Macro Green Booklet

Question 1

What is the Bank of England

Answer 1

Bank of England- the central bank in the UK economy which is in charge of monetary policy.

Question 2

What is the central bank?

Answer 2

central bank- controls the banking system and implements monetary policy on behalf of the government.

Question 3

Define monetary policy

Answer 3

Changes in interest rates, the money supply and the exchange rate by the central bank in order to influence AD

Question 4

Distinguish between monetary policy objectives and monetary policy instruments

Answer 4

•A monetary policy objective is the target or goal that the Bank of England aims to hit.
•A monetary policy instrument is the tool or technique of control used to achieve the objective.
Eg: Controlling inflation is the main monetary policy objective of the Bank of England, and the rate of interest has been the principal monetary policy instrument.

Question 5

What is the inflation rate target?

Answer 5

the CPI inflation rate target set by the

government for the Bank of England to try to achieve. The target is currently 2%.

Question 6

Who are the MPC?

Answer 6

Monetary Policy Committee (MPC) nine economists, chaired by the governor of the Bank of England, who meet once a month to set Bank Rate, the Bank of England’s key interest rate, and also decide whether other aspects of monetary policy need changing.

Question 7

What is the main monetary policy objective for the Bank of England?

Answer 7

Controlling inflation.
Since the 1990s, central government has set an inflation rate target for the Bank of England to achieve. The Bank of England’s Monetary Policy Committee (MPC) implements monetary policy to try to achieve the inflation rate target (2%) set by the government.

Question 8

What is the Bank Rate?

Answer 8

the rate of interest the Bank of England pays to commercial banks on their
deposits held at the Bank of England.

Question 9

Define is simple terms monetary policy

Answer 9

Monetary Policy involves the central bank taking action using monetary instruments such as the manipulation of interest rates, the supply of money and credit, and the exchange rate to achieve policy targets.

Question 10

What is the transmission mechanism?

Answer 10

The way in which changes to the interest rate affect the economy i.e. how changes are transmitted to impact the macroeconomic objectives

Question 11

Define contractionary monetary policy

Answer 11

contractionary monetary policy- uses higher interest rates to decrease aggregate demand and to shift the AD curve to the left.

Question 12

How can an increase in interest rates decreases aggregate demand? (contractionary monetary
policy)

Answer 12

• Higher interest rates reduce consumption (C). First, higher interest rates encourage people to save, which means that less income is spent on consumption. Second, higher interest rates may cause asset prices to fall, These falling prices reduce personal wealth, which reduces consumption (through the wealth effect), falling house and share prices reduce also consumer confidence, which further deflates consumption.
• Higher interest rates reduce business investment (I). Investment is the purchase of capital goods such as machines by firms. Businesses postpone or cancel investment projects as they believe that higher borrowing costs make buying capital goods unprofitable. This is likely to be exacerbated by a fall in business confidence and increased business pessimism.
•Changes in interest rates affect exports and imports via the exchange rate. The increased demand for sterling causes the pound’s exchange rate to rise, which makes UK exports less price competitive in world markets and imports more competitive in UK markets, The UK’s balance of payments on current account worsens, which shifts the AD curve leftward.

Question 13

Define exchange rate

Answer 13

the price of a currency, e.g. the pound, measured in terms of another currency such as the US dollar or the euro.

Question 14

What is expansionary monetary policy?

Answer 14

uses lower interest rates to increase aggregate demand and to shift the AD curve to the right.

Question 15

Explain Expansionary monetary policy

Answer 15

A Bank Rate cut discourages saving, while stimulating borrowing, consumption and investment spending. Exports also increase. As lower interest rates cause the exchange rate to fall, making exports more price competitive and imports less competitive. The AD curve shifts to the right, with the size of the shift depending on the size of the multiplier. Finally, the extent to which real output increases or the price level rises depends on the shape and slope of the economy’s SRAS curve, which in turn depends on the state of the economy. When the economy produces well below the normal capacity level of output, the SRAS curve is relatively flat’. In these circumstances, an expansionary monetary policy is likely to increase real output (and jobs), whereas the increasing steepness’ of the SRAS curve as normal capacity utilisation approaches means that the stimulation of real output gives way to price inflation

Question 16

How does the Bank of England influence the growth of the money supply?

Answer 16

Quantitative Easing
l. The Bank of England credits its own account making money electronically, therefore increasing money supply
2. using this extra money they buy assets, typically UK government bonds
and corporate bonds
3. The seller of the assets will now have more money so may go out and spend it
4. Banks have greater liquidity (more money in their pockets) so bank lending may increase
6. The increase in demand for assets will increase the price of financial assets such as corporate bonds
8. Higher bond prices will also mean lower yields reducing the LT costs of borrowing
9. Therefore Bank of England purchases of private sector debt can help to unblock credit markets by increasing access to credit at lower IR

10. With better financial conditions consumers and firms may be more willing to spend increasing AD

Question 17

What is the aim of Quantitative Easing?

Answer 17

To encourage High Street banks to lend to consumers and businesses rather than by lots of government bonds.

Question 18

How does Quantitive Easing work?

Answer 18

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Question 19

Problems with Quantitive Easing

Answer 19

• Leads to an increase in prices- causing demand pull inflation.
• Puts pressure on supplies to increase output to meet the excess demand.

Question 20

What is Quantity Theory of Money (a type of demand pull inflation)

Answer 20

• Increases in the money supply leads to an increase in the price level
• Linked to demand-pull inflation as the more money available the more goods demanded
• ‘’Too much money chasing too few goods’’

Question 21

What is Fisher’s Equation of exchange?

Answer 21

MV = PQ
• M=money supply (quantity of money)
• V=velocity of circulation (how quickly money is spent) • P=Price level
• Q=transactions (when a good is bought)
• Economists view:V and Q are constant
Changes in M will lead to changes in P
M>P leads to demand pull-inflation

Question 22

How can exchange rate manipulation lead to expansionary monetary policy?

Answer 22

Devaluing of the £ will increase exports and reduce imports as they will be more expensive. This will shift A.D. outwards and inflation will also rise.

Question 23

How can exchange rate manipulation be used as contractionary monetary policy?

Answer 23

A strong £ will make exports deerer and imports cheaper. We will therefore import more reducing AD and inflation as AD shifts inwards.

Question 24

Transmission Mechanism Diagram

Answer 24

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Question 25

How does Interest Rate rise in the transmission mechanism affect Asset prices?

Answer 25

Intrest Rates⬆️ saving becomes more attractive
⬆️ saving instead of spending on assets
Demand for assets falls
Creating a negative wealth affect

Question 26

How does Interest Rate rise in the transmission mechanism affect the Exchange Rate?

Answer 26

Intrest Rates rise
Encourages Foreign investors to put their money in UK banks
Demand for £ rises
Exchange rate rises
X ⬇️ M⬆️

Question 27

What are the four channels of monetary policy?

Answer 27

• INTEREST RATE CHANNEL
• BANK LENDING CHANNEL
• EXCHANGE RATE CHANNEL
• WEALTH EFFECT CHANNEL

(Explain how expansionary and contractionary monetary policy affects these channels. How these policies have a end result on AD)

Question 28

Define fiscal policy

Answer 28

Changes to government spending and taxation in order to influence AD

Question 29

What does G = T mean?

Answer 29

balanced budget

Question 30

What does G > T mean?

Answer 30

budget deficit

Question 31

What does G < T mean?

Answer 31

budget surplus

Question 32

Define expansionary fiscal policy

Answer 32

expansionary fiscal policy uses fiscal policy to increase aggregate demand and to shift the AD curve to the right.

Question 33

Define contractionary fiscal policy

Answer 33

contractionary fiscal policy uses fiscal policy to decrease aggregate demand and to shift the AD curve to the left.

Question 34

What is crowding out?

Answer 34

Governments might have to fund its spending using taxes or running a budget deficit. This leaves fewer funds in the private sector for firms to use, since the government is borrowing money, which crowds them out of the market.

Question 35

What are progressive taxes

Answer 35

As incomes rise, the proportion of income paid in tax also rises

Question 36

What are regressive taxes?

Answer 36

• As incomes rise the proportion of tax paid falls
• (Proportion of tax paid by the lower income groups is higher ie it takes more of their income than higher earning groups who pay less of their income as a proportion)

Question 37

What are proportional taxes?

Answer 37

a fixed rate for all taxpayers, regardless of income.

Question 38

What are the benefits of indirect taxes?

Answer 38

Flexibility: Indirect taxes can be changed more easily than direct taxes, since direct taxes can be changed once a year at the time of the budget.

Influencing spending patterns: tax changes can be effective in changing the overall pattern of demand for particular goods or services, by changing relative prices.

Correcting externalities: Indirect taxes can correct the spill over effects of economic transactions, for example ‘making the polluter pay’ by ‘internalising’ the external costs of production and consumption.

• Choice: People have a choice about whether to buy products that attract indirect taxes whereas direct taxes inevitably leave people with less of their take-home pay in their pockets, plus they are hard to avoid.

Question 39

What are the drawbacks of indirect taxes?

Answer 39

Distribution effects: The regressive nature of many indirect taxes means that they can make the distribution of income more unequal

Inflationary effects: Increases in indirect taxation can trigger cost push inflation, and a subsequent rise in expectations of inflation.

Crime: High levels of indirect taxation create incentives to avoid them

Stealth like- often hidden so difficult to identify tax burden

Question 40

What are the effects of G multiplier on an economy?

Answer 40

•Current spending – AD (multiplier) 
▪ This is the main purpose of FP
▪ Expansionary FP => boost AD
▪ Contractionary FP => reduces AD
•Capital spending – LRAS
▪ This is a side effect not main purpose of FP 
▪ Exp FP => right shift in LRAS
▪ Contr FP => left shift

Question 41

What is the aim of fiscal policy?

Answer 41

Fiscal policy aims to stimulate economic growth and stabilise the economy.

Question 42

Evaluate fiscal policy

Answer 42

Question 43

Define supply side policies

Answer 43

Polices designed to increase the productive capacity of the economy shifting LRAS to the right

Question 44

What is national debt?

Answer 44

the stock of all past central government borrowing that has not been paid back.

Question 45

Define structural budget deficit

Answer 45

the part of the budget deficit which
is not affected by the economic cycle but results from structural change in the economy affecting the government’s finances, and also from long-term government policy decisions.

Question 46

Explain how supply side policies shift LRAS

Answer 46

Supply side policies increase the productive capacity of the economy through:
•Quantity of Factors of production increase
•Quality of FOP improve
•Productive efficiency increases lowering costs of production
 In the long run, an increase in the productive capacity of an economy means output can now rise to Y1 and meet the excess demand. The price level falls to P2. This shows how an economy can experience sustained economic growth in the long term without inflationary pressures.

Question 47

What policies have the government adopted to increase the incentive to work?

Answer 47

• Increase in personal allowances to £12,570
  •Reduced income tax
• Reduce corporation Tax 19% to 17% by 2020 *
• Restrictions on benefits
• (Universal Benefits) •Stricter rules to apply •Annual rise is capped •JSA, state pensions

Question 48

What policies have the government adopted to increase labour productivity?

Answer 48

• National curriculum- improve basic education •Stay at school till 18 •More apprenticeship schemes
• Restart schemes •Access courses •Sponsored degrees •Focus on maths and literacy skills
• One off lump sums for maths/science teachers*
• Nursing bursaries *

Question 49

What policies have the government adopted to increase government infrastructure and investment?

Answer 49

• HS2, Crossrail •Modernising roads •Modernising key ports •Modernising bridges- (new Forth Road bridge in Scotland), flood defences
• Building schools, hospitals
• Nuclear Power plant at Hinkley Point
• Plans for 3rd runway (Heathrow) •Affordable housing

Question 50

What are the effects of adopting polices to increase the incentive to work?

Answer 50

 When taxes are cut or tax allowances raised this raises the incentives to work because this means households keep more of their income when they work. This boosts AD as the increase in Yd raise C and can create a positive multiplier. (demand side arguments)
 Reducing benefits will also increase the incentive to work as households will be better off in employment than on benefits
 However both policy examples lead to an increase in the quantity of labour available so shifting the LRAS right as the productive potential/capacity of the economy increases.

Question 51

What are the effects of adopting polices to increase labour productivity?

Answer 51

Improved education results in a better skilled workforce – increasing the quality of labour available. This means labour productivity increases- output/worker/hour. This increase in the quality of labour results in long term improvement in output so increasing the productive potential/capacity of the economy so shifting the LRAS to the right.

Question 52

What are the effects of adopting polices to increase government infrastructure?

Answer 52

 Huge infrastructure projects like HS2 aim to improve train links will mean workers spend less time commuting and more time at work producing. Therefore the output in the economy rises as the productive capacity of the economy is improved. This is shown by a right shift in the LRAS
 Also attract FDI-foreign MNC setting up in the UK increase the capital stock eg factories and bring in new investment and processes. This increases the potential quantity of output so increasing the UK’s productive capacity

Question 53

What are the problems with supply side policy?

Answer 53

 A firm’s investment in technology & better skills means that current workers are more productive – so does not necessarily mean more workers will be employed to increase output
•There is the argument that businesses will need less workers if they invest in more capital (technology/machines) (Technological unemployment- a form of structural unemployment)
•Supply side polices are very costly- a lot of money in up front before long term gains realised so conflict with deficit/debt?
-Subsidies – Opportunity cost -Training/investment
•Supply side economics is a LONG TERM policy- takes years/decades to appreciate full effects. For eg. Its takes TIME – to improve literacy & numeracy skills, time to complete an apprentice or a degree! Around 5 years time lag
•An increase in the capacity of the economy is of no help in itself unless there is a corresponding increase in AD - In a recession, supply-side policies cannot tackle the fundamental problem which is lack of aggregate demand.

Question 54

If a supply side policy is effective what are the benefits?

Answer 54

1. Achieve a sustained improvement in the possible trade-off between inflation and unemployment (see Phillips Curve)
2. Better able to absorb external demand and supply-side shocks such as rising energy prices or a Chinese slowdown
3. Raise living standards through stronger economic growth and spread the benefits of growth more widely / equitably
4. Reduce unemployment by lowering the natural rate of unemployment (less frictional & structural unemployment)
5. Improve UK competitiveness in global markets and achieve a stronger balance of trade in goods and services

Question 55

How fiscal policy can be used to influence AS:

Answer 55

The government could reduce income and corporation tax to encourage spending and investment.
The government could subsidise training or spend more on education. This lowers costs for firms, since they will have to train fewer workers. Spending more on healthcare helps improve the quality of the labour force and contributes towards higher productivity.
Governments could spend more on infrastructure, such as improving roads and schools.

Question 56

What are the types and reasons for pubic expenditure

Answer 56

Public Expenditure: Spending by central and local governments to provide public and merit goods
>provided due to the free rider problem

Capital spending - creates assets for future generations E.g. hospitals, schools, infrastructure

Current spending - does not create assets - day to day expenses E.g., Public sector wages, bills, medicines

Transfers - money transferred where no service is given - from taxpayers to receivers of benefits e.g., Pensioners or unemployed

Question 57

Explain possible economic reasons for changes in the level and distribution of government expenditure.

Answer 57

cyclical: in a recession, for example, welfare spending will automatically increase as more of the population become eligible, but government may also decide to spend more over and above this in order to minimise the recession and initiate a multiplier effect through capital project schemes.

•new decisions made over the provision of merit goods
•new decisions made over the provision of public goods
•to influence the distribution of income
•changing levels of concern internationally over environmental issues forces the UK government to commit more spending to the problem which could reduce, for example, the government financial support for the arts/culture etc

Question 58

What are the main objectives of the UK tax system?

Answer 58

1. Funding Government spending: Government must raise finance for their various expenditures. They are able to borrow money up to a certain extent, but the majority of the finance must come from taxation, in order to avoid
   inflationary pressure.
2. Managing the economy as a whole: Taxation can be used to influence the UK’s macroeconomic performance. The government may alter taxes and their rates in order to influence economic growth, inflation, unemployment and, to a lesser extent, the balance of payments. Governments also appreciate that reducing certain taxes can lead to important microeconomic supply-side improvements.
3. Redistribution of income: If a government judges the distribution of income to be unfair, or inequitable, it may levy taxes to reduce the income and wealth of some groups in society, in order to boost the income and wealth of
   other groups.
4. Correcting market failure: At a microeconomic level, the UK government often uses taxes to improve the workings of the markets. For example, taxes on cigarettes may be used to reduce the consumption of a demerit good.

Question 59

What are direct taxes

Answer 59

Direct taxes are imposed on income and are paid directly to the government from the taxpayer. Examples include income tax, corporation tax, NICs and inheritance tax. Consumers and firms are responsible for paying the whole tax
to the government.

Question 60

What are indirect taxes

Answer 60

indirect taxes are imposed on expenditure on goods and services, and they increase production costs for producers.
This increases market price and demand contracts.

Question 61

What is the difference between government debt and government deficit?

Answer 61

The national debt is the accumulation of the government deficit over time. It is the amount the government owes. The deficit (or surplus) is the difference between expenditure and revenue at any one point.
If the government is continuously running a deficit, the size of the debt increases.
If the government reduces the size of their deficit, the rate of increase of the total debt is slower, but the debt is still
increasing.
It is only when the government runs a budget surplus that the size of the national debt decreases.

Question 62

What is a cyclical budget deficit

Answer 62

This is a temporary deficit, which is related to the business cycle. A deficit might occur during recessions, when governments increase spending to stimulate the economy.

Question 63

Give cyclical reasons for a budget deficit

Answer 63

For many countries a rising budget deficit is the inevitable result of experiencing a recession or a sustained period of slow growth. In a downturn, revenue flows fall from direct and indirect taxes whilst at the same time, the government is required to pay more out in welfare benefits such as the means-tested income support, soreployment benefits and other welfare handouts. Therefore, part of a fiscal deficit may be the consequences unesutomatic stabilisers at work. These are the tax and government spending changes that happen automatically at different stages of the business cycle. The governments of most developed countries are prepared to allow the automatic stabilisers to work through because, when their economy recovers, the cyclical component of a fiscal deficit will diminish, indeed in an economic boom, the government may run a budget surplus.

Question 64

Give structural reasons for a budget deficit

Answer 64

b) Structural reasons
For some countries, fiscal deficits seem an almost permanent feature, rarely is the government able to find enough tax revenue to cover the annual spending budgets. What structural problems / issues might lead to persistent fiscal deficits?
1. High levels of tax avoidance and tax evasion - the deliberate evasion of tax is illegal - in some countries governments are less effective than they might be in countering shadow markets where no tax is paid or in tracking down agents who are not paying the tax that is due.
2. High levels of income and wealth inequality - some economists argue that highly unequal societies also end up with a worsening fiscal position for the government. The uber-rich are liable for higher taxes in a progressive system (and top rate taxpayers in the UK clearly pay a high % of total revenues) but they also have an incentive to use all of the legal tax avoidance schemes open to them. At the bottom end of the labour market, if millions of people are in low-paid, insecure work, many will not earn enough to pay much in tax and even more may remain dependent on top-up welfare benefits, adding to the pressure on government spending.
3. Demographic pressures - these can affect the fiscal position too, for example an ageing population will cause an increase in government spending on the state pension; a fast-growing population (perhaps boosted by net inward migration) will also put more pressure on the government to fund essential public and merit goods.
4. Government inefficiency - if the state sector is relatively less efficient in supplying public services, then value for money will be lower and more will have to be spent in total to provide the cover that people need. Free market economists favour a smaller government sector with many activities out sourced or privatised to the private sector to supply.
5. High levels of government subsidy / financial support - over time, total government spending can rise because of the many competing demand placed upon politicians and the effects of lobbying by (often influential / powerful) pressure groups. In some countries, public spending is bloated by very generous systems of farm / food / energy subsidies that are politically hugely difficult to remove. The state might also get locked into providing financial support for loss-making businesses and industries such as airlines.

Question 65

What are the main supply side polices

Answer 65

1) Increase incentives to work- taxes and benefits
2) Labour Productivity- education and training
3) Government capital investment projects- infrastructure

Question 66

What are interventionist supply side polices and give examples

Answer 66

Interventionist supply side policies occur when the government intervenes in and sometimes replace free markets, include government funding for research and development.
Spending on education/ training, infrastructure and subsides go promote investment.

Question 67

What are non interventionist supply side polices

Answer 67

involve policies to increase competitiveness and free-market efficiency. For example, privatisation, deregulation, lower income tax rates, and reduced power of trade unions.

Question 68

Explain examples of non-interventionist supply side polices

Answer 68

1. Privatisation

This involves selling state-owned assets to the private sector. It is argued that the private sector is more efficient in running businesses because they have a profit motive to reduce costs and develop better services.

2. Deregulation

This involves reducing barriers to entry to allow new firms to enter the market. This will make the market more competitive. For example, BT used to be a monopoly in telecommunications, but now several firms compete for our business. Competition tends to lead to lower prices and better quality of goods/service.

The difficulty is that not all industries are amenable to competition. For example, power generation and water supply is a natural monopoly. Privatising and deregulating these industries tends to create a private monopoly who can charge higher prices.

3. Reducing income tax rates

It is argued that lower income tax rates increase the incentives for people to work harder, leading to an increase in labour supply and more output. Similarly, a cut in corporation tax gives firms more retained profit they can use for investment.

However this is not necessarily true, lower taxes do not always increase work incentives. Firms may not invest the increased profit but give to shareholders or save.

5. Deregulate Labour Markets

Labour markets can be deregulated through policies such as
Reduce maximum working weeks and minimum holiday pay.
Enable zero-hour contracts which allow firms to employ workers when demand is greater.
If it is cheaper to hire and fire workers, the argument is that it encourages firms to take on workers in the first place, creating more employment opportunities.

However, more flexible labour markets can cause increased uncertainty and lower productivity.

5. Reducing the power of trades unions

This can involve legislation which reduces the ability of trade unions to go on strike. This should:

Increase efficiency of firms e.g. less time lost to strikes.
Reduce real wage unemployment. (if labour markets are competitive)
6. Reducing unemployment benefits

Lower benefits may encourage the unemployed to take jobs. Lower means-tested benefits for those in work may increase the incentive to work longer hours.

7. Deregulate financial markets

For example, building societies were allowed to become for profit-making banks. Deregulation should allow more competition and, in theory, lead to lower borrowing costs for consumers and firms.

7. Increase free-trade

Lower tariff barriers will increase trade and provide an incentive for export firms to invest. Increasingly important are non-tariff barriers. For example, the EU Single Market has harmonisation over regulations, which enables more frictionless trade. Negotiating frictionless trade-deals can lead to lower cost for business and improve productivity.

9. Removing unnecessary red tape

Planning restrictions can make it difficult for firms to expand and invest in new capacity. Reducing red tape and levels of bureaucracy reduce firms’ costs and encourage an environment conducive to encouraging investment.

10. Encourage immigration

Free-movement of labour can enable firms to fill labour shortages – whether they are skilled jobs, in construction and engineering or low-skilled jobs such as fruit picking. Liberal immigration policies make labour markets more flexible and in economic booms – help firms keep up with growing demand. This can prevent wage inflation and enable firms to increase productive capacity.