Macroeconomic policy Flashcards
What is monetary policy
Actions taken by the central bank, independent from the government, to influence aggregate demand using interest rates the money supply and exchange rate
expansionary monetary policy
aims to increase aggregate demand often in recessive periods of low growth
contractionary monetary policy
aims to decrease aggregate demand often to decrease inflation rate
what is the mandate for central banks
to control inflation
What are 3 ways contractionary monetary policy impacts economy
Can decrease inflation if above target
Prevent excess borrowing
Reduce a current account deficit
Diagram for effect of expansionary monetary policy
A cut in interest has 5 effects
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
impact of a fall in relative interest rates
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
Supply side effect of expansionary monetary policy on growth
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
Negative impact of expansionary monetary policy
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
2 Pros of Contractionary monetary policy
protect against systemic risks in the banking sector
improves the current account balance
2 Cons of contractionary monetary policy
Higher risk of directly triggering bank failure
Potential shocks causing a recession
Why could contractionary monetary policy risk bank failure
Households and businesses are more likely to default on their loans with interest rate rising rising bank insolvency
Do banks struggle to access liquidity at higher interest rates?
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
How can Contractionary monetary policy improve current account balance
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
Ev- Effectiveness of expansionary monetary policy (size)
depends on the size of the base rate cut. Large cuts have a stronger impact on spending
Bank of England cut in interest in 2008 from…
5.5% to 0.5% to encourage expenditure in the low recessive growth period
Ev- Effectiveness of expansionary monetary policy (liquidity trap)
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.
Diagram showing liquidity trap
What is quantitative easing ?
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
What are the stages of quantitative easing?
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
RWE: Action of the Bank of England between 2009 and 2012
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.
What is fiscal policy
Demand side policy implemented by the government in which it changes taxation and government spending to influence aggregate demand
What are 5 tools of expansionary fiscal policy
- Governments reduce the marginal tax rate on lower income tax bands or increase the tax free allowance
- Governments could reduce the marginal tax rate of income tax for the rich
- Governments could reduce the regressive tax levels
4.Governments could reduce corporation tax
- Governments increase their spending in the economy creating multiplier effects
What is a positive multiplier effect
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
Accelerator effect
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.
Negatives of expansionary fiscal policy
- Inflation likely to increase
- Ineffective due to Ricardian Equivalence
What is Ricardian equivalence
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.
What are austerity measures
Harsh policies aimed at reducing government budget deficit. Decrease government spending an increasing taxation
What is the core objective of austerity measures?
To improve the state of government finances
Pros of running a budget surplus via the use of austerity measures
Lower government borrowing and debt
keeping inflation low
How does a budget surplus lower government borrowing and debt?
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
How do austerity measures keep inflation low?
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.
What are 2 Cons of contractionary fiscal policy
- Unintended consequences
- Risk of causing potential shocks
What are the unintended consequences of using contractionary fiscal policy
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
Can increasing taxation decrease tax revenue?
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
How can contractionary fiscal policy cause a shock
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.
Recessions could cause the debt to GDP ratio to increase, what’s the effect of this?
Fails to improve the state of government finances and so the austerity measures have failed to achieve their core objective
But why might contractionary fiscal policy causing a recession not be a huge worry
Because of automatic stabilisers
What are automatic stabilisers
Fiscal policy tools that automatically influence GDP and counter fluctuations in the economic cycle
Name the 2 automatic stabilisers
- Progressive income taxation system
- Welfare benefits
Diagram showing the effect of automatic stabilisers on the economic cycle
