Macroeconomics (3.5 - 3.7)

Question 1

Monetary policy

Answer 1

involves adjusting interest rates and the money supply so as to influence AD. Central Banks are usually responsible for setting monetary policy

Question 2

Demand side policy

Answer 2

Government policy that aims to influence level of AD of the economy

Question 3

Goals of monetary policies

Answer 3

A low and stable rate of inflation
Low unemployment
Reduce business cycle fluctuations
Promote a stable economic environment for long-term growth
To control the level of exports and imports (net external balance)

Question 4

Money multiplier formula

Answer 4

1 / Reserve ratio

Question 5

Factors for setting interest rate

Answer 5

• Exchange rate
• Property prices
• Rate of growth and nominal wages
• State of the economy
• Business confidence levels

Question 6

Open market operations

Answer 6

Buying and selling of government securities by the Central Bank in the open market. Typically conducted with commercial banks and other financial institutions such as insurance companies
- By buying government bonds, money injected into the system and bank reserves increase so higher lending capacity leading to lower interest rates
- . By selling government bonds withdraws money from free circulation, bank reserves decrease so lower lending capacity and therefore higher interest rates

Question 7

Minimum reserve requirement

Answer 7

Refer to the regulations set by the Central Bank that mandate the minimum percentage of customer deposits that commercial banks must hold as reserves
- Ensures the stability and soundness of the banking system by enhancing liquidity and solvency. Provides buffer against deposit withdrawals or unexpected financial shocks
- Adjusting minimum reserve requirements can be used as a tool to influence the lending capacity of banks: Higher reserve ratio, less money available, money supply decreases | Lower reserve ratio, more money available, money supply increases

Question 8

Minimum lending rate

Answer 8

Interest rate charged by central bank on loans to commercial banks. MLR influences all interest rates on bank loans

Expansionary: Central bank lowers MLR hence AD increases

Contractionary: Central bank raise MLR, AD decreases

Question 9

Quantitative easing

Answer 9

Central bank injects money directly into the economy through purchasing corporate bonds.

1)The Central Bank creates new electronic reserves
2) Central Bank purchases government debt from financial institutions, injecting money into financial system
3) Interest rates decline due to higher capacity for lending and money creation
4) Businesses / consumers consume more
5) Spend more which stimulates economy

Question 10

Expansionary monetary policy

Answer 10

Aims to increase level of AD by increasing money supply and reducing interest rates

Question 11

Contractionary monetary policy

Answer 11

Aims to decrease level of AD by decreasing money supply and increasing interest rates

Question 12

Limitations of Monetary policies

Answer 12

• Conflicting goals e.g economic growth puts upward pressure on inflation
• Expansionary less effective during a deflationary gap. Consumers may not respond to lower interest rates when confidence is low
• Expansionary leads to cheaper credit which can inflate asset prices

Question 13

Strengths of monetary policy

Answer 13

Incremental: Can be adjusted incrementally to reduce risks of causing disruptions in economy
Flexible: Central bank independent from political interference, flexibility to act in best interest of economy
Reversible: Decision is reversible. Eg: If money multiplier underestimated and causes inflation, central bank can increase interstate rates
Short time lag: Can be implemented quicker than fiscal policy

Question 14

Fiscal policy

Answer 14

Use of government spending and taxation to fulfil macro economics by influencing AD

Question 15

Government expenditure

Answer 15

presents a significant portion of the aggregate demand in many economies. The expenditure can be broken down into three categories
- Current expenditure: daily payments required to run the government and public sector
- Capital expenditure: investments in infrastructure and capital equipment.
- Transfer payments: payments made by the government for which no goods/services are exchanged. Doesn’t contribute to AD as income is only transferred from one group of people to another

Question 16

Fiscal policy objectives

Answer 16

• Low unemployment
• Stable economic environment for long term growth
• Low and stable inflation
• Reducing business cycle fluctuations
• Achieving equitable distribution of income
• Trade balance

Question 17

Expansionary fiscal policy and impact on the economy

Answer 17

AD increased by increasing government expenditure or decreasing direct / indirect taxation.
- Firms net profits increase → investment by firms increases → AD increases
- Economic growth increases, inflation rises, unemployment decreases, exports and imports rise

Question 18

Contractionary fiscal policy and its impact on the economy

Answer 18

Contractionary fiscal policies include increasing taxes or decreasing government spending with the aim of decreasing AD
- Households pay more tax -> disposable income reduces -> AD reduces
- Economic growth slows down, inflation eases, unemployment increases, imports fall

Question 19

Keynesian multiplier

Answer 19

The ratio of change in real income to the injection that created the change. Based on the idea that one individual’s spending is another individual’s income; hence immediately increasing AD

Question 20

Keynesian multiplier formula

Answer 20

MPW=MPS+MPT+MPM

1/ MPW or 1/1-MPC

Question 21

Strengths of Fiscal policies

Answer 21

• Spending can be targeted at specific industries
• highly effective in restoring confidence in an economy during a deep recession
• Redistributes income through taxation
• Reduces negative externalities through taxation
• Increased consumption of merit/public goods
• Short term government spending can lead to an increase in the aggregate supply of an economy

Question 22

Fiscal policies limitations

Answer 22

• Policies can fluctuate significantly when new governments are elected, impacts long term infrastructure projects
• can create budget deficits which are added to the national debt, may lead to austerity on future generations
• Conflicts between objectives
• Time lags: It is difficult to predict exactly when the desired effect on the economy will occur. Fiscal policy also takes a longer time to plan and implement than monetary policy

Question 23

Supply side Policies

Answer 23

Aims to increase aggregate supply and productive capacity of an economy by improving quality or quantity of factors of production.

Question 24

Goals of Supply side policies

Answer 24

extremely useful in generating long term growth, lowering average price levels, and creating new jobs in an economy
- potential national output increases leading to higher GDP
- greater supply in the economy results in reductions in the prices of goods/services leading to disinflation and making the exports of the nation more competitive
- fall as lower wage bills allow firms to recruit more workers
- prices of goods/services often decrease which makes them relatively more attractive to foreigners, so exports increase

Question 25

Market based supply side policies

Answer 25

Aim to remove obstructions in the free market that are holding back improvements to the long-run potential

Question 26

Deregulation

Answer 26

Reduction or elimination of regulations to lower costs of production for firms which encourages competition. Consumers may benefit as variety of choices to choose from and firms likely improve quality of products or lower prices

Question 27

Privatisation

Answer 27

Process in which state owned enterprises transferred from public to private sector. Increases competition and effeciency as firms in private sector have greater degree of competition and incentive to make profits. Thus more efficient

Question 28

Trade Liberalization

Answer 28

Elimination of international trade barriers as it encourages free trade increasing competition leading to greater efficiency. Producers specialise according to advantages and trade with one another leading to better allocation of world’s resources

Question 29

Anti monopoly regulation

Answer 29

Policies aimed at limiting the market power of dominant firms in industry as monopolies have no incentive to increase effeciency or innovate, thus can promote market competition improving effeciency

Question 30

To reduce labour costs and create labour market flexibility

Answer 30

- Decreasing trade union power so wages can be decreased - Decreasing or abolishing minimum wages to lower costs of production - Restructuring the unemployment benefits system to incentivise the unemployed to seek work

Question 31

To increase incentives through tax c uts

Answer 31

- Reducing income/corporation tax rates incentivizes workers to work harder and provides firms with extra funds which they can use to invest - Taxes decrease → firms and individuals retain more money for themselves → incentives increase → productivity improves → long term growth increases

Question 32

Capital gains tax cut

Answer 32

Levied on profits earned from sales of assets like stock. Reducing will incentive firms to invest more, increases amount of capital goods in economy increasing LRAS and potential output

Question 33

Education and training

Answer 33

Increasing government spending on education and retraining raises the quality of the workforce resulting in productivity improvements

Question 34

Research and development

Answer 34

Business activities to introduce and innovate new products. Can improve quality or quantity of capital resources, increasing productive capacity and shifting LRAS outwards

Question 35

Provision of infrastructure

Answer 35

Refers to physical capital such as transportation systems. Investment may lower costs, improve effeciency and productivity increasing productive capacity of economy and shifting LRAS

Question 36

Industrial policies

Answer 36

Government policies which target specific industries to promote growth in key areas of economy. - Tax cuts - Tax allowances - Subsidized lending - Trade protectionist policies

Question 37

Market based supply side policies advantages

Answer 37

- Increasing the productive capacity of an economy requires more efficient use of its resources, including labour - Emphasis on freeing up markets and allowing market forces to drive efficiency and resource allocation means no requirement for government spending

Question 38

Market based policies disadvantages

Answer 38

-Distribution of income worsens as labour market reforms and wage policies lower worker's wages - significant time lags between expenditure and seeing the benefits - Large infrastructure projects almost always have some negative externalities associated with their creation

Question 39

Advantages of interventionist supply side policies

Answer 39

- Subsidies to specific industries increase the rate of growth of an economy, reducing unemployment and increasing level of exports - raise the quality of life for all citizens

Question 40

Disadvantages of interventionists supply side policies

Answer 40

- expensive to implement and are paid for using tax revenue - or increased government borrowing - ue to the long-term nature, changes in government often result in changes to budgets and scope of projects and the end result may be less effective than it could have been

Question 41

Effectiveness of supply side policies

Answer 41

In short run supply side policies can increase AD but in long run, can increase productive capacity shown by LRAS shifting where potential output increases leading to economic growth. Can also enable economies to grow while achieving low and stable inflation.

Question 42

Impacts of expansionary monetary policies

Answer 42

- Effect on economy: banks receive cash for their bonds → liquidity in the market increases → commercial banks lower lending rates → consumers and firms borrow more → consumption and investment increase → AD increases - Impact on macroeconomic aims: Economic growth increases, Inflation rises, Unemployment may fall, Net external demand worsens

Question 43

Impacts of contractionary monetary policies

Answer 43

- Effect on economy: loan repayments become more expensive → income reduces → consumption decreases → total demand falls. - Impact on macroeconomic aims: Economic growth slows down, Inflation eases, Unemployment may increase, Net export demand worsens

Question 44

Money creation process

Answer 44

1) Initial Deposit 2) Reserve Requirement 3) Lending and Loan creation 4) Deposit Expansnion 5) Money Supply Expansion

Question 45

Marginal propensities

Answer 45

Refer to the proportion of the next $ earned that a consumer saves, consumes, is taxed, or purchases imports with - MPC: proportion of additional income that is spent on consumption - MPS: The proportion of additional income that is saved - MPT: The proportion of additional income that is paid in tax - MPM: The proportion of additional income that is spent on imports

Question 46

Automatic stabilisers and how it works

Answer 46

automatic fiscal changes that occur as the economy moves through stages of the business/trade cycle - In recession: Lower tax revenue due to progressive taxation, higher unemployment benefits for consumption -> Higher GDP - In boom: Higher tax revenue due to progressive taxation, less unemployment benefits for consumption -> Lower real GDP

Question 47

Interventionists supply side policies

Answer 47

require government intervention in order to increase the full employment level of output