BoP: Deflation as an Expenditure-Reducing Policy

Question 1

What are deflationary policies aimed at?

Answer 1

Reducing AD and limiting expenditure on imports.

This aims to improve the current account balance.

Question 2

What is a contractionary fiscal policy?

Answer 2

Increasing taxes or reducing government spending

This is a method used in deflationary policies.

Question 3

What does contractionary monetary policy involve?

Answer 3

Raising interest rates to reduce borrowing and consumption

This method also aims to decrease aggregate demand.

Question 4

Define Marginal Propensity to Import (MPM).

Answer 4

A key concept in determining the effectiveness of deflationary measures

MPM indicates the proportion of additional income spent on imports.

Question 5

If MPM = 0.4, what is the impact of a £10 billion reduction in AD?

Answer 5

Leads to a £4 billion fall in import spending

This illustrates the relationship between AD reduction and import spending.

Question 6

What are the short-term effects of deflationary policies?

Answer 6

• Lower Import Demand
• Slower Inflation

These effects can enhance price competitiveness.

Question 7

What are the long-term effects of deflationary policies?

Answer 7

• Reduced Economic Growth
• Higher Unemployment

Less spending leads to lower GDP and reduced production.

Question 8

What is the expenditure-switching effect?

Answer 8

Shifts demand towards domestically produced goods if domestic inflation falls relative to trading partners

This effect is often modest in modern economies.

Question 9

True or False: Deflationary policies can lead to recessionary pressures.

Answer 9

True

Lower AD can push an economy into contraction.

Question 10

What risks are associated with deflationary policies?

Answer 10

• Unemployment Growth
• Reduced Investment
• Deflationary Spiral

These risks include businesses cutting jobs and delaying consumption.

Question 11

What is a key argument in favor of pursuing deflationary policies in the UK?

Answer 11

• High Marginal Propensity to Import
• Trade Surplus in Services
• Inflation Control

These factors suggest potential benefits in competitiveness and monetary stability.

Question 12

What is a key argument against pursuing deflationary policies in the UK?

Answer 12

• Low Economic Growth
• Trade Deficit in Goods
• Risk to Services Sector

These concerns highlight the potential negative impacts on the economy.

Question 13

What historical case study illustrates the consequences of deflationary policy?

Answer 13

UK Deflationary Policy in the 1920s

This case showed severe economic contraction and high unemployment.

Question 14

What were the outcomes of the UK’s deflationary policies in the 1920s?

Answer 14

• Deflation of 10% (1921)
• Deflation of 14% (1922)
• Unemployment rose above 20%

These outcomes indicate the negative impacts of the policy.

Question 15

What can deflationary policies potentially improve?

Answer 15

The balance of payments by cutting imports

However, they carry high risks of economic slowdown.

Question 16

What are expenditure-switching policies?

Answer 16

Policies like devaluation and tariffs that may be more effective when economic activity is weak

They aim to redirect demand towards domestic goods.

Question 17

What does historical evidence from the 1920s UK suggest about deflation?

Answer 17

When misapplied, it can worsen economic conditions rather than correct trade imbalances

This emphasizes the risks of deflationary measures.