LS12 Demand Side Policies

Question 1

Define monetary policy
The variables attempted to be controlled are known as…

Answer 1

The manipulation by government of monetary variables, such as interest rates, and the money supply, to achieve its objectives

• governments can control of the rate of interest, and the amount of borrowing/credit available from financial institutions, and the amount of money circulating in the economy.
• variables attempted to be controlled are known as the instruments of policy. This would be interest rates/the money supply/tax rates/government spending.
• The two main monetary policy instruments used our interest rates and quantitative easing

Question 2

Describe fiscal policy

Answer 2

The use of taxes, government spending, and government borrowing to achieve its objectives

Question 3

How does the government use interest rates as a monetary policy instrument?

Answer 3

Generally, the rate of interest is the price of money and lenders expect interest if money is supplied. The rate of interest influences aggregate demand. They are inversely proportionate

• Consumer durables are things like furniture or kitchen equipment. Often these are paid for in instalments, and therefore the interest rate would impact the size of the repayments
• The housing market is highly impacted by the rate of interest, because mortgages are the common way of paying for a house, and therefore are subject to increasing/decrease in value depending on the interest rate. If the interest rate decreases, then there are three results. Firstly an increase in demand for all types of housing which leads to more houses being built and this will be an investment in national income accounts. Secondly, moving house, stimulates the purchase of consumer durables and this increases consumption., thirdly, moving house can release money, and sometimes it can release equity if passengers trading down
• Wealth affects: I fall in interest me increase asset prices, which means homeowners can feel more confident mean increase their spending. A fall in interest can increase the price of government bonds.
• Higher interest makes saving more attractive compared to spending this may lead to a fall in aggregate demand
• A lower rate of interest means investment projects become more profitable, causing a higher level of investment and aggregate demand. This may also lead to an increase in investment as firms will need to increase supply to meet demand
• The exchange rate will also be impacted because a fall in the exchange rate can lead to a fall in the value of the domestic currency. This can lead to higher exports and fewer imports. This boosts aggregate demand.

Question 4

Describe the role of the Bank of England

Answer 4

• to directly control the monetary policy on an independent basis
• The most important decisions about monetary policy are made by the monetary policy committee (MPC), of the Bank of England This is a group of nine people, five from the bank of England and other four are independent experts.
• It sets the interest rate as well as discusses quantitative easing
• The MPC mainly concerns itself with the interest rate, but may also use the monetary policy to improve other government objectives like economic growth and employment
• Monetary policy is focused on the objectives of boosting, economic growth and reducing unemployment

Question 5

How does quantitative easing work?

Answer 5

• 1st the central bank digitally creates money and adds it to its balance sheet
• 2nd the central bank purchases financial assets from banks and other financial institutions
• 3rd financial institutions have more money and the increased demand for their bonds and other financial assets causes their value to rise -> the wealth of the owners of these assets therefore increases

this is intended to increase aggregate demand in two ways:
1. This increases the amount lended by Banks. Hopefully consumers and firms can increased their financed consumption and investment. If financial institutions use the money as intended then QE fulfils its role as an expansionary monetary policy.
2. The wealth effect leads to higher consumption: economic theory, predicts, that ceteris paribus an increase in demand, will cause an increase in price. And this will happen to financial assets which means banks and other investors will refund their portfolios by investing in assets with a higher yield. As reinvestment occurs, new liquidity is directed towards the sellers of funds and shares. The rise in the yields of all the assets create a wealth affect this raises confidence and stimulate spending.

Question 6

Define quantitative easing

Answer 6

The introduction of new money into the national supply by a central bank. In the UK, the Bank of England creates new money to buy financial assets from financial institutions. The aim is to encourage the financial sector to lend to consumers and firms.

Question 7

Describe direct and indirect taxes

Answer 7

A direct tax is levied directly on an individual or organisation, E.g. income tax or corporate tax
Indirect tax is levied on a good or service, for example, excise duties on petrol

Question 8

What are the two policies used to influence aggregate demand and how?

Answer 8

Fiscal policy and monetary policy is used to influence aggregate demand

Question 9

Describe monetary policy and aggregate demand

Answer 9

• monetary policy can be used to influence aggregate demand
• Expansionary, monetary policy can be lowering interest rates or increasing quantitative easing
• Contractionary, monetary policy can be raising interest rates or reducing quantitative easing

Question 10

Describe expansionary, demand-side policies and aggregate demand

Answer 10

• expansionary, demand-side policies shift aggregate demand to the right, so that it crosses the SRAS curve at a higher price level and higher real output
• Expansionary, demand-side policies can include: decreasing tax rate, increasing government spending, cutting taxes on company profits (this leads to increased investment)

Question 11

Describe contractionary demand side policies and aggregate demand

Answer 11

• policy aims to decrease aggregate demand
• The aggregate demand curve will intersect the SRAS curve at a lower price level and a lower level of real output
• ## This occurs when there is a fall in the budget deficit, or a rise in the budget surplus

Question 12

Why are economists divided about the effectiveness of demand-side policies?

Answer 12

• Keynesian economist favour the use of fiscal and monetary come on side policies when there is a recession or hyperinflation
• Classical economists argue that fiscal policies are ineffective, and governments should solely rely on monetary policy to influence aggregate demand

Question 13

State the strengths and weaknesses of demand-side policies

Answer 13

• speed of adjustment
  – Conflicting policies
  – The national debt
  – the rate of interest
• Quantitative easing
  – The size of the multiplier
  – Time lags
  – Fine-tuning

Question 14

Describe ‘speed of adjustment’ as a strength/weakness of demand-side policies

Answer 14

• economists disagree about how quickly an economy can revert to long run equilibrium
• Keynesian economists argue that short run disequilibrium can be sustained for years/decades because of a lack of AD. If economic agents all spend less than is needed to achieve full employment, the economy can remain depressed for a long time.
• Classical economists argue that economies adjust very quickly. If there is a long-term unemployment with no economic growth, it’s because of supply-side problems rather than a recession. Using demand side policies to stimulate growth will have no impact.

Question 15

Describe ‘ conflicting policies,’ as a strength/weakness of demand-side policies
In this example, there is high unemployment and the economy is in a recession

Answer 15

• Keynesian economist would advocate for expansionary fiscal and monetary policies to stimulate growth
• Since the financial crisis, some right wing economists argue that fiscal policy should be contractionary whilst monetary policy remains expansionary. This is because the cost of increasing the national debt would be greater than the benefits of increasing aggregate demand

Question 16

Describe ‘ the national debt’ as a strength/weakness of demand-side policies
- example: in a recession

Answer 16

• expansionary fiscal policy can be a demand-side policy to increase AD. However, it will increase the size of the national debt, and some economists argue that the benefit of increased aggregate demand is outweighed by the impact of increasing the national debt in the short-run
• Keynesian economists argue the opposite, which is as long as the government can print money or borrow money than the national debt is not a problem in the short run.
• Nearly all economists agree that in the long-term large national debts can be a problem, especially if financed by borrowing from foreigners

Question 17

Describe ‘ the rate of interest’ as a strength/weakness of demand-side policies
- example: in a recession

Answer 17

• It is agreed generally that the central bank should cut interest rates to stimulate aggregate demand
• Following the financial crisis in 2008, it was discovered that after reducing the interest rates to 0, there was a little impact on aggregate demand. Hence the governments resorted to quantitative easing.
• Therefore interest rates have limitations on their effectiveness

Question 18

Describe ‘ quantitive, easing’ as a strength/weakness of demand-side policies

Answer 18

• economists disagree about the effectiveness of quantitative easing
• Some argue that it significantly boosts aggregate demand because households and firms can finance increased consumption
• Some argue that it only pushes up asset prices and households and firms only borrow money to buy secondhand houses which pushes a price level up but doesn’t increase aggregate demand

Question 19

Describe ‘ the size of the multiplier’ as a strength/weakness of demand-side policies

Answer 19

• classical economists argue that the multiplier is zero, even in the short term. They argue that extra government spending crowds out private sector spending and cuts in taxes (financed by government borrowing) only means the private sector can borrow less money. Hence, an increase in the budget deficit. Only lead to inflation not extra output.
• Keynesian economists argue that the multiplier is positive and can be large if government spending and taxes are carefully targeted. If there is large-scale unemployment for example, government spending on building new housing can increase AD

Question 20

Describe ‘ time, lags’ as a strength/weakness of demand-side policies

Answer 20

• demand-side policies have significant time lags
• If the UK government announces plans to build new infrastructure, in order to revitalise a stagnant economy, this policy will fail. This is because there is an inevitable 5 year time lag between announcement and spending. By the time the project is underway the economic situation could have changed significantly.
• Demand-side policies need to be more effective within a short period of time in order to change, aggregate, demand and address the economic issues taking place

Question 21

Describe ‘fine-tuning’ as a strength/weakness of demand-side policies

Answer 21

• in the 1950s, Keynesian economist thought that demand-side policies could nudge the economy to a precise level of national income
• Most economists agree that this is impossible as there are too many small/large/random shocks to the economic system, and too little precision about the tools of demand-side policy for this to work

Question 22

Briefly describe the Great Depression

Answer 22

• this was a severe worldwide economic depression beginning in the United States
• In most countries, it lasted from 1929 until the late 1930s
• It is a commonly used example of how intensely the worlds economy can decline. In fact, it was the most widespread longest and deepest depression of the 20th century.
• It started because of a major fall in stock prices which began in September, and this became worldwide news on ‘Black Tuesday’ October 29th, 1929
• The worldwide GDP fell by an estimated 15%, in order to contextualise this: during the great recession (2008-09) worldwide GDP fell by <1%
• For many countries, the negative effects of the great depression lasted until the beginning of World War II

Question 23

What was the policy responses to the great depression in the UK

Answer 23

• as a result of the great depression in the UK: government revenue fell, unemployment benefits paid out rose, there was an expected increase in the budget deficit
• In the 1920s, the classical economic idea was the mainstream view: balancing the budget is the most important economic goal. Therefore, the UK followed deflationary fiscal policy: cuts in government spending, cuts to public sector pay, cuts to unemployment benefits. This made things worse as unemployment kept rising, and the economy stayed in the recession.
• The monetary policy was also contractionary, because Britain was a part of the gold standard. This was a system where currency could be swapped at the central bank for a fixed amount of gold, so that amount of currency in the system was fixed. Therefore Britain could not use expansionary monetary policy (expanding money supply/lowering interest rates). This meant the exchange rates were also fixed ( and UK exports were not competitive).
• The economy only recovered when Britain left the gold standard in 1931 and could lower interest rates and devalue the pound which had an expansionary effect and increased consumption as well as investment. This meant more houses were built and there were increases in defence spending in response to Nazi Germany (both increase AD).

Question 24

What were the policy responses to the great depression in the US?

Answer 24

• under President Hoover, the responses were laissez-faire, which meant the economy was left to market forces, with minimal government interference
• Taxes were kept low to encourage business investment, and consumption. However, as government revenue fell during the Great Depression, taxes were increased to avoid a budget deficit. As the depression worsened, the government was criticised for not helping the unemployed and the poor.
• In 1933, president Roosevelt introduced the “new deal “which included expansionary policies. This meant government spending increased -> government funded jobs + infrastructure projects
• These projects, reduced unemployment and poverty. However, unemployment began to rise in the late 1930s, but fell when defence spending during World War II contributed to economic recovery.

Question 25

What were the policy responses to the global financial crisis in the UK?

Answer 25

Fiscal policy:
- tax cuts for basic rate tax payers
- A temporary 2.5% point cut in the VAT rate.
- £3 billion worth of investment spending
- £20 billion small enterprise loan guarantee scheme
- Training help for the young unemployed
- ‘Car scrappage’ scheme
- From 2010 however, focus moved towards reducing the budget deficit

Monetary policy:
- The MPC cut the bank rate by 0.25% initially, but over the course of 2008 it was cut a further five times and took a historic low of 0.5% in March 2009.
- The MPC initially authorised a purchase of 200 billion worth of assets, but the total asset purchases accumulated to £375 billion

Question 26

Describe neutral fiscal policy
Why does the change in government spending not increase demand by the value of the change in G ?

Answer 26

• These are policies which will result in no change in aggregate demand
• the multiplier effect changes the value of G
• The multiplier affect becomes larger as leakages from the circular flow become smaller