Macroeconomic policy

Question 1

What is monetary policy

Answer 1

Actions taken by the central bank, independent from the government, to influence aggregate demand using interest rates the money supply and exchange rate

Question 2

expansionary monetary policy

Answer 2

aims to increase aggregate demand often in recessive periods of low growth

Question 3

contractionary monetary policy

Answer 3

aims to decrease aggregate demand often to decrease inflation rate

Question 4

what is the mandate for central banks

Answer 4

to control inflation

Question 5

What are 3 ways contractionary monetary policy impacts economy

Answer 5

Can decrease inflation if above target
Prevent excess borrowing
Reduce a current account deficit

Question 6

Diagram for effect of expansionary monetary policy

Answer 6

Question 7

A cut in interest has 5 effects

Answer 7

reduces the costs of borrowing for individuals
reduces the costs of borrowing for firms
reduces the rate of return
relative interest rates fall
reduce monthly payments for people with variable rate or tracked mortgages

Question 8

impact of a fall in relative interest rates

Answer 8

investors will move their money out of UK financial institutions and to other places in the world where they receive a higher rate of return. This causes hot money outflows out of the UK and therefore increasing the money supply thus causing the exchange rate to depreciate. A weaker exchange rate makes exports cheaper and imports dearer. Export demand and revenue increases while import demand and expenditure decreases. This helps to improve then trade balance f the current account improving any deficits. But also has an effect on aggregate demand where (X-M) in the AD equation increases and therefore causes AD to increase

Question 9

Supply side effect of expansionary monetary policy on growth

Answer 9

Lower costs of borrowing for firms so they can more easily reach the rate of return for their investment. As a result firms find it easer to finance the reinvestments, improving capital, increasing the quality and quantity of factors of production (capital) which then also lowers firms long run costs and results in productive efficiency. This all shifts LRAS to the right increasing growth

Question 10

Negative impact of expansionary monetary policy

Answer 10

A cut in interest rates could harm savers, especially the elderly and retired individuals who receive. lower rate of return on their savings. Can impact their living standards for this saving money in pension funds during retirement

Question 11

2 Pros of Contractionary monetary policy

Answer 11

protect against systemic risks in the banking sector

improves the current account balance

Question 12

2 Cons of contractionary monetary policy

Answer 12

Higher risk of directly triggering bank failure

Potential shocks causing a recession

Question 13

Why could contractionary monetary policy risk bank failure

Answer 13

Households and businesses are more likely to default on their loans with interest rate rising rising bank insolvency

Question 14

Do banks struggle to access liquidity at higher interest rates?

Answer 14

Yes
They may struggle to access liquidity and individuals may move savings away from savings accounts onto higher yielding assets elsewhere in the economy which can increase the risk of liquidity crisis

Question 15

How can Contractionary monetary policy improve current account balance

Answer 15

Expenditure reducing policy
Less AD in the economy so less growth and therefore lower incomes for households
Reduces marginal propensity to import
Less sucking in of imports
With ceteris paribus will improve the trade balance of the current account improving its overall balance

Question 16

Ev- Effectiveness of expansionary monetary policy (size)

Answer 16

depends on the size of the base rate cut. Large cuts have a stronger impact on spending

Question 17

Bank of England cut in interest in 2008 from…

Answer 17

5.5% to 0.5% to encourage expenditure in the low recessive growth period

Question 18

Ev- Effectiveness of expansionary monetary policy (liquidity trap)

Answer 18

Keynesian economists argue that there is a point where interest rates hit their “lower bound” where they cannot be lowered anymore. Interest rates at this point are so low that households and individuals have converted all tier. non liquid assets in liquid forms to spend on goods and services and this is because there is no incentive to save with such a low rate of return so the demand for money curve (liquidity preference curve) becomes flat.
So if the central bank tries to reduce interest rates further to increase money supply from Sm1 to Sm2 then it will have no effect because banks will not drop their rate any further and therefore borrowing will not rise, AD will not rise, growth will not rise. So expansionary monetary policy is not effective when the economy is in a liquidity trap.

Question 19

Diagram showing liquidity trap

Answer 19

Question 20

What is quantitative easing ?

Answer 20

Tool in expansionary monetary policy where the central bank electronically prints and creates more new money, which is then used to buy financial assets from banks to increase the money supply and encourage borrowing and consumption

Question 21

What are the stages of quantitative easing?

Answer 21

Central bank electronically creates new money to buy financial assets
Drives up price of bonds and reduces their yields
Institutions that now have large cash reserves will buy other assets in the economy with higher yields
Drives up prices reducing their yield
Yields fall, lowering the coupon rate that banks offer on their corporate bonds
Allows banks to offer lower interest rates on general loans and mortgages
Reduces cost of borrowing and encourages borrowing and consumption, boosting AD

Question 22

RWE: Action of the Bank of England between 2009 and 2012

Answer 22

Bought up £375 billion worth of bonds
Direct response to the financial crisis and deep recession and due to the limited effectiveness of interest rates that had reached their lower bound.

Question 23

What is fiscal policy

Answer 23

Demand side policy implemented by the government in which it changes taxation and government spending to influence aggregate demand

Question 24

What are 5 tools of expansionary fiscal policy

Answer 24

1. Governments reduce the marginal tax rate on lower income tax bands or increase the tax free allowance
2. Governments could reduce the marginal tax rate of income tax for the rich
3. Governments could reduce the regressive tax levels

4.Governments could reduce corporation tax

5. Governments increase their spending in the economy creating multiplier effects

Question 25

What is a positive multiplier effect

Answer 25

The initial boost in AD, increases growth which causes incomes to rise, therefore facilitating further rounds of spending in the economy increasing AD even further

Question 26

Accelerator effect

Answer 26

When investment leads to a positive feedback loop. Increase in investments, job creation and incomes, promoting consumption and leading to more profits and increases in investment.

Question 27

Negatives of expansionary fiscal policy

Answer 27

1. Inflation likely to increase
2. Ineffective due to Ricardian Equivalence

Question 28

What is Ricardian equivalence

Answer 28

When the vernal population predict future tax rises or spending cuts to fund the policy, as a result individuals save their disposable incomes instead of spending in preparation for tax increases in the future, reducing the gains from expansionary fiscal policy and increases in AD.

Question 29

What are austerity measures

Answer 29

Harsh policies aimed at reducing government budget deficit. Decrease government spending an increasing taxation

Question 30

What is the core objective of austerity measures?

Answer 30

To improve the state of government finances

Question 31

Pros of running a budget surplus via the use of austerity measures

Answer 31

Lower government borrowing and debt
keeping inflation low

Question 32

How does a budget surplus lower government borrowing and debt?

Answer 32

Increases in taxation and cuts in G so don’t need to borrow as much
Allows tax revenue to build up
This revenue can then be used to help service debt
Budget deficit and national debt reduce
Increases confidence in the state of government finance

Question 33

How do austerity measures keep inflation low?

Answer 33

They reduce AD through less government spending and possibly less consumption is taxation rises also. This increases spare capacity in the economy and so there is less pressure on existing factors of production, reducing the rate at which their prices rise and resulting in disinflationary pressure and lower inflation as a result. This impact could be useful if inflation is above the target rate.

Question 34

What are 2 Cons of contractionary fiscal policy

Answer 34

1. Unintended consequences
2. Risk of causing potential shocks

Question 35

What are the unintended consequences of using contractionary fiscal policy

Answer 35

Raising income and corporation tax
Raising income tax = disincentive work and decrease entrepreneurial spirits
Rising corporation tax = discouraging FDI and domestic investment
Long run growth suffers as result

Question 36

Can increasing taxation decrease tax revenue?

Answer 36

Yes
This is outlined by Laffer on the Laffer curve where taxation to a point will increase tax revenue but after that point people become less incentivised to work and can work less to reach target incomes and therefore fall into lower tax bands as a result less tax revenue is generated

Question 37

How can contractionary fiscal policy cause a shock

Answer 37

Fragile economies especially affected
lack of government spending, and greater taxation reducing consumption and investment, AD falls considerably, reducing economic growth and unemployment increase causing a recession.

Question 38

Recessions could cause the debt to GDP ratio to increase, what’s the effect of this?

Answer 38

Fails to improve the state of government finances and so the austerity measures have failed to achieve their core objective

Question 39

But why might contractionary fiscal policy causing a recession not be a huge worry

Answer 39

Because of automatic stabilisers

Question 40

What are automatic stabilisers

Answer 40

Fiscal policy tools that automatically influence GDP and counter fluctuations in the economic cycle

Question 41

Name the 2 automatic stabilisers

Answer 41

1. Progressive income taxation system
2. Welfare benefits

Question 42

Diagram showing the effect of automatic stabilisers on the economic cycle

Answer 42