Demand-side policies Flashcards
Name the two types of demand-side policies and their key components and who conducts them
Fiscal policy(government): expansionary and deflationary(government spending and taxation)
Monetary policy (Bank of England): Interest rates and quantitative easing
Explain fiscal policy
The use of government spending, taxation and borrowing to stimulate aggregate demand and therefore economic activity
Explain monetary policy
The use of interest rates and quantitative easing to control the flow of money and stimulate aggregate demand and economic activity - controlled by the monetary policy committee
Explain how interest rates are used by the MPC
Controls the supply of money
Control inflation rates
High interest rates - used in periods of high inflation - reward for saving is high and the cost of borrowing is higher encouraging consumers to save more and spend less causing aggregate demand to decrease pushing prices down
Low interest rates - reward for saving is low and the cost of borrowing is low so consumers and firms can access credit cheaply encouraging spending and investment. Usually done during low inflation as causes demand pull inflation however during the financial crisis the UK interest rate fell to a historic low of 0.5%, despite high inflation it was set at a low rate to stimulate AD and boost growth
Explain quantitative easing
Asset purchases to increase the supply of money MV=PY quantity theory of money
usually when low inflation and very low interest rates
pump money into economy to stimulate it. Bank buys assets in the form of government bonds using created money, Then used to buy bonds from investors which increases cash flow in financial system encouraging more lending to firms and individuals as it makes the cost of borrowing lower encouraging investment and spending and so growth
Can lead to high inflation however Bank of England can reduce the money supply by selling their assets to cause disinflation
Money market diagram with two | | money supply lines showing increase n supply with diagonal money demand and price (interest rates) going down
Limitations of monetary policy
Banks might not pass base rate onto consumers meaning that changes in interest rates are ineffective or if they do my be time lags until affects economy and we change our behaviour
Even if interest rates are low consumers may be unable to borrow as banks aren’t willing to lend i.e. after 2008 financial crisis when banks become more risk averse
If confidence is low then unlikely to spend regardless of interest rates
QE can lead to hyperinflation e.g. in Zimbabwe and also deflation when money taken back out of economy
Blunt instrument - interest rates affect entire county and different regions have different inflation rates so could cause deflation in one area and high inflation in another
Explain government spending and taxation
Increase government spending, injection into circular flow increasing AD
Most spent on pensions, healthcare, education, benefits
Reduce tax, consumption increases increasing AD
Income tax is the biggest source of tax revenue in the UK
Expansionary fiscal policy cost and benefit
increase aggregate demand by increasing spending or reducing taxing improving growth rates - leads to worsening of government’s budget deficit and may mean governments have to borrow more to finance this
Deflationary fiscal policy cost and benefit
decrease aggregate demand by cutting spending or raising taxes reducing consumer spending but worsening growth rates - leads to improvement of budget deficit
Example of ad valorem tax
VAT 20% of the unit price - main indirect tax in the UK
Example of specific tax
58p per litre fuel duty on unleaded petrol
Limitations of fiscal policy
Governments may have imperfect information about the economy leading to inefficient spending
Significant time lag involved as takes time to implement new taxes and regulations
If government borrow from the private sector there are fewer funds available for the private sector leading to public sector spending crowding out private sector spending
The bigger the size of the multiplier, the bigger the effect on AD and the effectiveness of the policy so the size of the multiplier is a limitation (use for ceteris paribus)
If in recession then confidence low so cutting taxes may lead to increase in saving rather than spending
High interest rates means fiscal policy may be ineffective
If the government spends too much they worsen their budget deficit and there could be difficulties paying the debt back making it more difficult to borrow in the future
Conflicting government objectives as causes demand pull inflation
Fiscal policies only change once a year whereas MPC meet 8 times a year so can make changes quicker
Data from 2008 financial crisis
Vat cut from 17.5% to 15%
Interest rates from 5% to 0.5%
Initial £75bn of QE
Credit crunch - high amounts of credit from deregulation then bubble burst
Impact of expansionary fiscal policy on inflation
(-ve) demand pull inflation
Impact of expansionary fiscal policy on GDP
(+ve) increase in aggregate demand increases amount of goods and services produced and economic growth and GDP
