Macroeconomics Flashcards
Define fiscal.
Relating to government revenue, specifically from taxes.
What is fiscal policy?
The use of government spending and tax policies to influence the economy.
Name 4 things that fiscal policy will affect.
- Demand for goods / services
- Inflation
- Employment
- Economic growth
Whose ideas is fiscal policy based on?
John Maynard Keynes
What did Keynes believe?
That governments could / should regulate the economy by adjusting spending and taxes
Fiscal policy can either be expansionary or contractionary. What does expansionary mean?
That the policy is intended to increase economic growth.
Fiscal policy can either be expansionary or contractionary. What does contractionary mean?
That the policy is intended to slow / reduce economic growth.
Describe the ‘virtuous cycle’ of expansionary fiscal policy (with regards to taxes) in 5 steps.
- The government lowers taxes
- People therefore have more disposable income and spend / save more
- This creates higher demand for goods / services, creating employment
- Firms must then compete for labour, causing a rise in wages
- People then have even more money to spend / invest
This leads to economic growth.
When might a government employ expansionary fiscal policy?
In a recession.
Describe the ‘virtuous cycle’ of expansionary fiscal policy (with regards to government spending) in 5 steps.
- The government spends more, for example on national infrastructure
- This creates employment
- People therefore have more disposable income and can spend / save more.
- This increases the demand for goods / services, further boosting employment.
- As more people are employed, the government will receive higher tax revenue.
This leads to economic growth.
This leads to economic growth.
What is expansionary fiscal policy characterised by?
Deficit spending.
What is deficit spending?
When the government spends more money than it earns from taxes, thus creating government debt.
Why is expansionary fiscal policy thought of as risky? Give 3 reasons.
- If a government spends too readily, it can crowd-out investment from the private sector
- Economic expansion that happens too rapidly can create asset bubbles. Once these burst, it can lead to recession / a need for austerity
- It is difficult to reverse
Fiscal policy is unpopular with voters, whether it has the desired effects or not. Why?
Voters like low taxes and high public spending (so changes to either can be unpopular).
What is contractionary fiscal policy characterised by?
Cuts to public spending and public sector jobs.
A government may induce a recession under contractionary fiscal policy. True or false?
True - this would be to ‘balance’ the economy
Under what circumstances might a government employ contractionary fiscal policy?
Mounting inflation
Explain how a government might employ contractionary fiscal policy to combat mounting inflation. Give steps.
- By cutting public spending / public sector jobs, people will have less disposable income
- People will therefore have reduced spending / saving capacity
- As less people are buying things, demand for goods / services goes down
- This will reduce the price of goods / services (result in deflation)
Why is contractionary fiscal policy rarely used?
It is considered hugely unethical (to cut people’s jobs).
Can fiscal policy be neutral and neither increase nor decrease economic growth?
Yes.
Who implements monetary policy?
The monetary authority of a country, i.e. the central bank
Who is the monetary authority in the UK?
The Bank of England.
Define monetary policy.
How the central bank governs the money supply and interest rates in an economy.
What 3 things does monetary policy influence?
- Output
- Employment
- Prices
Monetary policy seeks to control…
Name 4 things.
- Inflation
- Consumption
- Growth
- Liquidity
Define liquidity.
The degree to which an asset can be bought or sold quickly in the marketplace at a price reflecting its intrinsic value.
What is the most liquid asset and why?
Cash, as it can be quickly / easily converted to other types of asset.
Name 3 illiquid assets (relative to cash).
- Property
- Fine art
- Collectibles
Name 4 ways in which monetary policy is employed.
- Modifying the interest rate
- Buying / selling government bonds
- Regulating forex rates.
- Changing the amount of money banks are requires to hold as reserves.
Name 5 factors that might influence monetary policy.
- GDP
- Inflation
- Industry / sector-specific growth rates
- Geopolitical developments in international markets
- Concerns raised by lobbyists
Monetary policy seeks to…
Name 4 things.
- Achieve a stable rise in GDP
- Maintain low unemployment
- Maintain forex rates
- Maintain predictable inflation rates
Basically, monetary policy strives for stability.
Monetary policy is always an alternative to fiscal policy. True or false?
False - it can be used in conjunction with fiscal policy.
Monetary policy can be either expansionary or contractionary. What does expansionary monetary policy seek to achieve?
To grow the economy.
Monetary policy can be either expansionary or contractionary. What does contractionary monetary policy seek to achieve?
To slow / reduce economic growth.
When might expansionary monetary policy be used?
During an economic slump or recession.
How would expansionary monetary policy be employed? Give 4 points.
- The central bank would lower the interest rate
- This encourages spending but discourages saving
- Individuals therefore spend more / companies take out loans to expand their productive activities
- Increased spending leads to increased money supply in the market
Why does a low interest rate encourage spending but discourage saving?
It makes it cheaper to borrow money, but you get less return on your savings.
Explain why increased money supply might be bad if left unchecked. Give 3 points.
- More money in circulation results in a decrease in purchasing power
- This creates inflation
- This increases the cost of living and doing business
Define purchasing power.
The financial ability to purchase goods / services.
Define increased purchasing power.
You can buy more with the same unit of currency, i.e. prices drop.
Define decreased purchasing power.
You can buy less with the same unit of currency, i.e. prices rise.
How would contractionary monetary policy be employed to reduce inflation? Give points.
- The central bank would raise the interest rate
- This encourages saving but discourages spending
- People therefore spend less money
- This leads to less money in the money supply
As demand for goods is decreased, prices will drop.
Contractionary monetary policy can increase unemployment. True or false?
True - this is often required to tame inflation.
Unconventional monetary policy also exists. It was employed by many countries after the 2008 financial crisis. Name 3 strategies of unconventional monetary policy.
- Discount lending
- Open market operations
- Quantitative easing
Define quantitative easing (QE).
When the central bank purchases longer-term securities in order to increase the money supply, thereby encouraging lending and investment.
What is the point of quantitative easing (QE)?
To increase the money supply quickly and spur economic activity.
Give 2 longer-term securities purchased under QE.
- Government bonds
2. Mortgage-backed securities (MBS)
In QE, what happens when the central bank purchases longer-term securities? Give 2 points.
- Banks are provided with liquidity
- They can then lend freely / lower their interest rates to encourage people to spend
This boosts economic growth.
Under normal circumstances, name 3 ways in which the central bank would implement monetary policy.
- Open market operations
- Changing the interest rate
- Changing reserve requirements
What does ‘open market operations’ mean?
Buying and selling short-term bonds on the open market.
How would the central bank add money into the banking system through open market operations? What effect would this have?
It would buy assets from the banks.
Banks then have more money to lend at lower rates.
How would the central bank remove money from the banking system through open market operations? What effect would this have?
It would sell assets to the banks.
The banks then have less money to lend and would charge higher rates.
Using open market operations, the central bank would buy / sell assets from banks until their interest rate target is met. True or false?
True
The central bank is seen as the ‘lender of last resort’. What does that mean?
It means they loan money to the banks in times of crisis, but only if it is absolutely necessary, e.g. during the financial crisis.
If the central bank lowered their interest rates, would this grow / shrink the economy? How?
If the central bank lowered their interest rates / charged less collateral, banks can be riskier with their own lending (i.e. offer loans with lower interest and operate with less reserves) because it would not be too costly to ask for a bailout from the central bank if needed.
This is an example of expansionary monetary policy (to grow the economy).
If the central bank raised their interest rates, would this grow / shrink the economy? How?
If the central bank raised their interest rates / charged more collateral, banks would be more cautious with their own lending or risk failure, because it would be very costly to ask for a bailout from the central bank.
This is an example of contractionary monetary policy (to shrink the economy).
What are bank reserves?
The proportion of the deposits made by their customers that banks are required to keep to cover their liabilities (i.e. emergency funds).
To expand the economy, how might the central bank change the reserve requirements for banks?
The central bank would lower the reserve requirement so that banks have more capital to spend (buy more assets / offer loans to customers), thus increasing the money supply
To shrink the economy, how might the central bank change the reserve requirements for banks?
The central bank would raise the reserve requirement so that banks have less capital to lend, thus reducing the money supply
Define money supply.
The total amount of money in circulation in the economy.
Why might a central banker choose NOT to talk about monetary policy that is about to be implemented?
It will make a policy shift unpredictable, thereby preventing pre-emptive action by investors (avoiding ‘baked in’ results)
Why might a central banker choose to talk about monetary policy that is about to be implemented?
It will make policy shift predictable, thereby stabilising market expectations / preventing market swings
Announcements about monetary policy from the central bank are always influential on the economy. True or false?
False - they only have an impact if the authority is credible
Is the monetary authority (central bank) independent from government?
Ideally, but not always
What might happen if the monetary authority is NOT independent from government?
The government can apply political pressure and force the central bank to announce populist measures, thereby influencing an upcoming election
What is inflation?
The rate at which the average price for a basket of goods / services increases over time.
What is deflation?
The rate at which the average price for a basket of goods / services decreases over time.
How is inflation expressed?
As a percentage.
If inflation continues to rise, what happens to the purchasing power of money? What does this lead to?
The purchasing power decreases as the same unit of currency buys you less stuff.
This leads to currency depreciation.
How does a loss of purchasing power affect the cost of living?
It increases the cost of living because you need more money to buy the same stuff.
What happens to the economy when purchasing power decreases and why?
Economic growth slows / stops because people stop spending.
Inflation results from rising prices, but there are 3 types of inflation based on the cause. What are they?
- Demand-pull
- Cost-push
- Built-in
What is demand-pull inflation?
When demand for a good / service outweighs supply / production capacity.
When might demand-pull inflation occur? Give 2 circumstances.
- When a resource becomes scarce
2. When consumers have more disposable income
If the central bank prints more money, it can lead to demand-pull inflation. Why? Give 4 points.
- There will be more money in circulation
- Consumers will therefore have more disposable income
- They will want to spend more, so demand for goods / services goes up
- This increases the price of those goods / services as demand outweighs supply
What is cost-push inflation?
When production costs increase, thereby increasing the price of the good / service.
Give 2 ways in which production costs might rise.
- Labour costs
2. Raw material costs
What is built-in inflation?
When inflation happens, workers need higher wages to maintain their standard of living. These increased wages cause higher production costs which therefore further increases the price of goods / services.
It creates a ‘wage-price spiral’
When does sustained inflation occur?
When there is more money in the money supply than there should be based on the rate of economic growth. This causes currency depreciation.
What are the 2 most common economic indicators used to measure inflation?
- CPI
2. WPI
How is CPI calculated?
CPI examines the weighted average of prices in a basket of goods which are of primary consumer need.
CPI is based on the prices of goods / services of ‘primary consumer need’. Which goods / services does this refer to?
Food, transportation and medical care
Which prices are used to calculate CPI?
Retail prices, i.e. the prices that consumers pay
What do changes in CPI reflect?
Changes in the cost of living.
What does WPI stand for and what is it?
Wholesale Price Index
The same as CPI, except the prices are tracked at the producer / wholesaler level (rather than what the consumer pays for the finished good)
Some countries use a derivative of WPI called PPI. What does PPI stand for and what is it?
Producer Price Index
An index that tracks changes in the selling price by the domestic producers of goods / services
Why does inflation promote investing in both individuals / companies?
People expect to get bigger returns on their investments.
What is considered to be the best hedge against inflation?
Buying stocks.
Inflation can be positive or negative, depending on your viewpoint. Who might see inflation as positive?
Those with tangible assets might see inflation as a rise in value of those assets, meaning they can sell them for a higher price.
Inflation can be positive or negative, depending on your viewpoint. Who might see inflation as negative?
People with cash holdings (your average consumer) will see inflation as an erosion of those cash holdings, because they need more money to buy the same goods.
An optimum level of inflation must be maintained to encourage people to spend (rather than just save). Why?
To produce economic growth
What would happen if the inflation rate stayed the same for a number of years?
There would be no change to people’s spending habits and thus no economic growth.
What happens if inflation is too high?
People do not spend money, decreasing the money supply and slowing economic growth.
Changes to inflation are necessary for economic growth, but only within an optimal range. True or false?
True.
List 5 things that might happen if inflation is too low, high or uncertain.
- Uncertainties in the market
- Businesses cannot make investment decisions
- Unemployment
- Hoarding
- Changes to forex rates
Why would inflation lead to hoarding?
If inflation was rising / uncertain, people might rush to stock necessary goods in fear of a price rise, thereby increasing demand and creating a price rise…
What 3 factors might promote a stable economy and why?
- Moderate interest rates that do not discourage people from borrowing money
- Price stability, i.e. a constant level of inflation, which allows businesses to plan for the future
- Maximum employment, created through price stability
Maximum employment means zero unemployment. True or false?
False - there is always volatility as people leave / start new roles.
Countries experiencing rapid economic growth cannot cope with high inflation rates. True or false?
False - countries with rapid economic growth can absorb higher inflation rates (the cost of living rises as people are earning more money and can afford to pay the prices)
Fiscal deficit, budget deficit and deficit spending are all the same thing. True or false?
True - they are all names for the same things.
Name 8 things in the government budget.
- Healthcare
- Welfare
- Defence
- Education
- Housing
- The environment
- Public law and order
- Debt repayments
In what 3 ways can the government finance its operations?
- Tax revenue
- Borrowing
- Printing money
How does the government borrow money to finance its operations? Give 2 ways.
- Selling bonds to investors
2. Borrowing from pension funds
Is printing money a good way for the government to finance its operations? Why / why not?
No, it is very high risk because it increases the money supply, thus devaluing the currency.
Ideally, the government’s budget should be covered by tax revenue alone. What then is a fiscal deficit?
When the government’s budget (spending) exceeds the income it receives from taxes.
It is rare for governments to run small deficits. True or false?
False - it is common for governments to continuously run small deficits. If debts can be repaid / interest is not too high, this is not a problem.
What is debt default?
When the borrower cannot pay back what they owe?
When might a government risk default?
If the debt is too large / interest is so high that they cannot make the repayments
Deficit spending is a key principle of Keynesianism. Why might a government start deficit spending during a recession? Give 4 points.
- Due to the recession, there is unemployment and thus less tax revenue and consumer spending
- The government might start spending on national infrastructure to create jobs
- The creation of jobs boosts tax revenue and consumer spending
- This would lead to economic growth
When would a government stop deficit spending in response to a recession?
When full employment is achieved. This would create maximum tax revenue, meaning the government debt can be repaid.
Deficit spending can cause inflation. How?
Because deficit spending creates jobs, people have more disposable income they want to spend. This increases the demand for goods / services, thereby producing inflation.
Keynes argued that, if deficit spending caused inflation, a government could…
Raise taxes - this would reduce the amount of disposable income available to people and stop their spending, thereby reducing demand for goods / services and causing deflation.
What did Keynes argue was the main role of deficit spending?
To prevent or reverse a recession.
Why is deficit spending sometimes misinterpreted as an economic growth strategy?
Because there are correlations with government spending and a rise in GDP.
In fact, government spending is a component of GDP. They do not have to rise and fall together.
What did Keynes think the secondary role of deficit spending was?
The Multiplier Effect
What is the Multiplier Effect?
The proportional amount of increase that results from an injection of spending
i.e. if you put £1 in you get more than £1 back
Why do economists think that deficit spending, if left unchecked, will threaten economic growth. Give 4 reasons.
- Can cause inflation
- Can raise taxes (as a response to inflation)
- Risk of debt default
- Crowds out private sector investment, therefore distorting prices / interest rates in the market
What are two other names for government debt?
Public debt
National debt
When governments run a fiscal deficit, i.e. when they don’t earn enough from taxes to cover their spending, where do they get the extra money from?
Borrowing money from investors (citizens or companies)
How do governments borrow from their citizens?
By selling bonds
How do bonds work?
The borrower sells a bond, which is basically an IOU, in exchange for a loan. The borrower then pays a fixed rate of interest on the bond until it reaches maturity, when the bond must be paid back in full to the investor.
A proportion of government spending is always dedicated to debt repayments. Why?
Although ideally it is best to cover expenses with taxes, sometimes borrowing is necessary to meet planned expenditure.
A certain level of debt repayment must always be maintained. Why? Give 2 reasons.
- To avoid excess interest incurred
2. To avoid default
Define government / public / national debt.
The total sum of money owed by a country’s government, including it’s historic debt.
How is government debt calculated?
A government’s total debt minus its liquid assets.
How does inflation help to reduce a debt burden?
Rising prices reduce the value of money.
How do governments repay debt?
With taxes
Nations with stable economies / large taxpaying populations can sustain more debt. Why?
Because they get more tax revenue to help pay off their debts.
Name the four components of GDP.
- Private consumption
- Government consumption
- Gross fixed capital formation
- Net exports
When a citizen earns money, what 4 places does that money go?
- Goods / services consumed by the citizen
- Taxes paid to the government
- Savings in the bank
- Contribution to retirement / medical / insurance benefits
How do good / services consumed by a citizen contribute to GDP?
This is the ‘private consumption’ component of GDP
What is ‘government consumption’ made up of (which contributes to GDP)?
Taxes paid to the government by citizens
Contribution to retirement / medical / insurance benefits by citizens
How citizen’s savings in the bank contribute to GDP?
This is the ‘gross fixed capital formation’ component of GDP
The banks invest deposits by their citizens into capital goods (to make more money)
Why are citizens’ contributions to retirement / medical / insurance benefits considered as the ‘government consumption’ part of GDP? Give 2 points.
- This money could be kept in a bank, but because these funds are huge it is not considered safe
- The funds are instead used to buy the safest asset possible: ‘government securities’, which means the money is used to create national infrastructure
As an economy grows, so do the contributions to retirement / medical / insurance funds. What does this mean with regards to debt?
It creates ‘debt opportunities’, i.e. a surplus of money that the government can spend on infrastructure. This will have to be repaid later when the citizens claim their benefits.
Explain how governments accumulate debt during periods of economic growth.
Give 5 points
- As the economy grows, contributions to retirement / medical / insurance funds grow
- It is not safe to keep these massive funds in a bank
- Instead, governments use these funds for nation building, thus creating debt
- Debt is therefore an opportunity to improve infrastructure
- The government must repay these funds later on
Debt can be an indictor of a healthy economy. Why?
- It indicates public spending, which can further boost economic growth
- In theory, you wouldn’t run a deficit if you couldn’t afford to repay it
Why does government debt have a bad reputation?
Because of the Greek debt crisis from 2008-2018 which nearly collapsed the Eurozone.
When people think of government debt, they think of Greece, and they don’t want to end up like that
What was the Greek Debt Crisis?
Greece was so indebted to the EU that it almost defaulted on its debt. The EU had to loan Greece even more to continue making repayments.
Economists believe a healthy level of debt is good. Why?
Government debt, i.e. borrowing from its citizens, is a useful way to pay for important things, like national infrastructure.
When is a ‘good time’ for governments to be in debt?
When interest rates are low, meaning it is cheaper to borrow money.
The debt of stable, reliable governments creates ‘safe assets’, meaning…
National infrastructure
After the financial crisis in 2008, the U.S., Britain and the Eurozone have adopted austerity. This is to avoid deficit spending and reduce debt. However, this has…
Prolonged the economic slump, as a reduction in public spending increases unemployment, thereby reducing tax revenue and consumer spending
It is popular belief that ‘government debt is finite’. What does this mean?
That there is a limit to how much debt a government can carry, and once this limit is reached the government will default on their debt.
If a government persistently runs a deficit, therefore continuously accumulating debt, it is popular belief they will reach the debt limit and default. True or false?
True
The austerity implemented in Britain and the Eurozone to avoid deficit spending / government debt has had no effect on politics. True or false?
False - it has created a rise in populist parties on both the far left and far right
Why is the implementation of austerity since the 2008 financial crisis misdirected?
The economy needs investment to get out of the economic slump it is currently in. Governments should be running a deficit and investing what they borrow into creating national infrastructure, which will create jobs and therefore boost tax revenue / consumer spending
A paper by the IMF in 2018 demonstrated that the ‘debt capacity of advanced economies in good standing appears to be infinite’. What is the key concept here?
The affordability of the debt - if you can afford your repayments, you can maintain a level of debt.
If a government runs a surplus, what does that mean?
It makes more money in tax revenue than it spends.
If a government runs a surplus, it can pay off its debts. However, most governments do not do this. What do they do instead?
Refinance their debts, i.e. they replace an existing debt obligation with a new one.
Define ‘debt servicing cost’.
The annual cost of paying interest on outstanding debts
How can government debt be sustained?
When debt servicing costs are comfortably payable from current income
When is government debt sustainable indefinitely?
When the interest rate is less than / equal to the growth rate of NGDP
What does NGDP stand for?
Nominal gross domestic product
Define NGDP
GDP evaluated at current market prices, thereby including price changes resulting from inflation
In large, advanced economies, government debt capacity is infinite as long as debt repayment remains affordable. True or false?
True
What did the EU’s Maastricht treaty do?
Impose very strict debt limits for its member states (as a way of imposing austerity)
Short-term debt can be bad for governments - why? Give 2 reasons.
- It creates greater financing pressure as lots of money must be found in a short space of time
- It increases the risk of default because they might not be able to get the money together in time
Short-term debt is more sustainable than long-term debt for governments. True or false?
False - long-term debt is more sustainable because there is reduced financing pressure and less risk of default
What two factors affect a government’s debt capacity?
- Debt affordability (whether they can maintain repayments)
2. The term of the debt (long-term is easier to manage than short-term)
The common misconception is that government debt is bad because it is unaffordable. Is this true or false? Why?
It is false - the real risk of debt comes from rollover, which happens with short-term debt
Define debt rollover.
Extending the loan’s repayment date for an additional fee
Why is rollover a feature of short-term debt?
The borrower cannot repay the loan in a short space of time and so asks to extend the repayment date.
What could a government do to increase their debt capacity?
Extend the length of their debt portfolios
Government debt is perceived as bad due to the fear of debt default. There is little risk of debt default if…
- Fiscal institutions are strong / taxation continues
2. The long-term productive capacity of the economy is secure (i.e. jobs are safe)
If there are low interest rates on government bonds, what does this say about investors’ confidence?
They are confident that buying government bonds is low risk (which means they are not scared of default)
Is debt a reliable indicator of how good a government is?
No - there are countries with low debt and terrible economies / countries with high debt and strong economies
Give an example of a country with high debt and a strong economy.
The U.S. had a debt of 120% GDP when it mobilised the economy to win WW2.
Give an example of a country with low debt and a volatile economy.
Venezuela has been in crises for years but its debt is ~ 23% GDP
How many years has the British government been in debt?
300 years!
