L22 - Fiscal and Monetary Policy

Question 1

What is Fiscal Policy?

Answer 1

Government spending and taxes.
Use of the budget to achieve macroeconomics objectives.

Two types:

• Discretionary Fiscal Policy
• Expansionary Fiscal Policy

Question 2

What is Stabilisation Policy?

Answer 2

Govt. actions to try to keep output close to its potential level.

Question 3

What is the Budget Deficit?

Answer 3

When Government spending is higher than Govt. savings (expenses exceed revenue)

Question 4

What is National Debt?

Answer 4

Stock of outstanding govt. debt

Question 5

What do Direct taxes affect?

Answer 5

Affects the slope of the consumption function and therefore affects the IS curve.

Question 6

What is one of the critiques to fiscal policy?

Answer 6

Sayes Law:

- Demand always creates its own supply.

Question 7

What does fiscal stabilisation policy focus on?

Answer 7

Focused on fine-tuning aggregate demand in order to keep the economy close to potential GDP,

often referred to as full employment GDP

Question 8

What has the Keynesian revolution of the 1930’s established?

Answer 8

Established that economic policymaking could be used in a counter-cyclical manner to minimize
fluctuations of GDP around its potential level.

Question 9

What does the budget surplus function show?

Answer 9

The budget surplus is negative at low levels of GDP and the budget surplus is positive at high levels of GDP

Question 10

What does and doesn’t vary with GDP increases?

Answer 10

• Tax revenues change with GDP

- Govt. spending is assumed not to vary with GDP

Question 11

What can cause changes in aggregate spending?

Answer 11

• Shift in exogenous spending changes GDP by the
  value of the shift times the simple multiplier
• Shift in aggregate spending done by fiscal policy

Question 12

What does the original theory of fiscal stabilisation argue?

Answer 12

• the budget should be balanced over the cycle with
  deficits in slumps being covered by surpluses in
  booms

So, no long-term in total debt due to such policies

Question 13

What did experience show about the fiscal stabilisation theory?

Answer 13

• Although many governments were willing to allow
  deficits to occur in slumps, they were less willing to
  raise taxes or cut spending in boom periods in order
  to produce a cyclically balanced budget.

Question 14

What is the cornerstone of monetary policy?

Answer 14

Inflation targeting framework

• Introduced in 1993 and
• Reinforced in 1997 with the setting up of the independent Monetary Policy Committee

Question 15

How does monetary policy work in normal times?

Answer 15

Works via setting of a specific interest rate (known as bank rate)

Question 16

What did the BoE do from 2013?

Answer 16

Introduce forward guidance.

Question 17

What are the 2 dimensions of central bank independence?

Answer 17

• Instrument independence (BoE), and/or

- Both instrument and target independence (ECB)

Question 18

What kind of independence has the BoE been given?

Answer 18

In that it can set the official interest rate at whatever level it deems appropriate.

But doesn’t have goal independence as the government determines that control of inflation will be its main goal and then sets the target rate.

So, only instrument independence.

Same with reserve bank of New Zealand

Question 19

What is the UK’s target rate?

Answer 19

2% with an allowance of 50% either way.

ECB has a similar commitment to inflation

Question 20

What is the Taylor rule?

Answer 20

It is an interest rate setting rule.

It states that changes in monetary policy rate should be set in relation to deviations in:

• Inflation from its target
• Output from its potential

Essentially monetary policy to be tightened by raising interest rate when inflation up above target and when actual output higher than its potential (Positive Output Gap)

Question 21

What is the Algebraic Representation of Taylor’s rule?

Answer 21

it = 2 + πt + α(πt - π*) + β(yt - y)

Where:

• It: Is monetary policy rate
• πt; Is latest annual inflation rate
• π*: Is target inflation rate
• Yt: Is actual GDP
• Y*: Is potential GDP

The constant of 2 denotes long run real average interest rate.

Question 22

How does Quantitative Easing work?

Answer 22

1) Central bank makes money electronically
2) That money is used to buy financial assets (govt. bonds) from financial institutions
3) P of Govt. bonds up, Interest falls
4) Financial Institutions either loan this money out or invest in riskier corporate bonds or shares
5) P of Corporate Bonds up, and interest down. (Reducing cost of borrowing money)
6) Access to credit improves, general interest rates down and willingness to lend should increase at lower interest rate
7) Stimulates borrowing, spending and investment

Question 23

When is QE used?

Answer 23

Used when traditional approaches to monetary policy have failed.
- Low availability of credit
- Low consumer/business 
  confidence
- Low willingness of banks to 
  lend

Question 24

How does QE affect AD?

Answer 24

By affecting the following:

• Interest rates
• Money supply
• Asset prices and spending
• Confidence