Demand-side policies

Question 1

Name the two types of demand-side policies and their key components and who conducts them

Answer 1

Fiscal policy(government): expansionary and deflationary(government spending and taxation)

Monetary policy (Bank of England): Interest rates and quantitative easing

Question 2

Explain fiscal policy

Answer 2

The use of government spending, taxation and borrowing to stimulate aggregate demand and therefore economic activity

Question 3

Explain monetary policy

Answer 3

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

Question 4

Explain how interest rates are used by the MPC

Answer 4

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

Question 5

Explain quantitative easing

Answer 5

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

Question 6

Limitations of monetary policy

Answer 6

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

Question 7

Explain government spending and taxation

Answer 7

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

Question 8

Expansionary fiscal policy cost and benefit

Answer 8

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

Question 9

Deflationary fiscal policy cost and benefit

Answer 9

decrease aggregate demand by cutting spending or raising taxes reducing consumer spending but worsening growth rates - leads to improvement of budget deficit

Question 10

Example of ad valorem tax

Answer 10

VAT 20% of the unit price - main indirect tax in the UK

Question 11

Example of specific tax

Answer 11

58p per litre fuel duty on unleaded petrol

Question 12

Limitations of fiscal policy

Answer 12

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

Question 13

Data from 2008 financial crisis

Answer 13

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

Question 14

Impact of expansionary fiscal policy on inflation

Answer 14

(-ve) demand pull inflation

Question 15

Impact of expansionary fiscal policy on GDP

Answer 15

(+ve) increase in aggregate demand increases amount of goods and services produced and economic growth and GDP

Question 16

Impact of expansionary fiscal policy on unemployment

Answer 16

(+ve) AD increases extending supply meaning firms need to employ more decreasing unemployment

Question 17

Impact of expansionary fiscal policy on balance of payments

Answer 17

(-ve) imports are normal goods as UK has high marginal propensity to import meaning that increase in AD causes incomes to rise meaning we import more causing deficit to increase

Question 18

How are net exports affected by interest rates

Answer 18

Lower interest rates
Saving in UK banks is less profitable than EU banks with higher interest rates 
Demand for £ decreases
Exchange rate decreases (Price in S&D diagram)
Import price increases
Export price decreases
Import less export more
Injection into circular flow of income
Increase aggregate demand

Question 19

What factors do the MPC consider when making monetary policy decisions?

Answer 19

Business confidence (lead variable)
Oil prices/Factors of production (lead variable)
Exchange rate 
Wage growth
Disposable income
Growth forecast in house prices
Consumer confidence
Employment (lag variable)

Question 20

Economist statement for evaluation of demand-side policies

Answer 20

Friedman said demand side policies cannot cause real economic growth whereas Philips curve says opposite