Macroeconomics Pack 4 demand side policy Flashcards
Fiscal policy
Use of government spending and taxation to influence the level of aggregate demand.
Difference between monetary policy and fiscal policy
Fiscal policy is set by the government in the chancellor’s annual budget statement where as monetary policy has been conducted by the Bank of England since 1997
Expansionary fiscal policy
- Increasing government spending
- Cutting income tax
- Cutting cooperation tax
Contractionary fiscal policy
- Decreasing government spending
- Raising income tax
- Raising corporation tax
Indirect tax and examples
When we buy a good, we pay VAT indirectly. It is the responsibility of the firm telling the good to give 20% of selling price to the government eg. VAT, petrol duties, tobacco tax, excise duties, stamp duties
Difference between direct and indirect tax
Direct taxes are imposed on one’s income and earnings and are paid directly to the government. On the other hand, indirect taxes are quite the opposite and are given to the government whenever any goods or services are purchased.
Requirements of a good tax system
- Horizontal equity - people in the same circumstances should pay the same taxes
- Vertical equity - a degree of proportionality is important, eg. progressive taxes
- Cheap to collect
- Difficult to evade
- Efficient, non-distortion (if taxes are too high people may be put of working)
- Easy to understand
Reasons for tax
- Raise revenue for government spending
- To promote redistribution of income and wealth
- Discourage consumption/production of goods with negative externalities
Budget deficit
When the government spends more than it receives in tax revenue in a given year
Budget surplus
When the government receives more tax revenue than Government spending in a given year
Where do the government borrow from
They sell government bonds to:
- Individuals
- UK banks and financial institutions
- Foreign governments, banks and individuals
What is national debt
The sum of all previous debts the government has run up
Consequences of national debt
- Tax rises in future
- Opportunity cost: by borrowing money the government will have to pay back interest and therefore can spend less money on other essential services such as healthcare and education
- Higher interest rates: Interest payments for government debt is higher, these are transferred to consumers
- Crowding out: The more the government borrows, the more market interest rates will rise which will restrict C,I and (X-M) and therefore AD
- No one wants to lend to the UK (in extreme cases eg. Greece)
Relationship between budget deficit on AD/AS
- The budget deficit increases then more money is injected into economy so AD boosted
- The budget deficit decreases then less money is injected so AD shifts inwards
Relationship between budget surplus on AD/AS
- The budget surplus decrease then less money is being withdrawn (through taxes) from the circular flow so AD boosted
- The budget surplus increases then more money being withdrawn from circular flow so AD shifts inwards
Monetary policy
The use of monetary instruments, such as interest rates and the money supply, to influence aggregate demand
What is the inflation target
2% CPI inflation (plus or minus 1%)
Expansionary monetary policy
Where monetary policy is used to boost AD
- Reducing interest rates
- Increasing money supply (via quantitive easing)
Contractionary monetary policy
Monetary policy is used to reduce AD
- Increasing interest rates
- Reducing the money supply
Interest rates
The cost of borrowing and reward from saving
What is the base rate
The rate at which the Bank of England charges commercial banks when it lends them money. Therefore, usually when the base rate changes, financial institutions change their interest rates in the same direction, due to its effect on their costs
How does a reduction in interest rates boost consumption, investment and net exports
Boost consumption: There is less incentive for consumers to save as there is a lower reward for saving, more incentive to borrow as credit is cheaper. Home owners on variable mortgages have higher disposable incomes so their consumption increases
Boost investment: Less incentive for businesses to save money in the bank due to low returns on saving and there is more incentive to borrow to finance investment as the cost of borrowing is lower
Boost net exports: Lower interest rates means less foreign investors will put money into UK banks thus reducing demand for the pound and reducing the exchange rate. A lower exchange rate will make imports more expensive and exports cheaper which should boost the UK net exports: assuming demand is elastic, a drop in the price of exports will boost export revenues and rise in price of imports which will reduce import revenue
Quantitive easing
Quantitative easing is a monetary policy where a central bank increases the money supply by buying government bonds (and sometimes other financial assets) from banks and financial institutions. This injects money into the economy, encouraging lending and investment.
Reasons why quantitive easing would boost consumption and investment
Direct increase in consumption and investment -Those economic agents who have Government bonds bought from them can use this money to spend and invest in the economy, boosting consumption and investment
Banking lending increases - Banks who have bonds bought from them can use that money to lend in the economy (in order to increase their profits) and therefore this over stimulates consumption and investment but could be inflationary due to the AD increase
Cheaper cost of borrowing - Cheaper borrowing costs can over stimulate consumption and investment and therefore be inflationary due to AD increases
Asset prices increases eg. housing - There is a lot of cheap money lowering interest rates, therefore the return on saving is lower and therefore speculators to move into other markets such as housing
