4.3.7 Role of Government in Growth

Question 1

What are the three ways of affecting he money supply?

Answer 1

• Interest Rates
• Quantitative Easing
• Exchange Rates

Question 2

Define Monetary Policy

Answer 2

The use of interest rates, the money supply and exchange rates to influence the rate of economic activity in an economy

Question 3

What are the two kinds of monetary policy?

Answer 3

Expansionary and Contractionary Monetary Policy

Question 4

How can increasing interest rates affect the rate of economic activity in an economy?

Answer 4

Increasing interest rates decreases Aggregate Demand because it is more worth it to save so consumption decreases

Question 5

How can decreasing interest rates affect the rate of economic activity in an economy?

Answer 5

Decreasing interest rates increases Aggregate Demand because:

• it is more worth it to spend so consumption increases
• Investment increases because of cheap borrowing
• Net exports increase because exchange rate falls

Question 6

What is the relationship between interest rates, exchange rates and money supply?

Answer 6

As interest rates increase, so do exchange rates, but money supply goes down.

Question 7

How does interest rate mean increasing exchange rate?

Answer 7

Higher interest rate increases demand for the Pound, so currency speculators invest in the pound/hot money flows in, strengthening it in relation to other currencies

Question 8

How does inflation targeting support economic activity?

Answer 8

Ensures low and stable inflation, so more stability and planned production for businesses

Question 9

How might inflation targeting be bad for economic activity?

Answer 9

If it is a ‘max’ target rather than a ‘+/-1%’, because they will always seek to keep it lower than the max to protect from fluctuations, but it is more likely to cause deflation unintentionally that way as well if it fluctuates down too.

Question 10

Explain how Quantitative Easing works

Answer 10

Money is created electronically which is used to buy govt assets like bonds, which increases demand for those bonds, causing their price to go up, and their yield to go down, so investors are disincentivised from holding onto the bonds, so they invest instead in corporate bonds which then increase in demand and decrease in yield, which causes overall interest rates to go down and willingness to lend to go up as access to credit improves. Leads to increase in AD and Economic Growth

Question 11

Explain impact of falling exchange rate on the economy

Answer 11

Imports more expensive and exports cheaper so increased AD, increased employed and increased inflation. Decrease current account deficit due to exports - imports

Question 12

Evaluate the impact of falling exchange rates on the economy

Answer 12

Effect depends on magnitude of exchange rate changes. Unemployment will only decrease if there are a lot of exporting industries. Time Lag

Question 13

Evaluate the effectiveness of changing interest rates at affecting AD

Answer 13

• Cutting demand for imports through cutting interest rates depends on the import elasticity of demand.
• Will increase Output but not prices if there is considerable spare capacity in the economy
• Doesn’t affect Government Spending (Exogenous Factor)
• Time Lag
• MEC: If interest rates are above RoI then investment will decrease

Question 14

Define Fiscal Policy

Answer 14

the use of the taxation system and public spending to control the level and rate of economic activity

Question 15

Difference between direct and indirect taxes

Answer 15

• Direct taxes are taxes levied directly on an individual or organisation, e.g. Income or corporation tax.
• Indirect taxes are levied on a good or service e.g. VAT or Council Tax.

Question 16

What is the purpose of taxation?

Answer 16

• To fund government expenditure
• To correct negative externalities
• To influence economic variables such as inflation, unemployment and the BoP
• To redistribute income by taxing those who have more to fund services for the underprivileged e.g. Welfare.

Question 17

What are the ‘canons’ of taxation?

Answer 17

• Low cost of collection in relation to yield of tax.
• The timing and amount of collection should be clear and certain
• The means and timing of payment should be convenient to the taxpayer
• Taxes should be proportional to the means/income of the taxpayer,so they can pay it.
• Should lead to the least loss of economic efficiency or increase it
• Compatible with foreign tax regimes
• Automatically adjusts to the changes in the GPL

Question 18

What effects can taxation have on the efficiency of the economy?

Answer 18

Some taxes can make markets more efficient by removing negative externalities like the tobacco industry
Some taxes can make markets less efficient e.g. A market with perfect competition having a tax levied on it, altering the level of competition and decreasing efficiency
Law of ‘second best’ - the more broad the definition for the good being taxed the less likely that it will lead to efficiency losses.

Question 19

How can corporation tax be used to manage the economy?

Answer 19

If corporate tax is lowered, this can achieve a greater level of economic activity, because firms will have less costs, whereas if corporate tax is higher, then welfare spending can increase to reduce income inequality.

Question 20

How can income tax be used to manage the economy?

Answer 20

Can be used to manipulate variables like inflation by increasing or decreasing consumption by changing tax rates. E.g. Decrease in tax rates causes an increase in consumption because of more average expendable income. Demand increases quickly causing demand-push inflation.
(BUT REQUIRES SPENDING CUTS TO FINANCE, MEANING LESS GOVT SPENDING)

Question 21

Define crowding out

Answer 21

when government spending fails to increase overall aggregate demand because higher government spending causes an equivalent fall in private sector spending and investment.

Question 22

define resource crowding out

Answer 22

if the private sector lend money to the government they have less money to invest in private sector projects, so the public sector grows at the sacrifice of private sector growth.

Question 23

What are the factors that determine the best level of public spending in an economy?

Answer 23

• Technical Efficiency
• Equity
• Incidence of Tax
• Government Borrowing

Question 24

How does technical efficiency in the economy determine the best size of public sector/spending?

Answer 24

The private sector is arguably more technically efficient so the economy could be made more efficient through privatisation

Question 25

How does the degree of equity in the economy act as a factor determining the size of the public sector?

Answer 25

Privatisation can lead to high levels of inequity e.g. in healthcare. If public sector, everyone has access to healthcare, regardless of ability to afford it.

Question 26

How does the incidence of tax determine the best size of the public sector?

Answer 26

The Public sector cannot be too large because then tax rates will be so high that it will disincentivise people from working, decreasing the rate and level of economic activity

Question 27

How does the trade cycle count as a factor determining the best level of public spending?

Answer 27

Keynesians believe that in a slump/recession, public spending should increase to stimulate AD

Question 28

How does government spending determine the best size of the public sector?

Answer 28

If the public sector is so large to the point that it must be financed by an unsustainable level of government borrowing then it is too large.

Question 29

What is the budget deficit?

Answer 29

The measure of how much the government needs to borrow in order to finance their spending

Question 30

What is the national debt?

Answer 30

The total amount of borrowing undertaken by the government which has not yet been repaid

Question 31

What are the arguments against raising taxes to reduce the budget deficit?

Answer 31

• Disincentive to work
• Could reduce tax revenue (laffer curve)
• increases risk of tax evasion/avoidance
• cutting spending has more certain outcomes in the short term

Question 32

What are the arguments for cutting spending to reduce the budget deficit?

Answer 32

• Public sector too large and inefficient. Private sector more efficient
• Reduce the danger of crowding out private sector investment. Investment increase leads to more corp. tax

Question 33

What are the evaluations for the arguments for cutting spending to reduce the budget deficit?

Answer 33

• Effect of cuts depends on where cuts are made
• Size of private sector growth might not equal reduction in public sector
• May have adverse affect on economic recovery and cause recession
• Increased income inequality due to dependency by low incomes on benefits

Question 34

Arguments for raising tax

Answer 34

• Can afford to raise tax because the UK has the lowest corporate tax compared to the US, France and Germany. Raising it will only be a problem if its over the rates of the other countries
• Increasing tax on luxuries decreases income inequality and is naturally progressive
• Raising tax won’t have an impact on future infrastructure

Question 35

List causes of a fiscal deficit

Answer 35

• Expansionary Fiscal Policy
• Decrease in tax due to low wage growth after economic crash
• Economic Crash 2008-9

Question 36

What are the negative effects of cutting the fiscal deficit too slowly?

Answer 36

• If cut too slowly, debt servicing payments rise so less money for future government to spend on public sector (opportunity cost)
• Rise in government spending on debt servicing increases AMD which causes inflation
• The quicker the debt is reduced, the lower the risk of crowding out.
• Risk of further downgrade by CRAs, making it more expensive to borrow

Question 37

What are the negative effects of cutting the fiscal deficit too quickly?

Answer 37

• Cutting spending too quickly would impede recovery due to negative multiplier
• Workers may emigrate due to higher unemployment from cutting public sector
• Reduction in quality of life due to worse public sector (but private sector may fill in the gaps)

Question 38

How does reducing the deficit quickly reduce the risk of crowding out?

Answer 38

When investment is more risky because debts aren’t being paid off quickly enough, the yields on govt. bonds may rise to encourage lenders to risk buying bonds. Commercial interest rates will increase to compete, reducing borrowing to fund investment

Question 39

Give the main point in support of a rise in the national debt not being a cause for concern

Answer 39

• If the money is being used to finance improvements in infrastructure and capital projects, as it will make it easier to repay the debt in future

Question 40

Give the evaluation points in opposition to rising national debt not being a problem

Answer 40

• Even if money is spent on infrastructure there is an opportunity cost because more paid servicing the debt means less money for the future
• Money spent on infrastructure means increase in size of public sector which means resource or financial crowding out
• Inflation if caused by concurrent fiscal deficits
• May be forced to raise taxes to reduce it
• Limits ability for fiscal loosening