Different Approaches to Macroeconomic Policy

Question 1

Keynesian Fiscal Policy was Widely Used in the Mid 20th Century

Answer 1

1. Experience of the Great Depression contributed to rising interest in the work of Keynes, which argued that government spending could boost an economy during recession and get it back on track.
2. Keynesian demand management policies of adjusting government spending to control economic growth were popular in the middle of the 20th century - in the UK the government focused on full employment, and adjusted taxation and spending to influence demand and try and msooth out the economic cycle.
3. There was steady growth and near full employment in the UK in the 1950s and 1960s, as well as fairly low and stable inflation. There were boom and bust cycles, but the downturns were fairly weak.

Question 2

Keynesians think the Economy adjusts slowly

Answer 2

• Keynesian believe that the government often needs to intervene to get the economy closer to reaching full employment, and operating at full capacity (i.e. on the vertical part of the Keynesian LRAS curve)
• They think when there’s a shock like a recession that causes AD to drop, it takes a very long time for demand to recover, because prices and wages adjust slowly. So the economy is likely to be operating below capacity for a long time, unless the government steps in to boost demand.
• Classical economists think that the economy generally operates at full capacity (and full employment) on its own (i.e. it’s usually on the classical LRAS curve)
• They believe that when demand falls the economy recovers quickly, because wages and prices easily adjust.
• Monetarists take the classical view, i.e. the economy is quick to adjust back to full capacity.

Question 3

The government’s approach to fiscal policy Changed

Answer 3

Governments now generally use fiscal policy differently to the Keynesian approach:

• Supply-side fiscal policy is used to increase AS, which will help a govt to achieve all 4 of its main economic objectives. E.g. tax cuts could be offered to entrepreneurs to encourage them to start up new businesses that will increase the productive potential of the economy.
• Fiscal policy is used on a microeconomic level to influence the behaviour consumers and firms. For example, demerit goods are taxed to decrease consumption, and merit goods can be provided by the state or subsidised to increase their consumption. Fiscal policy can also be used to help governments achieve their environmental policy objectives. E.g. the govt could introduce ‘green taxes’ that discourage the use of coal or oil, or provide subsidies to firms that use renewable energy.
• Government spending can be directed at specific regions that need extra help. E.g. if a region loses a big employer is suffering from structural unemployment, then the government could invest in that region to create jobs, or encourage firms to move there with subsidies and tax breaks.
• Progressive taxation allows the government to redistribute wealth from those who are better off to those who are less well off.

Question 4

Funding for lending and Forwards Guidance aim to Stimulate Lending

Answer 4

After the 2008 financial crisis, bank lending to households and businesses was falling, which contributed to slow growth. Funding for Lending and forward guidance are policies to encourage lending, with the aim of stimulating the economy.
1.
- Funding for Lending was launched in July 2012. It involves the bank of England lending money to commercial banks below market rates, with the intention that these cheap loans would be passed on to households and businesses.
- The scheme was closed for household lending when the govt decided the housing market had recovered, and was also adjusted to favour lending to small and medium sized businesses over large corporations.
- The success of Funding for Lending has been questioned. More mortgages were approved and mortgage interest rates fell, but there may not have been much to benefit for the wider economy. However, without the scheme things might have been worse.
2.
- Forward guidance involves the central bank publicly announcing its intentions to keep the base rate at a certain level for a set period of time, or while certain economic conditions remain (e.g. while unemployment is above a certain rate).
- The aim is to allow businesses and individuals to plan their borrowing and spending, without having to worry about sudden changes in interest rates.
- The Bank of England has used forward guidance since 2013.

Question 5

Quantative Easing injects New Money into the Economy

Answer 5

1. Quantative Easing (QE) is used when it’s necessary to adopt a ‘loose’ monetary policy to stimulate to AD (or create upwards pressure on inflation) at a time when interest rates are already very low (or negative).
2. QE increases the money supply, which will enable individuals and firms to spend more.
3. It involves the Bank of England (or other central bank) ‘creating new money’ and using it to buy assets owned by financial institutions and other firms. The hope is that these will then either spend money or lend it to other ppl to spend.
4. QE was introduced in the UK in 2009. AD needed to be stimulated after the 2008 recession, but interest rates were already at a very low rate (0.5%).
   - The Bank of England bought assets from firms such as insurance companies and commercial banks.
   - However, QE was slow to work at first because the banks were still reluctant to lend after the credit crunch. Instead they used it just to increase their reserves of money.
   - Eventually these banks did begin to lend money to other firms and individuals - who used money to, for example, invest in new machinery, start new businesses or buy houses.
   - All of this spending boosted AD and => an increase in the rate of inflation
5. Using QE to bring up the rate of inflation (rather than decreasing interest rates) has the added benefit that it will keep a currency weak (i.e. its exchange rate will remain low). This can increase the competitiveness of an economy and boost exports.
6. QE also provides a boost to overall confidence in an economy (esp during a recession), as consumers and firms see the central bank taking action.
7. One danger of using QE is that financial institutions may initially use this ‘new money’ to increase their reserves, and only lend it out when the economy improves. This extra lending at a time when inflation may already be increasing can => demand-pull inflation becoming harder to control.

Question 6

The Bank of England also has to consider the Wider Economy

Answer 6

1. The main aim of monetary policy in the UK is to ensure price stability - i.e. keep inflation close to its target rate. Under normal circumstances, this would mean that during a period of high inflation, interest rates would increase.
2. But between January 2010 and March 2012, inflation was 3% or higher, but the Bank of England kept interest rates at 0.5% during this entire period and continued its use of QE.
3. The reason is that the UK economy suffered some ‘economic shocks’, and there were concerns about the possibility of entering the second dip of a ‘double dip’ recession.
4. The Bank of England reasoned that raising interest rates was unnecessary - it said inflation would fall naturally even without an interest rate rise, and that if it did increase interest rates, then a double dip recession was more likely.
5. Remember…. as long as inflation is under control, the Bank has a duty to support the govt’s economic objectives. The Bank therefore continued with its very loose monetary policy in order not to further harm the economy.