Pack 4 yr 12 Flashcards
What is a fiscal policy and what are the two types?
- use of government spending and taxation to influence the level of AD
Expansionary fiscal policy: increase AD:
- increase gov spending
- cutting taxation
Contractionary fiscal policy: decrease AD:
- decrease gov spending
- increasing taxation
How can change in taxation be used?
Direct tax: e.g income tax and corporation tax
- shift AD
Indirect tax:
- tax levied on consumption of goods/services such as Vat or tax on fuel
- shift short run AS and lead to movement along AD
- Pros:
- beneficial as does not distort incentive to work
- flexible as can be changed between budgets
- Cons:
- regressive in nature so take higher percentage of income from those on low incomes
- increase income inequality
What is a budget deficit and budget surplus?
budget deficit = gov spends more than it receives in tax revenue in a given year
budget surplus = gov receives more tax revenue than gov spending in a given year
What are the consequences of running a budget deficit?
tax rises in future: could reduce AD and economic growth
opportunity cost gov will have to pay back interest, so spend les money on other essential services e.g healthcare
Crowding out: due to higher market interest rates as gov increase demand for loans or fewer resources for private sector to use
impact on credit rating: if gov policies lead to increased national debt and has less chance of paying back the debt then their credit rating may reduce - lead to higher interest needing to be paid to reflect this risk
No one wants to lend: extreme cases investors may have little confidence that gov will pay interest back and so won’t buy bonds at all
When is a budget expansionary and when is it contractionary?
expansionary:
- if budget deficit increases: there is larger net injection into circular flow compared to last year and therefore boosts AD
- if budget surplus decreases : there is a smaller net withdrawal from circular flow compared to last year
contractionary:
- budget deficit decreases: smaller net injection into circular flow compared to last year and therefore reduces AD
- budget surplus increases: larger net withdrawal from circular flow = reduced AD
What are the strengths of Fiscal policy?
-
can be used to achieve macroeconomic objectives: demand side policies shift AD and changes in this can allow objectives to be achieved
e/g influencing economic growth and jobs
e.g managing government budget - short-run macroeconomic management: will have time lags (18-24 months) still much shorter than supply-side policies
What are the weaknesses of Fiscal policy?
Demand-side policies cannot achieve all objectives at once:
- e.g cannot increase GDP and control inflation
Inadequacy of the data, knowledge and the economic model:
- decisions often based on forecasts (may be wrong/inaccurate)
Time lags: all policies have them as time needed to recognise problem, create policy and implement it
Effectiveness of changing taxation:
Tax cuts may not boost economic growth: due to low consumer/business confidence, they may not respond either if they think change is temporary and taxes will increase in future
Tax rises may not reduce budget deficit: may not lead to higher tax revenue, e.g if income tax increased = less incentive to work and so less hours/workers to tax at higher rate
Side effects on the budget balance and national
- debt interest payments = opportunity cost for gov
- need for tax rises in future to reduce budget deficit
Conflict with other macroeconomic policies:
- fiscal and monetary policy: conflict as lead to higher market interest rates due to financial crowding out
- fiscal and supply-side policies: cutting spending on education/healthcare or raising direct taxation could reduces LRAS
What is the role of the bank of england?
- BofEs Monetary Policy committee (MPC) consists of nine members
- they meet 8 x a year to set the monetary policy
- at this meeting they set Bank rate and discuss if quantitative easing is required or should continue
- policy decided by majority vote
- can take up to 2 years for full effects of decisions to be seen in economy
- important consideration is inflation target of 2%
What factors influence decisions made by MPC?
DEMAND SIDE FACTORS:
- consumption prospects: such as incomes, employment, consumer confidence etc
- Investment prospects: such as current/future profits, corporation tax levels, availability of credit
- government spending changes such as changes announced by chancellor in budget
-Net export prospects: exchange rates, world incomes, price/quality of imports/exports
SUPPLY SIDE FACTORS:
- exchange rates: influencing costs of imports
- Commodity prices such as changes in oil prices
- changes in indirect taxation such as VAT
- firm’s wages and costs: imported raw material costs and wage costs
- changes in productivity: influence labour unit costs
What are the two types of monetary policy instruments?
interest rates
quantitative easing
How are interest rates used as an expansionary monetary policy?
Expansionary monetary policy: reduce interest rates:
increase AD:
- higher consumption: less incentive for consumers to save, more incentive to borrow as credit cheaper
- higher investment: less incentive for businesses to save and more incentive to borrow as cost lower
Higher net exports:
- fewer foreign investors putting money into UK banks due to low return on saving
- reduce demand for the pound and weaken exchange rate
- reduce price of exports and so boost net exports
Contractionary monetary policy: increase interest rates
How can quantitative easing be used as a monetary policy instrument?
- involved increasing the money supply (electronically) and using this extra money to purchase government bonds from FINANCIAL INSTITUTIONS/COMMERCIAL BANKS
- the BofE purchase of gov bonds can lead to higher consumption/investment:
- direct increase in consumption/investment: those economic agents who have gov bonds bought from them can use this money to spend/invest in economy
- bank lending increases: banks who have bonds bought from them can use that money to lend in economy (to increase profits) this stimulates consumption/investment
Quantitative easing may also boost AD due to reduction in gov bond yields:
- BofE increases money supply and purchases gov bonds from banks
- price of gov bonds will increase as demand increased
- this reduces return on investment for gov bond (bond yield)
LEADS TO:
- higher asset prices: investors looking for higher yield investments such as property, lead to rise in demand/price of assets = wealth affect = increase consumption
- cheaper cost of borrowing: lower bond yields, due to rise in price of bonds, causes itnerest rates to go down and so cost to fall
- fall in exchange rate: foreign investors demand fewer £ as less likely to invest in UK gov bonds due to fall in yield = lower demand, reduce exchange rate and boost net exports, also increases the supply of the currency
What are the strengths of monetary policy?
can be used to achieve macroeconomic objectives:
e.g - influencing economic growth and jobs: leads to increased AD and boosted real GDP
- managing inflation target: using interest rates
Short run economic management: although demand-side policies have time lags much shorter than supply-side policies, so in short term macroeconomic objectives can be achieved by shifting AD
What are weaknesses of monetary policy (like all demand side policies)?
- cannot achieve all objectives at one
- inadequacy of data,knowledge and economic model
- time lags
What are specific weaknesses of monetary policy?
Effectiveness of monetary policy instruments at boosting AD:
- will lower interest rates work?: limit to how far they can be cut, may not result in higher investment/consumption if confidence low, banks may not pass bank rate to consumers
- will quantitative easing work?: consumption/investment may be constrained by other factors e.g confidence
Side effects of monetary policy:
- higher interest rates can increase income inequality: low income households more likely to borrow than save
- higher interest rates can reduce competitiveness: can leas to stronger exchange rate as foreigners put money into uk banks = higher price for exports
- quantitative easing can cause asset bubbles: as investors switch to higher return investments = damage economic growth if bubbles burst
Conflict between policies:
- monetary and supply side policies : BofE use higher interest rates to reduce inflation, but can lead to lower business investment and damage LRAD and conflict aim of supply-side policies
What happened during the great depression?
what happened:
- period 1929-37 where major economy saw fall in output, prices, rise in unemployment and real economic hardship
- wall street crash, 1929 caused it
- US particularly effected due to growth in credit in years leading up to it
- UK more insulated as had experienced no real credit boom in 1920s, however duet o UK economy relying heavily on trade, decline in global demand hit UK economy with lower exports and so economy went into recession
- 1931, real GDP fell 5%
What was fiscal policy response to great depression?
USA:
- expansionary fiscal policy
- main example Roosevelt’s New deal (increased gov expenditure)
- money spent on building infrastructure/employing people in both conservation/construction
- protectionist policies intended to protect jobs/employment in US
UK:
- contractionary fiscal policy
- focused on balancing budget rather than using fiscal policy to boost AS
- 1931, emergency budget cut public sector wages/unemployment pay by 10%
- raised income tax
- also introduced protectionist measures
What were the monetary policy responses to the great depression?
US:
- many different views: some believed tight policy to blame for start/length of depression, with high interest rates constraining AD and increasing firm bankruptcies
- others disagree that monetary policy was even that contractionary
- 1930 interest rates where cut from 6% to 4% although later raised them to preserve value of dollar
- US also acted to increase money supply from April-June 1930
UK:
- expansionary monetary policy
- left gold standard = interest rates cut from 6 to 2%
- recovery aided by dramatic fall in sterling exchange rate after leaving gold standard = increased international competitiveness
conclusion on responses to great depression
- classical economists initially advised using contractionary fiscal policy, but this only reduced AD further and causes negative multiplier effects
- some view high interest rates in US as another contractionary demand-side policy that did not help and contributed to causing/prolonging Great Depression
- countries most successful were military dictatorships who spent significant amounts on military spending
- key response was protectionism - however some believed this may prolonged great depression as did not allow export-led growth and led to retaliation between countries
- recovery only really occured when spending increased because of the war
What occurred in the global financial crisis?
US:
- cheap credit, inflow of capital from Asia and lax regulation all contributed to a boom in housing market
- rise in unorthodox mortgage lending, when mortgage defaults started to rise in US, banks started having to write off bad loans and banks around world lost money and became reluctant to lend
- caused fall in house prices=decline in wealth=lower consumer spending
- result in fall in investment/spending in economy
What were the fiscal policy responses to global financial crisis?
US:
- expansionary
- e.g 2008 Economic Stimulus Act
UK:
- expansionary
- tax cut for basic rate tax payers and cut in VAT
- after 2010 focus shifted to reducing budget deficit, under coalition gov
- contrast to great depression protectionism not as widespread in US/UK
what were the monetary policy responses to financial crisis?
US:
- federal reserve used aggressive expansionary monetary policy
- cut interest rates from 5.25% to 2.25% over final 3 months of 2007
UK:
- aggressive expansionary policy also used
conclusion of responses to financial crisis
- Both governments were forced to nationalise banks and building societies and
guarantee savers their money in order to prevent the chaos of a collapsed banking
system. For example, the** British government bought Northern Rock and most of
Royal Bank of Scotland and Lloyds Bank**.
● They used expansionary monetary policies with record low interest rates and
quantitative easing. The Bank of England said the QE led to lower unemployment
and higher growth than would otherwise have been the case.
● However, the USA government had a more expansionary fiscal policy and this is
perhaps why it recovered faster. In 2010, the UK prioritised reducing National Debt
over providing a fiscal stimulus, but the USA did not make this decision until 2013.
What are supply side policies?
What are the differences between interventionist and market-based supply side policies?
- policies undertaken by gov designed to increase productive potential of economy and LRAS
Interventionist: government intervenes to try to improve economy, via higher gov spending and regulations (favoured left wing govs)
Market-based: freeing up markets to work more efficiently (increasing incentive to work), by reducing tax, government spending and regulations (right wing gov)
