Demand-Side Policies 2.6

Question 1

Demand-Side policies def. + types

Answer 1

Ways the government can manipulate Aggregate Demand

Monetary Policy - Controlling the availability of credit and its price (interest rates)

Fiscal Policy - Changes in government spending & taxation

e.g. US Recovery and Reinvestment Act of 2009. $831billion on infrastructure etc. recovered from recession faster than UK’s austerity

Question 2

Interest Rates (Monetary policy)

Answer 2

Rise in the Base Rate leads major banks to increase their interest rates to deal with the cost, while also increasing interest rates on savings to remain competitive

Question 3

Impact of Interest Rates on consumption & investment

Answer 3

Consumption - High interest rates increase the cost of borrowing which is important for ‘big ticket’ spending on cars and houses. Also makes saving more attractive, thus consumption decreases. Also has an impact on ‘wealth effects’. Low interest rates drive up the prices of houses, causing owners to have more disposable income

Investment - Fall in rates encourages investment & vice versa

Question 4

Expansionary vs Contractionary Fiscal Policy

Answer 4

Expansionary - Tax cuts, increase in gov. spending

Contractionary - Tax increases, cuts in gov. spending

Question 5

Evaluation of Demand-Side Policies

Neoclassical vs Keynesian

Answer 5

Neoclassical economists - argue that low taxation and avoidance of government borrowing are the way for LT economic growth, not demand-side policies. This theory was what was behind Austerity. Point out Greece pre- financial crisis. Debt was 200% of GDP, lenders refused to lend any more and GReece had to be bailed out by the EU and IMF on conditions they would raise taxes and reduce gov. spending. This led to unemployment of over 20%
AD should be stimulated through monetary policy (interest rates) and inflation should be kept at the target rate

Keynesian economists - believe fiscal policy is very useful in maintaining employment and growth. Point out after The Great Depression of the 1930s, Germany and USA came out of recession much faster than the UK as they took use of heavy government spending vs the UK’s budget balancing

Question 6

Monetary Policy Eval.

Answer 6

Changes in Interest Rates can take up to 2 years to take effect, small changes are likely to not impact decisions greatly

Liquidity Trap means if interest rates are already low (like in the UK now at 0.1%) then lowering makes no difference as everyone has already withdrawn their money. This happened in Japan in the 1990s, where low interest rates had little to no effect on investment

Lack of confidence in the economy may mean that, no matter how low IR are, investment may remain low

Question 7

Quantitative Easing

Answer 7

When BoE buys assets to increase the money supply. Can prevent the liquidity trap that occurs with extremely low interest rates

Question 8

Pros & Cons of QE

Answer 8

Increased AD due to wealth effects as Assets are being bought so higher prices for them

Private sector firms receive more money which can be invested

Cons

• Can cause inflation
• No guarantee that higher asset prices = more consumption if confidence is low
• Can increase inequality. e.g. since 2013 QE rapidly increased housing and share prices, meaning worse geographical mobility and the rich (who may own shares) have wealth effects while lower-income groups do not

Question 9

Fiscal Policy

Answer 9

Changes in tax or spending

Question 10

Cons of Fiscal Policy

Answer 10

Tax changes can worsen inequality or reduce incentives to work (poverty trap)

Political Issues can mean governments are reluctant to impose taxes

Impact of Gov. Spending depends on the multiplier. Classical economists argue that it is almost 0, while Keynesian argues it is higher

Worsening of budget deficit