4.3.7 Role of Government in Growth Flashcards
What are the three ways of affecting he money supply?
- Interest Rates
- Quantitative Easing
- Exchange Rates
Define Monetary Policy
The use of interest rates, the money supply and exchange rates to influence the rate of economic activity in an economy
What are the two kinds of monetary policy?
Expansionary and Contractionary Monetary Policy
How can increasing interest rates affect the rate of economic activity in an economy?
Increasing interest rates decreases Aggregate Demand because it is more worth it to save so consumption decreases
How can decreasing interest rates affect the rate of economic activity in an economy?
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
What is the relationship between interest rates, exchange rates and money supply?
As interest rates increase, so do exchange rates, but money supply goes down.
How does interest rate mean increasing exchange rate?
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
How does inflation targeting support economic activity?
Ensures low and stable inflation, so more stability and planned production for businesses
How might inflation targeting be bad for economic activity?
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.
Explain how Quantitative Easing works
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
Explain impact of falling exchange rate on the economy
Imports more expensive and exports cheaper so increased AD, increased employed and increased inflation. Decrease current account deficit due to exports - imports
Evaluate the impact of falling exchange rates on the economy
Effect depends on magnitude of exchange rate changes. Unemployment will only decrease if there are a lot of exporting industries. Time Lag
Evaluate the effectiveness of changing interest rates at affecting AD
- 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
Define Fiscal Policy
the use of the taxation system and public spending to control the level and rate of economic activity
Difference between direct and indirect taxes
- 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.
What is the purpose of taxation?
- 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.
What are the ‘canons’ of taxation?
- 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
What effects can taxation have on the efficiency of the economy?
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.
How can corporation tax be used to manage the economy?
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.
How can income tax be used to manage the economy?
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)
Define crowding out
when government spending fails to increase overall aggregate demand because higher government spending causes an equivalent fall in private sector spending and investment.
define resource crowding out
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.
What are the factors that determine the best level of public spending in an economy?
- Technical Efficiency
- Equity
- Incidence of Tax
- Government Borrowing
How does technical efficiency in the economy determine the best size of public sector/spending?
The private sector is arguably more technically efficient so the economy could be made more efficient through privatisation
