrow from each other
In theory this should be passed on to consumer/firms via a decrease in mortgage rates/loans. Will have various effects on the components of AD/AS

Question 5

The effect on the housing market and consumption if the base rate falls

Answer 5

Mortgages cheaper -> allows first-time buyers to take out mortgages -> housing market booms
Housing market booms -> existing homeowners experience positive wealth effect as houses rise in value -> may take out larger mortgages -> more money to spend
Exisiting mortgage holders have lower monthly repayments -> more disposable income

Question 6

The effect on consumption if the base rate falls

Answer 6

Loans are cheaper -> people borrow more to finance consumption -> AD rises -> opposite multiplier effects
Return on savings falls when interest falls -> opportunit cost of consuming falls -> people spend more

Question 7

The effect on government spending if the base rate falls

Answer 7

Lower corporate borrowing rates -> government can borrow money at an even lower interest rate
Government can borrow cheaply meaning running a fiscal deficit is less negative than when interest rates are high
HOWEVER, in a booming economy tax revenues may rise -> fiscal deficit less likely

Question 8

The effect on trade and exchange rates if the base rate falls

Answer 8

Lower interest rates means hot money flows out -> increase in supply of sterling -> fall in demand for stirling -> stirling depreciates
Results in imports becoming more expensive but exports become cheaper -> demand for x rise, m falls -> value of x rises, m falls -> trade deficit falls -> AD rises

Question 9

The effect on business investment if the base rate falls

Answer 9

Loans cheaper -> more investment in projects i.e. construction -> real GDP rises

Question 10

Who has control of the money supply and what have they been doing since 2008?

Answer 10

Bank of England. They have undertaken a programme of quantative easing since the 2008 financial crash

Question 11

Quantative easing

Answer 11

• Central bank creates new money (adding zeros to their bank account) -> uses this money to purchase bonds from commercial banks or pension funds -> commercial banks/pension funds have cash to spend elsewhere in the economy -> new money injected into economy
• BOE’s demand for govt. bonds increases their price -> brings done their yield (return)
• Means pension funds and banks go in search of a higher yield i.e. housing or the stock market. HOWEVER, they could hoard it or invest it abroad

Question 12

Issues with quantative easing

Answer 12

Cause inflation
Financial institutions may hoard it rather than invest it into the ‘real economy’
ULTIMATELY, seen as a useful tool to stimulate the economy when interest rates are virually as low as they can go

Question 13

What is the Bank of England?

Answer 13

Central bank of the UK
Made operationally independent in 1997 -> not directly accountable to the government

Question 14

Bank of England’s objectives

Answer 14

Inflation at 2%
Allowed a +/- 1% point in inflation taret before it ha to write a letter to the Chancellor explaining why its away from target, whats being done about it and when it will be back on track
No exchange rate target since 1992

Question 15

What is the Monetary Policy Committee?

Answer 15

Made up of 9 members
Meet once a month to decide whether there will be a change in monetary levers or not

Question 16

Factors affecting the Monetary Policy Committee’s decision

Answer 16

Inflation expectations
Consumer spending forecasts
Real GDP rate
Exchange rate
Trade balance
Consumer and firms’ confidence
State of labour market, full employment, wage pressures - unemployment and employment trends

Question 17

Microeconomic functions of fiscal policy

Answer 17

Governments levy taxes to provide merit goods, public goods, reduce negative externalities and reduce consumption of demerit goods

Question 18

Macroeconomic functions of fiscal policy

Answer 18

Governments levy taxes to redistribute income and wealth by giving out transfer payments (i.e. benefits) to reduce inequality

Question 19

Effect of fiscal policy on the government budget

Answer 19

Fiscal policy depends on government budget
Deficit = spending > revenue
Surplus = spending < revenue

Question 20

Impact of fiscal policy on AD

Answer 20

Governments use fiscal policy to influence AD and so macroeconomic objectives
-> i.e. if in a recession and a negatice output gap -> expansionary fiscal policy used like cutting income tac for those on lower income -> AD rises as these people have a higher marginal propensity to consumer (MPC)
Could also spend more on building schools and hospitals to increase govt. spending -> multiplier effect -> increase AD

Question 21

Impact of fiscal policy on AS

Answer 21

If corporation tax cut -> firms have higher post-tax profits -> investment may rise -> should boost human capital and physical capital -> increases productive capacity of the economy
If income tax cut -> attract foreign workers -> shifts LRAS to right
If spend more on infrastructure -> AD + LRAS could shift right

Question 22

What happened during the Great Depression?

Answer 22

1929 Wall Street crash caused global depression. Saw a rise in keynesian economic

Question 23

What is keynesian economics?

Answer 23

Idea that economies should be left alone by the government othe than in repsonse to recession and depression where expansionary fiscal policy and monetary policy should be used to stimulate

Question 24

Stimulating demand during the Great Depression

Answer 24

Governments paid out benefits and increased spending in order to increase AD and move the economy out of recession

Question 25

Government expenditure during the Great Depression

Answer 25

Spending filtered to the workers through increased employment and wages and improved confidence in the economy

Question 26

The UK’s ‘austerity’ in response to the 2008 financial crisis

Answer 26

UK government saw excessive sovereign debt as a risk to the stability of the country and aimed for a government budget surplus in order to reduce the debt

Question 27

UK government spending during the 2008 financial crisis

Answer 27

Reduced spending on infrastructure projects, reducing budgets of government departments
Pay freezes and caps on wage rises in public sector jobs

Question 28

Impact of UK policy during the 2008 financial crisis

Answer 28

Outcome was reduced budget deficit. Took several years for the government to turn a surplus so the level of national debt was not reduced but not siginificantly worsened
Side effects: decrease in AD due to reduced government spending and reduced incomes for public sector workers
This, plus loss of confidence abd availability in the market contributed to slow economic and wage growth since

Question 29

US policy during 2008 financial crisis

Answer 29

Fiscal stimulus. Aimed to spend their way out like the 1930s
Increased spending on infrastructure in an attempt to ‘jump-start’ the economy

Question 30

Impact of US policy during the 2008 financial crisis

Answer 30

US saw a rapid return to the developed countries trend rate of economic growth of 2% in 2010 which has remained fairly stable since (marginally lower than before the crash)

Question 31

Strengths of fiscal policy

Answer 31

Fastest acting of the 3 key types of economic policy: Increased government spending and tax cuts can be felt almost immediately -> real incomes rise as well as profits
Can target particular parts of the economy which need the most help

Question 32

Weaknesses of fiscal policy

Answer 32

Expansionary fiscal policy leads to increase government and national debt -> if government debt already high may lead to national bankruptcy