April Test

Question 1

Definition of Demand Side Policies

Answer 1

Instruments at the disposal of the government to help it influence aggregate demand to achieve its main macroeconomic objectives.

Question 2

Definition of Fiscal Policy

Answer 2

The use of government spending and/or taxation to manage the level of aggregate demand.

Question 3

Definition of Expansionary Fiscal Policy

Answer 3

Fiscal policy which is used in a recession to boost aggregate demand.

Involves increasing government spending, and decreasing tax, requiring the government to run a budget deficit.

Question 4

Definition of a Budget Deficit (Expansionary Policy)

Answer 4

If a government does not have sufficient tax revenue to finance its expenditure, it may need to borrow in order to execute its plans.

A budget deficit exists when government spending exceeds tax revenues

Question 5

Definition of Contractionary Fiscal Policy

Answer 5

Fiscal policy which is used in an economic boom to reduce aggregate demand.

It involves increasing tax, and decreasing government spending, requiring the government to run a budget surplus.

Question 6

Discretionary Fiscal Policy vs. Automatic Stabilisers (Recession)

Answer 6

Due to the tax and benefit system, fiscal policy automatically works in a counter-cyclical way as unemployment / employment rates change throughout the economic cycle.

Government spending and taxation also dampen the effects of the trade cycle automatically.

This is because government expenditure automatically rises during recessions owing to the payment of more unemployment benefit as the number of unemployed claiming benefits rise.

Furthermore, tax revenues automatically fall due to falling household incomes and lower income tax receipts.

Lower consumption in a recession will also lead to falling VAT receipts.

Furthermore, in a recession, company profits are likely to be lower and therefore the government collects less in corporation tax.

The dual effect of rising government spending and falling tax receipts in a recession means the government is likely to spend more than it receives in taxation, known as a budget deficit.

Question 7

Discretionary Fiscal Policy vs. Automatic Stabilisers (Boom)

Answer 7

The government spends less on Job Seekers Allowance and collects more tax revenue from income tax, VAT and corporation tax.

This may eventually lead to the government running a budget surplus, where government spending is lower than the receipts from taxation.

So it can be seen that taxes such as income tax, VAT and corporation tax, as well as Job Seekers Allowance (JSA) act as automatic stabilisers of the trade cycle, slowing down the economy in boom times and speeding up growth in times of recession.

Question 8

Definition of Budget Surplus (Contractionary Policy)

Answer 8

A government surplus arising from government spending being less than tax revenues.

Governments can use the difference to repay part of the national debt.

Question 9

Definition of a Balanced Budget

Answer 9

A statement of spending and income plans by the government where spending is equal to its receipts, mainly tax revenues

Question 10

Definition of a Budget

Answer 10

A statement of the spending and income plans of an individual firm or government.

The Budget is the yearly statement on government spending and taxation plans in the UK.

Question 11

Definition of Bank of England Base Rate

Answer 11

The rate of interest charged by the Bank of England to banks to borrow money overnight.

It is the most important interest rate in the UK financial system because it influences other interest rates in the UK such as savings rates and rates of interest on loans by banks.

Question 12

Definition of a Direct Tax

Answer 12

A tax levied directly on individuals or companies such as income tax or corporation tax.

Question 13

Definition of Fiscal Stance

Answer 13

Whether fiscal policy is expansionary, contractionary, or neutral

Question 14

Definition of Instruments of Policy

Answer 14

An economic variable, such as the rate of interest, income tax rate, or government spending on education, which is used to achieve a target of government policy.

Question 15

Definition of Discretionary Fiscal Policy

Answer 15

Deliberate changes to fiscal policy made by the government to influence the economic cycle. E.g. reductions in rates of income or corporation tax or large government spending plans

Question 16

Fiscal Crowding Out (Evaluation of Expansionary FP)

Answer 16

The argument that government borrowing reduces the amount available for private sector borrowing and investment.

Firms find it difficult to borrow because the available borrowable loans have been taken by government.

Also, when the government needs to borrow money through the issuance of bonds, it pushes up IR due to the high demand for loanable funds. This disincentivises private firms from borrowing as it becomes more expensive.

So, any increases in G and counteracted by a fall in I.

Question 17

The Willingness and Ability of the Government to Borrow (Evaluation of FP)

Answer 17

Determined by political ideology:

Left-leaning governments are more inclined to run up a budget deficit.

Right-leaning governments are more fiscally constrained

Ability depends on credit rating, which in turn, depends on the size of the existing national debt.

Application:

After 2008, the UK was limited in its ability to take discretionary fiscal action by the significant burden that bank bail-outs had on public finances.

This contributed to a significant rise in the deficit to an estimated £175 billion (12.4% of GDP) in 2009-10, and a rise in the national debt above 80% of GDP at its peak.

Question 18

Definition of National Debt

Answer 18

The total accumulated borrowing of government which remains to be paid to lenders.

If a government repeatedly runs a budget deficit, these debts will accumulate. The accumulated debt is known as the national debt.

Question 19

Incentive Effects (Evaluation of FP)

Answer 19

Fiscal policy is said to be very distorting because it impacts incentives and therefore changes people’s decision making and behaviour.

High levels of corporation tax reduce the reward for entrepreneurial risk taking. Therefore, there is less of an incentive for people to start or expand firms.

High CT also reduces the amount of retained profit that firms have for investment; this may lead to a brain-drain.

On the other hand, high levels of government spending allows people to make a comfortable living on unemployment benefits. Hence, there isn’t an incentive to seek employment.

Question 20

Political constraints (Evaluation of FP)

Answer 20

In the US, all spending programs must be gain congressional approval, which can be very difficult if Congress is held by the opposing party, possibly leading to a government shutdown (e.g. 2018–19 United States federal government shutdown).

Question 21

Effectiveness in a Deep Recession (Strengths of FP)

Answer 21

In a deep recession, monetary policy is ineffective because interests rates are already ultra-low and near the zero lower-bound, meaning that they can’t be lowered further.

Consumer confidence and employment security is also low, and monetary policy doesn’t necessarily change the willingness of people to borrow.

Fiscal policy on the other hand is much more direct as it doesn’t depend on confidence and the response of firms and consumers.

Government spending is also a direct component of AD so there is no complex transmission mechanism, meaning that it is much more effective in a deep recession.

Question 22

Ability to Target Certain Regions or Sectors of the Economy (Strengths of FP)

Answer 22

Monetary policy is a ‘one size fits all’ approach that is applied to the whole economy.

Application: This is particularly the case in the Eurozone where individual Eurozone members do not have the ability to set an interest rate to suit their own economic needs (IR are set by the ECB for the whole Eurozone), so member states are heavily dependent on fiscal policy to help boost growth and investment, if IR is not doing enough.

Question 23

Ability to Improve the Supply-Side of the Economy (Strengths of FP)

Answer 23

Government spending on education will improve human capital, skills and productivity.

Infrastructure is going to improve physical capital e.g. transport, meaning greater productivity.

improved healthcare means fewer sick days, harnessing the power of the labour force much more than before.

Question 24

Neo-Classical Critique of Fiscal Policy

Answer 24

Due to the Neo-Classical belief that an economy will return to full employment naturally in the long-run, monetarist economists argue that fiscal policy is at best, not needed, and at worst, extremely inflationary for the economy.

Expansionary FP in a recession: not necessary as wages will fall to restore full employment.

Expansionary FP at full employment: extremely inflationary.

Question 25

Definition of Monetary Policy

Answer 25

A type of demand-side policy which involves the use of monetary tools (the interest rate, the money supply, and the exchange rate) to influence the macroeconomy.

It is conducted by a country’s central bank who often have responsibility for ensuring price stability (they adjust IR to meet the inflation target)

In modern times, CBs primarily use interest rates as their tool of choice (though sometimes resort to Quantitative Easing - expanding the money supply - if interest rates cannot be adjusted any lower)

Question 26

Definition of Interest Rates

Answer 26

The cost of borrowing money and the reward for saving

Question 27

Contractionary Monetary Policy

Answer 27

The CB would increase IR to decrease AD, if inflation was predicted to rise above target.

Question 28

Expansionary Monetary Policy

Answer 28

The CB would decrease IR to increase AD, if inflation was predicted to fall below target.

Question 29

How do IR influence AD?

Answer 29

Buying consumer durables on credit becomes cheaper. This means that the demand for cars, furniture, and whitewoods, which are often purchased on payment plans, would increase, boosting C.

Loans for investment become cheaper, and so investment projects become more profitable. Also, a rise in C leads to a rise in revenues and retained profits for firms, which in turn stimulate more investment as firms need to invest to supply the extra goods and services being demanded by consumers.

Those on variable rate mortgages see their monthly repayments fall, and so an increase in disposable income, increasing C.

Savings become less rewarding, and so people would rather spend instead of saving, increasing C.

A fall in IR would cause a depreciation of the exchange rate, increasing international competitiveness as it makes a country’s imports more expensive and its exports less expensive in foreign markets. Thus, there is an increase in Net Exports.

A fall in IR may increase asset prices. For instance, falling IR may lead to an increase in the demand for housing, which in turn pushes up house prices. Hence, this causes a wealth effect as homeowners are better of because their houses have increased in value.

Question 30

Definition of Quantitative Easing

Answer 30

A form of expansionary monetary policy in which the central bank injects new created electronic money into the financial system through the purchase of government bonds and other high-quality assets.

Question 31

How does QE stimulate the economy?

Answer 31

The banks and financial institutions who sell bonds and other debt to the Central Bank exchange illiquid assets for liquid cash, which they can then lend out or use to purchase other assets.

When the CB conducts large scale asset purchases, this increases the demand for those assets and drives up asset prices.

Commercial banks also use their new cash to purchase other assets, which increases prices of other assets like stocks and shares.

As QE increases the money supply, this will cause a fall in the market interest rates (for example on commercial loans or mortgages) which stimulates borrowing.

There will also be downwards pressure on the exchange rate which could stimulate net exports.

Question 32

Negative Interest Rates

Answer 32

Negative interest rates are designed to get commercial banks lending because they will pay the central bank interest for holding money on deposit with them.

Negative rates may also bring about a reduction in real interest rates – which might in turn stimulate increased business investment and help an economy escape a liquidity trap and return to stronger economic growth

Negative rates are partly designed to cause an outflow of hot money thereby depreciating the exchange rate, and stimulating net-exports.

Application:
In 2009 and 2010, Sweden and, in 2012, Denmark used negative interest rates to stem hot money flows into their economies.

Question 33

Evaluation of Negative Interest Rates

Answer 33

Negative interest rates can lower bank profitability by narrowing the interest-rate margins between savings and loans rates – this is a threat to their long run stability

Lower interest rates on deposits may cause households and businesses to hoard cash rather than spend/invest

Pension and insurance companies may struggle to meet their long term liabilities if long term interest rates (yields) are close to zero or below

The economy may become dependent on ultra-low interest rates whereas expansionary fiscal policy might be more effective in stimulating real investment and growth.

Question 34

Whether lower Interest Rates can boost AD depends on how far interest rates can be lowered (Evaluation of MP)

Answer 34

In 2008, interests rates in the UK fell from 5% to 0.5%, drawing the rate even closer to the zero-lower bound and ushering in a period of ultra-low interest rates.

Consequently, as there is little room to decrease IR again in another recession, actually decreasing them again would be very ineffective, unless you take into account unconventional methods, like Negative Interest Rates and Quantitative Easing.

Question 35

Whether lower Interest Rates can boost AD depends on consumer and business confidence (the stage of the business cycle) (Evaluation of MP)

Answer 35

In a deep recession, consumer confidence decreases with the fall in wages and growth in unemployment (lack of job security). Consequently, consumers are less willing to borrow.

In a deep recession, banks are concerned with loans to being repaid and the growing prospect of insolvency. Thus, this decreases their willingness to lend, making credit less available (credit crunch).

Question 36

The effectiveness of monetary policy depends on the level of indebtedness in an economy (Evaluation of MP)

Answer 36

Where there is a high level of indebtedness, there is a high proportion of people on variable rate mortgages, with credit card debt, consumer debts, and lots of existing business loans. Thus, these repayments are impacted by changes in IR.

However if the level of indebtedness is low (maybe due to a culture of home ownership), fewer payments will be affected by the change in IR, and so changing them would be an ineffective tool.

Question 37

The effectiveness of monetary policy depends on the credibility of the Central Bank (Evaluation of MP)

Answer 37

Inflation is a self-fulfilling prophecy. Therefore, controlling expectations of it is a way to control it.

As a result, the bank must be independent with not political orientation in order to appear credible.

Since 1997, MP in the UK has been set by an independent MPC. This independence has meant that there has been more confidence in markets, since firms and individuals know that the MPC will now always intervene to restrain excessive inflation.

Since inflation expectations are important in determining behaviour, being able to manage people’s expectations of inflation helps to manage inflation itself.

As a result, we have seen a period of high investment and lower wage demands, as firms and individuals expect a stable economic environment.

Question 38

Time-Lags (Evaluation of MP)

Answer 38

There is a time-lag with MP. The MPC estimates this to be 1 year for policy changes to affect the behaviour of firms/individuals, then a further year for this to have an effect on inflation.

This time lag exists because firms need time to plan and execute an investment project, many mortgages are fixed rate, and consumers take time to recognise that money may be best off in a savings account.

This ultimately means that changes in IR do not affect the economy until ups to 2 years later. Thus, when the MPC decide on policy, they must do this based on expectations for 2 years ahead, not the current situation. This creates much uncertainty.

Question 39

Elasticity of the AS Curve (Evaluation of MP)

Answer 39

If the economy is in a slump, and there is lots of spare capacity, then any cut in IR will have a relatively large effect on GDP, but less of an effect on inflation.

If the economy is in a boom, with a small negative output gap, any cut in IR will be much more inflationary in nature.

Thus, it is important that the MPC has reliable data on the economy, and can make accurate predictions of the future economy based on this.

If the MPC believes that the output gap is different to what it actually is, then the effect of MP may be vastly different to what was expected, and the problem may be made worse.

Question 40

Monetary Policy as a blunt policy tool (Evaluation of MP)

Answer 40

The MPC has just one remit: to maintain CPI inflation at 2%. This is arguably a very narrow remit as it does not take into account any other aspect of the economy.

Changes in the IR affect the overall level of economic activity, so may have differing impacts on different regions and sectors and may involve trade-offs with the objectives.

Due to the reliance on different sectors of the economy in the North of England compared to the South, the IR may not be suited for all sectors. It is often criticised that the MPC focuses too much on maintaining steady inflation in the South, at the expense of high unemployment in the North.

Consequently, the government may need to use FP or supply-side policies in combination with MP, in order to ensure other aspects of the economy are also stable.

Question 41

Definition of Cyclical Unemployment

Answer 41

When there is insufficient demand in the economy for all worker who wish to work at current wage rates to obtain a job.

Question 42

Ability to reduce unemployment depends on the type of unemployment (Evaluation of MP)

Answer 42

Monetary Policy only tackles cyclical unemployment.

This is because CU occurs due to insufficient AD in the economy for all workers to get a job during a recession.

Thus, as MP aims to increase AD, it can help neutralise CU by stimulating derived demand.

Question 43

Evaluations of MP

Answer 43

1) Ability to reduce unemployment depends on the type of unemployment
2) Monetary Policy as a blunt policy tool
3) Elasticity of the AS Curve
4) Time-Lags
5) The effectiveness of monetary policy depends on the credibility of the Central Bank
6) The effectiveness of monetary policy depends on the level of indebtedness in an economy
7) Whether lower Interest Rates can boost AD depends on consumer and business confidence (the stage of the business cycle)
8) Whether lower Interest Rates can boost AD depends on how far interest rates can be lowered

Question 44

Evaluations of FP

Answer 44

1) Fiscal Crowding Out
2) The Willingness and Ability of the Government to Borrow
3) Incentive Effects
4) Political constraints

Question 45

Strengths of FP

Answer 45

1) Effectiveness in a Deep Recession
2) Ability to Target Certain Regions or Sectors of the Economy
3) Ability to Improve the Supply-Side of the Economy

Question 46

Definition of Hot Money

Answer 46

Money that flows freely and quickly around the world looking to earn the best rate of return.