Monetary and Fiscal Policy

Question 1

What are Monetary Policies involve?

Answer 1

Changes to interest rates, the money supply, and the exchange rate by the Central Bank in order to influence AD.

• Focuses on Interest mostly

Question 2

What are Fiscal Policies involve?

Answer 2

Fiscal policy involves the use of government spending, direct and indirect taxation and government borrowing to affect the level and growth of aggregate demand in the economy, output and jobs.

Question 3

Pros of expansionary Fiscal policies?

(with eval)

Answer 3

1) Boost GDP growth/ Reduce Unemployment (spare capacity/ recession/ banks cut interest?/ MPC)

3) Increase inflation = incentivise/ capitalise/ investment (if demand-driven)

4) Redistribute income = decrease inequality

5) Greater future returns (short-run/long-run)

6) “Crowding - in” + demand fuelled

Question 4

Pros of contractionary Fiscal policy?

(with eval)

Answer 4

1) Reduce Inflation = boost export comp.

2) Reduce budget deficit/ National debt

3) Reduce current account deficit (less imports)

4) Budget Surplus (fiscal flexibility/ credit rating/ reduced national debt)

5) Taxation can be used to discourage negative externalities

6) reduced benefits = increased motivation to work

Question 5

What are the cons of expansionary Fiscal policy?

(with eval)

Answer 5

1) Demand-pull inflation = deteriorating purchasing power (capacity)

2) Financing = burdening future generations. (current financial status)

3) Bonds yield increase if Gov. sells too many – increasing what needs to be paid back.

4) “Crowding out effect” + “credit crunch”.

5) Ricardian theory

6) X - inefficiency

Question 6

What are the cons of contractionary Fiscal policy?

(with eval)

Answer 6

1) Disincentive effect (work) (increases unemployment)

2) Demand side shocks = worsen ad (economic cycle)

3) Regressive (causes further income inequality) reduced welfare

4) Laffer curve - “brain drain”

5) Decrease price comp. = damage BoP.

6) reverse multiplier effect

Question 7

What does the success of expansionary Fiscal policy depend on?

Answer 7

1) The initial level of economic activity. (how close AD is to YFE)

2) Cost-pull inflation?

3) MPC and Multiplier effect

Question 8

Pros of expansionary Monetary policy?

(with eval)

Answer 8

2) Increase Growth/ Reduce Unemployment

4) independant from politics

5) Weakening the currency/ boost exports

6) Dual impacts on AD+AS.

7) increased discretional incomes = benefit poor/ lower mortgage

Question 9

Pros of contractionary Monetary policy?

Answer 9

1) Reduce current account deficit (stronger currency?)

3) Discourage Household debt ~~> reducing bank failure. Encourage saving ~~~> safety net + more investment in the future

4) More sustainable borrowing (only those who need) ~~~> less likely to get asset price bubbles ~~~> = less chance for recession.

5) Hot money inflows = strenghthening of currency

6) More affordable housing / reduced demand for houses/ dampens/ house/ rates = more affordable

Question 10

Cons of contractionary Monetary policy?

(with eval)

Answer 10

1) Lower growth/ Higher cyclical, derived, unemployment

3) Reduces investments = further inflation (boom/ economic cycle)

4) Worsening CA deficit via Exchange rate strengthening

5) Buying more imports (during boom/ time-lag)

Question 11

Cons of expansionary Monetary Policy?

Answer 11

1) Too much demand-pull inflation (output gap)

2) Decrease in” hot money” –> deppreciation + “marshall learner” = worsening net trade (fixed/ floating exchange)

3) Negative impact on savers (no safety net if everything is spent)

5) Time lags (Needs to go through transmission mechanism ~~> 18mths)

6) Risk of hyper inflation

7) Ricardian equivalence (consumer confidence)

Question 12

The effectiveness of expansionary Monetary policy depends on the?

Answer 12

1) Size of the output gap (Near YFE= no decrease in unemployment. Only increase in inflation).

2) Consumer confidence + Business confidence. (Scared to borrow).

3) Banks’ willingness to lend/ pass in the full cut

4) Size of the interest rate cut

5) Offset by other factors?

6) Size of the Multiplier

Question 13

Funding for lending? (Monetary)

Answer 13

Offering funds at lower than the going rate to financial institutions with the specific purpose of encouraging lending for investment

Question 14

Monetary VS Fiscal?

Answer 14

Fiscal :
- Shorter time lags
- Can direct spending to specific purposes (not general)
- Taxation can be used to decrease NE’s

Monetary:
- Central banks are independent and Politically neutral

Question 15

What is the Transmission mechanism?

Answer 15

Shows how interest rates work their way through the economy, firstly affecting:

• Market rates (affecting borrowers, savers, and firms)
• House prices (increased demand, given lower mortgage repayments)
• Expectations/ confidence ( react by changing consumption)
• Exchange rate

Question 16

What are the principles/canon’s regarding Taxation?

Answer 16

Adam Smith argued that taxation should follow the four principles of Fairness, Certainty, Convenience and Efficiency.

Fairness ~> compatible with taxpayers’ condition.

Certainty ~> Taxpayers are clearly informed about why and how taxes are levied.

Convenience ~~> ease of compliance for the taxpayers.

Efficiency ~> collection of taxes shouldn’t cost more resources than the taxes themselves.

Question 17

Does economic growth always increase living standards? (Yes and No, points)

Answer 17

Yes:

• Increased consumption (more total utility)
• Improved public services ( Tax rev. spent on education and healthcare).
• Reduced unemployment (reduction in poverty)

No:

• Externalities (pollution, global warming, etc)
• Increased crime and social problems (more things to steal).
  General association between growth and crime, fuelled by envy (USA).
• Disease of affluence (obesity, tobacco, alcohol, etc).

Question 18

Explain the Crowding out effect caused by Fiscal policy?

Answer 18

When Fiscal policy is implemented, the Gov. increases their consumption of loanable funds. This increases the demand for said loans, which then increases the interest rate per quantity, for the market. As interest rates rise, private firms will find it difficult to acquire such loans, from entities that charge a high interest rate.

This holds bank borrowing and investment from Firms such that AD will decrease.

Question 19

Government expenditure, on….

• Transfer payments
• Infrastructure investment
• Current payments (doesn’t effect AD as much)

Answer 19

• Transfer payments = are welfare payments from the government. They aim to provide a minimum standard of living for those on low incomes. No goods or services are exchanged for transfer payments.
• Infrastructure exp. = includes all the spending on physical assets, services and facilities that help societies develop and grow.
• Current payments = expenditure on day to day running costs, for example, government spending on wages of public sector workers or buying raw materials.

Question 20

What is meant by Crowding in?

Answer 20

It is a Keynesian economic theory that suggests that an decrease in government spending can lead to an increase in private investment.

Question 21

Cyclical Fiscal balance (budget position):

Answer 21

A cyclical budget deficit takes into account fluctuations in tax revenue and spending due to the economic cycle. For example, in a recession, tax revenues fall and spending on unemployment benefits increases.

Question 22

Structural Fiscal balance (budget position):

Answer 22

This the level of the deficit even when the economy is at full employment.

Question 23

The benefits and negatives of Budget Surplus (Austerity)? + Eval

Answer 23

Benefits:

• improved credit rating = cheaper to borrow (long-term).
• reduce inflation/ improve current account.
• increased confidence = + FDI
• future/ Fiscal flexibility
• Crowing in? / encourages private investment

Negatives:

• increased inequality
• too much/ AD, demand-side shock/ decreasing growth.
• tax = less competitiveness / brain drain/ laffer curve
• reduced welfare = NET’s

Eval:

• economics cycle/ stage
• state/ finances
• debt: gdp ratio
• does tax and government spending/ both need manipulation?

Question 24

Benefits and negatives of Budget deficit? + Eval

Answer 24

Benefits:

• growth/ employment/ future tax returns
• government spending = solving mkt failure + PE’s
• redistribution of income
• crowding in + accelerator ?

Negatives:

• adds to national debt
• increased tax in future
• crowding out?
• worsened credit state = expensive loans= opp cost
• reduced business confidence = -FDI

Eval:

• state of finance
• economic cycle/ recession necessary

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