Countercyclical policy

Question 1

What are countercyclical policies?

Answer 1

countercyclical policies are policies aimed at countering the economic cycle

they can be fiscal (to do with government spending or taxes) or monetary (to do with the the central bank manipulating the interest rate, the exchange rate, or the money supply)

Question 2

Fiscal Policy Concepts:

Answer 2

Government Spending
= G + transfers + interest
(interest that they have to pay on their debts)

Government Revenues = taxes

Deficit = spending - revenues = change in debt

Surplus = revenues - spending = change in debt

we can’t increase the deficit indefinitely because we would be accumulating an infinite amount of debt

Governments usually try to have a deficit in recession and a surplus in boom (so they can pay off their deficit from the recession). This means they have a balanced budget in the long run instead of trying to make sure their budget is always balanced.

Fiscal policy can be a source of demand shocks or used to counter demand shocks

Question 3

The fiscal multiplier

Answer 3

the change in GDP which results from a £1 change in the deficit

varies depending on the state of the economy

usually between 0 and 1 (greater than 0 because it works but less than 1 because crowding out leads to other factors of AD decreasing)

it could be greater than 1 in severe recessions because the crowding out effect would disappear, as consumption is already very low and therefore unlikely to be reduced further

Question 4

What is crowding out

Answer 4

crowding out is when an increase in G leads to a decrease in the other components of AD, leading to a fiscal multiplier that is less than 1.

this happens because:
1. an increase in the deficit would mean an increase in government debt. Consumers and investors would know that the government will need to increase taxes in order to pay off this debt. Anticipating a reduction in their wealth, they may be more likely to save and less likely to spend

2. an increase in the deficit would mean increased borrowing and therefore increased interest rates, which would also make people more likely to save than spend

Question 5

Monetary policy

Answer 5

actions taken by the central bank in order to change interest rates and therefore C and I

Question 6

Policy Rates

Answer 6

Policy rates are the interest rates set directly by the central bank.
They are set on commercial banks’ deposits with or loans from the central bank.

Question 7

The effect of interest rate changes on I and C

Answer 7

when interest rates are high, I and C are low and when interest rates are low, I and C are high

Cash-poor people and firms have to borrow in order to buy or invest, so high interest rates mean having to decide whether or not what they want to buy or invest in is worth the interest rate.

Cash-rich people and firms are also less likely to buy or invest when interest rates are high because the interest they get from keeping their money in a bank may be worth more than what they want to purchase. They therefore have to decide whether the opportunity cost of making their purchase is worth it.

Question 8

The effective lower bound or zero lower bound

Answer 8

the minimum interest rate that can be set

used to be thought to be 0 (ZLB) but we now know it can be negative (ELB)

but negative interest rates encourage people to borrow from banks and hoard the money in cash instead of in banks (so they don’t have to pay the negative interest rates back)

we can get around the ELB by abolishing paper currency (or at least large denominations of paper currency) in order to stop people from hoarding it

at this lower bound, interest rates can’t get any lower through open market operations (printing money and buying short term government bonds)

Question 9

Quantitative easing and how it works

Answer 9

to raise interest rates, central banks may switch from buying short-term bonds to buying longer- term bonds (which will have positive interest rates even if short term bonds have negative or zero interest rates)

this is because the more long-term bonds are, the higher their interest rates are

this is because short term loans are more convenient, as the money can be accessed again sooner.

When a lot of long-term bonds are bought, the money supply increases and the interest rate goes down

Question 10

Pros and cons of quantitative easing

Answer 10

+ boosts stock market: investors would be more likely to invest in the stock market because they’d get a higher return than they would from interest bearing assets (because the interest rate has become lower). This also makes it easier for firms to sell shares and increases the wealth of shareholders.

+ depreciates exchange rate: quantitative easing increases the money supply, which makes the currency cheaper

+ boosts consumer and investor confidence because the public sees the central bank doing something

+ makes room for loans on commercial banks’ balance sheets (FILL IN WHEN COVERED LATER)

• There isn’t enough evidence to prove that it works
• it may not affect interest rates much and the change in interest rates may not affect AD much (especially in a recession, when people have less confidence or are trying to pay off existing debts)

Question 11

the natural level of output for an economy

Answer 11

the economy always gravitates towards its “natural” level of output

we don’t know what this level is, so central banks can only make predictions and look at the results of their policies after a year has passed

shocks are self-correcting

countercyclical policies only reduce the length of recessions or extreme booms. If countercyclical policies didn’t exist, they would still eventually end.