CH38 Demand-side policies

Question 1

what is monetary policy?

Answer 1

it is the manipulation by governments of monetary variables, such as interest rates and the money supply, to achieve its objectives

Question 2

what is fiscal policy?

Answer 2

it is the use of taxes, government spending and government borrowing to achieve its objectives

Question 3

what is meant by instruments of policy?

Answer 3

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

Question 4

what are the 2 main monetary policy instruments which the UK gov has used, through the Bank of England, to influence the economy? and why have they been used?

Answer 4

the UK gov, through the Bank of England, has used two main monetary policy instruments to influence the economy as a whole: interest rates and quantitative easing
-they have been used to get the economy out of the deep and prolonged recession that occurred after the financial crisis of 2008

Question 5

what is the rate of interest?

Answer 5

it is the price of money. Or in other words, it is the cost of borrowing and the reward for saving given as a percentage.

Question 6

how does the rate of interest affect the economy? the higher the rate of interest, the what?

Answer 6

-the rate of interest affects the economy through its influence of aggregate demand.
-the higher the rate of interest, the lower the level of AD.

Question 7

what are the 6 ways in which interest rates affect the AD curve?

Answer 7

-consumer durables: the higher the rate of interest, the greater the monthly payments will have to be for any given sum borrowed. Hence, high interest rates lead to lower sales of durable goods and hence lower consumption expenditure
-the housing market: houses are typically bought using a mortgage. The lower the rate of interst, the lower the mortgage repayments on a given sum borrowed. This makes houses more affordable. It might encourage more people to buy houses.
-wealth effects: a fall in rates of interest may increase asset prices. For instance, falling interest rates may lead to an increase in demand for housing, which in turn pushes up the prices of houses. If house prices rise, all homeowners are better off because their houses have increased in value. This may encourage them to increase their spending. Equally, a fall in interest rates will raise the price of gov bonds. Rises in the price of bonds held by individuals or businesses will increase their financial wealth, which again may have a positive impact on consumer expenditure.
-saving: higher interest rates make saving more attractive compared to spending. This may lead to a fall in AD at the present time.
-investment: the lower the rate of interest, the more investment projects become profitable.
-the exchange rate: a fall in the interest rate is likely to lead to a fall in the value of the domestic currency. For the UK a fall in the value of the pound means that foreigners can now get more pounds for each unit of their currency. However, UK residents have to pay more pounds to get the same number of US dollars or Japanese yen. This in turn means that goods priced in pounds become cheaper for foreigners to buy, whilst foreign goods become more expensive for British firms to buy.

Question 8

what did governments do in response to the financial crisis of 2008 in terms of interest rates? did it work? what did they introduce instead?

Answer 8

-they pushed interest rates to their minimum levels.
-however, historically low interest rates failed to stimulate aggregate demand sufficiently.
-instead, central banks then introduced a policy of quantitative easing

Question 9

what is quantitative easing?

Answer 9

it is a monetary policy instrument where the central bank buys financial assets in exchange for money in order to increase borrowing and lending in the economy.
-e.g. a commercial bank in an economy might hold (i.e. own) bonds. Bonds are loans issued either by governments or by firms. With quantitative easing, the central bank buys bonds from banks in exchange for money. The commercial bank now holds fewer bonds, or loans, and more money. It can then lend out that money to customers. Those customers might be firms wanting to borrow to invest in new equipment. It might be households wanting to buy a car or a new kitchen. Higher investment and higher consumption then increases AD

Question 10

what affect does quantitative easing have on interest rates? what else does this have an affect on?

Answer 10

-quantitative easing also has the effect of lowering interest rates further and so encouraging borrowing
-this also has an effect on the exchange rate. By lowering interest rates, the exchange rate of a country falls. E.g if the UK engages in quantitative easing, interest rates in the UK fall. This encourages international investors to switch their money out of the UK assets and into other assets in other countries. This leads to a fall in demand for the pound and a rise in its supply, so causing a fall in the price of the pound against other currencies. A lower exchange rate will make exports more competitive

Question 11

does the elected government directly control monetary policy in the UK?

Answer 11

No it does not.
-instead, this is delegated to the Bank of England, which operates monetary policy on an independent basis

Question 12

who makes up the Monetary Policy Committee?

Answer 12

9 people make up the MPC
-five are from the Bank of England, including the Governor of the Bank of England.
-the other four are independent outside experts, mainly professional economists.

Question 13

who are the most important decisions about monetary policy made by

Answer 13

made by the monetary policy committee (MPC) of the Bank of England

Question 14

what happens if inflation exceeds three percent or is less than one percent?

Answer 14

-the Governor of the Bank of England has to write to the Chancellor of the Exchequer to explain the reasons for this and outline what actions, if any, the Bank of England is taking to bring the inflation rate back to its target of 2 percent

Question 15

what would the MPC do if the rate of inflation rose?

Answer 15

-in normal times, a rise in the rate of inflation would indicate excess demand in the economy. The Monetary Policy Committee would then increase interest rates to reduce AD.

Question 16

what would the MPC do if the rate of inflation fell towards zero?

Answer 16

the MPC would cut interest rates to boost aggregate demand and nudge inflation back up to its target level

Question 17

from March 2009, at what level did the MPC keep base rates at?

Answer 17

from March 2009, the MPC kept base rates at record low levels of 0.5 percent.
-it recognised that any inflation above 2percent was most unlikely to be caused by excess demand. This was because unemployment was high and economic growth very weak.

Question 18

what are the main areas of public spending?

Answer 18

the main areas of public spending are the National Health Service, defence, education, and roads.
in addition, the gov is also responsible for transferring large sums of money around the economy through its spending on social security and National Insurance benefits.
-all of this is financed mainly through taxes, such as income tax and VAT

Question 19

in the post-war era, what have govs rarely balanced?

Answer 19

govs have rarely balanced their budgets.
-in most years, they have run budget deficits, spending more than they receive. As a result, in most years govs have had to borrow money

Question 20

what is a budget deficit?

Answer 20

when government spending is greater than its receipts (revenue from taxes)

Question 21

what is meant by public sector net borrowing (PSNB)?

Answer 21

it is the difference between gov spending and its receipts in the UK.
-in other words, it is the borrowing of the public sector (central gov, local gov and other state bodies as nationalised industries) over a period of time.

Question 22

in which years did the UK gov have a budget surplus?

Answer 22

between 1969-70, 1988-89, 1998-2001, the UK gov received more revenue than it spent.

Question 23

what does a budget surplus allow a gov to do?

Answer 23

it allows a gov to pay off part of its accumulated debt.
-this debt, called the National Debt, dates back to the founding of the Bank of England in 1694

Question 24

what is the official name of the National Debt in the UK?

Answer 24

the public sector net debt (PSND)

Question 25

what is meant by a balanced budget?

Answer 25

when gov receipts equal gov spending

Question 26

what are the two key dates in the year for fiscal policy?

Answer 26

-one is the day of the Budget which occurs in March. In the Budget, the Chancellor gives a forecast of government spending and taxation in the coming financial year. Changes in taxation are also announced.
-the other key date occurs in November or December with the Chancellor’s Autumn Statement. In this report, the Chancellor gives another forecast of gov spending and taxation and announces the govs spending plans for the year.

Question 27

when does the financial year in the UK start?

Answer 27

6 April and runs until 5 April the following year

Question 28

What is a direct tax?

Answer 28

a tax levied directly on an individual or organisation. For example, income tax is a direct tax that individual income earners have responsibility for paying. The other main direct tax levied on individuals is National Insurance contributions which, like income tax, is levied on earnings. Corporation tax is a direct tax paid by companies. It is levied on company profits

Question 29

what is an indirect tax?

Answer 29

an indirect tax is a tax on a good or service.
-For instance, value added tax is an indirect tax because it is a 20 percent tax on most goods and services.
- Excise duties on goods such as petrol, drink and tobacco, are indirect taxes levied on the volume of goods bought.
-Council tax is an indirect tax paid by homeowners on the notional value of a property whilst business rates, paid by firms, is an indirect tax on the notional rent of a property.

Question 30

what will a rise in gov spending increase?

Answer 30

a rise in gov spending will increase AD

Question 31

what happens to AD if gov spending is kept constant but tax rates fall?

Answer 31

there will be a rise in AD. This is because if the gov cuts income tax, the disposable income of households will increase which will lead to an increase in consumption, although there will also be a rise in imports.
- If the gov cuts VAT or excise duties, prices of consumer goods should fall again, leading to a rise in consumption. If govs cut taxes on company profits, this might encourage firms to increase investment.

Question 32

What other way can the gov increase AD?

Answer 32

the gov could also increase AD by raising both gov spending and taxes but raising taxes by less than the increase in gov spending.
- Equally, a cut in taxes but a smaller cut in gov spending will also lead to a rise in AD.

Question 33

In general, what is a rise in the budget surplus or a fall in the budget surplus likely to increase? What would this be called?

Answer 33

a rise in the budget deficit or a fall in the budget surplus is likely to increase AD. This would be called expansionary fiscal policy.

Question 34

When does contractionary fiscal policy occur?

Answer 34

occurs when there is a fall in the budget deficit or a rise in the budget surplus.

Question 35

what is meant by the fiscal stance or budget position?

Answer 35

A: whether fiscal policy is expansionary or contractionary or neutral

Question 36

What is neutral fiscal policy?

Answer 36

it is when changes to gov spending and taxation leave the overall budget surplus or deficit unchanged and have no effect on AD

Question 37

Will a rise in gov spending only increase AD by the value of the increase in G?

Answer 37

no it will not just increase AD by the value of the increase in G. There will be a multiple increase in AD. This multiplier effect will be larger, the smaller the leakages from the circular flow.
- In a modern economy, where leakages from savings, taxes and imports are a relatively high proportion of national income, multiplier values tend to be small.

Question 38

How does expansionary monetary policy, or loosening of monetary policy, work?

Answer 38

It works, for example, through lowering interest rates or increasing quantitative easing.

Question 39

How does contractionary monetary policy, or tightening of monetary policy, work?

Answer 39

it works, for example, through raising interest rates or reducing quantitative easing

Question 40

What Keynesian economists tend to favour the use of when the economy is in recession or is growing so fast that inflation begins to increase?

Answer 40

they favour the use of both fiscal and monetary demand-side policies.

Question 41

what do classical economists tend to argue about fiscal policies?

Answer 41

Classical economists tend to argue that fiscal policies are ineffective and govs should rely solely on monetary policy to influence AD, if at all.

Question 42

what do Keynesian economists argue about the speed of adjustment of an economy?

Answer 42

Keynesian economists tend to argue that an economy could be in short-run disequilibrium for years and even decades because of a lack of demand. If consumers, firms and govs spend less than is needed to get the economy to full employment, then the economy can remain depressed for a long time.

Question 43

what do classical economists argue about the speed of adjustment of an economy?

Answer 43

classical economists tend to argue that economies adjust very quickly. If there is long-term unemployment, for example, with no economic growth, this is not because there is a recession in the economy. It is because there are supply-side problems in the economy. Using demand-side policies to get a stagnant economy moving again will have no effect, according to classical economists.

Question 44

what would Keynesian economists argue if there is high unemployment and the economy is in recession? However, since 2008, what do some economists argue?

Answer 44

Keynesian economists would argue that govs should use both expansionary fiscal and monetary policies to get the economy back to growth.
- However, since 2008, some economists have argued that fiscal policy should be contractionary, whilst monetary policy should be expansionary. This is because they argue that the costs of increasing the National Debt from expansionary fiscal policy are greater than any benefits to AD that might result. Some might go further and argue that fiscal policy has no impact on AD and so raising taxes and cutting gov spending is not contractionary.

Question 45

what is a disadvantage of using expansionary fiscal policy to increase AD when the economy is in a recession? However, what do Keynesian economists argue?

Answer 45

A: the disadvantage is that it will increase in the size of the national debt. This is because govs will reduce taxes, so they will receive less tax revenue, and will increase spending. In order to finance this spending, govs will have to borrow money, thus leading to more debt. Some economists argue that the benefit of increased AD in the short term is outweighed by the negative impact of increasing the National Debt.
- Keynesian economists argue the contrary. So long as a gov can print money to finance its deficit without fuelling inflation or borrow money from the financial markets, then the National Debt is not a problem in the short term. Nearly all economists, however, would argue that, in the long term, large National Debts can be a problem, particularly if they are financed mainly by borrowing money from foreigners.

Question 46

in a recession, what do economists agree about happening? However, after the crash of 2008 what was discovered about interest rates?

Answer 46

economists agree that the central bank should cut interest rates to stimulate AD.
- However, following the financial crash of 2008, many central banks effectively reduced interest rates to zero and found it had little impact on AD. It was because of this that they resorted to quantitative easing. So interest rates have limitations on their effectiveness.

Question 47

What do economists argue about the effectiveness of quantitative easing?

Answer 47

Some argue that it significantly boosts AD because households and firms borrow to spend on real goods and services. Other economists argue that it mainly pushes up asset prices such as houses or stocks and shares. Households and firms borrow money but instead, for example, of buying or building new houses, they instead buy second-hand houses, pushing up their price but not increasing AD. (think about the circular flow of income)

Question 48

What do classical economists argue about the size of the multiplier?

Answer 48

they tend to argue that it is virtually zero even in the short term. They argue that extra gov spending crowds out (or forces out) private sector spending. Cuts in tax financed by gov borrowing mean that the private sector can borrow less money. An increase in the budget deficit financed by printing more money only leads to inflation, not extra output.

Question 49

what do Keynesian economists argue about the size of the multiplier?

Answer 49

they argue that the multiplier is positive and can be large if gov spending and tax changes are carefully targeted.
-For example, if there is large-scale unemployment in the construction industry, extra gov spending on building new social housing could work its way quickly through the economy to increase AD

Question 50

what is a disadvantage of demand-side policies? (hint: to do with time)

Answer 50

demand-side policies can have significant time lags.
-e.g. if the UK gov announces plans to build new motorways, high speed rail links or nuclear power stations to revitalise a stagnant economy, then the policy will fail. This is because there is inevitably at least a five-year time lag between announcement and spending taking place on big infrastructure projects.
-by the time the project is underway, the economic situation is likely to have changed significantly.
-demand-side policies need to be focused on changing AD within a very short period of time to be effective in responding to problems in the economy.

Question 51

in the 1950s and 1960s what did Keynesian economists think demand-side policies can do? what do most economists today think about this?

Answer 51

they thought that demand-side policies could nudge the economy to a very precise level of national income.
-today, most economists agree that such fine-tuning is impossible. There are too many small, or indeed large, random shocks to the economic system and too little precision about the tools of demand-side policy for this to work.