Unit 13.1 to 13.5

Question 1

What are the two types of demand side policies

Answer 1

Monetary and fiscal

Question 2

What are two categories of supply side policies

Answer 2

market based- which relies on the workings of the market
interventionist- which relies on government intervention

Question 3

The aims of monetary policy

Answer 3

Governments have different economic tools they can use to target their macroeconomic objectives:

Sustainable economic growth
Low unemployment
External balance on the current account balance of payments
Low inflation or price stability

Question 4

How does a monetary policy work

Answer 4

Monetary policy is where the government uses interest rates and the supply of money to achieve its macroeconomic objectives. For example, the central bank of a country uses interest rates and the supply of money to manage the rate of inflation.

Question 5

Importance of the central bank

Answer 5

The central bank in an economy is the key institution the government uses to apply monetary policy. It is independant from the government so that it is not hindered in the decision making. The central bank applies monetary policy by using the following tools:

Base interest (discount) rates
Quantitative easing
Open market operations

Question 6

Goals of monetary policy

Answer 6

Low and stable rate of inflation:

Aiming to keep inflation predictable to foster economic decision-making and maintain purchasing power.
Utilizing inflation targeting to manage inflation expectations and guide monetary policy actions.

Low unemployment:

Striving for full employment to maximize economic output and individual welfare.
Balancing inflation and employment goals, often facing trade-offs between them.

Reduction of business cycle fluctuations:

Smoothing out the peaks and troughs of the business cycle to avoid extreme economic volatility.
Implementing monetary policy to mitigate the effects of recessions and overheating in the economy.

Promotion of a stable economic environment for long-term growth:

Creating conditions conducive to investment and productivity, which are key to sustained economic growth.
Ensuring that the macroeconomic environment supports innovation and development.

External balance:

Managing the country’s exports and imports over time to prevent large deficits or surpluses.
Influencing the exchange rate through monetary policy to maintain a competitive balance in international trade.

Question 7

What is and how does an expansionary monetary policy work

Answer 7

Expansionary Monetary Policy:

The central bank lowers interest rates, making borrowing cheaper for consumers and businesses, which can stimulate spending and investment.

Increasing the money supply encourages more economic activity, boosting aggregate demand and potentially reducing unemployment.

How the Policy Achieves Economic Goals:

Reduced interest rates decrease the cost of borrowing and increase disposable income for consumers, leading to higher consumption.

With more investment by firms due to lower borrowing costs, production can increase, contributing to economic growth and job creation.

Question 8

Strengths of expansionary monetary policy

Answer 8

Quick implementation allows central banks to promptly address economic downturns or rising unemployment by lowering base rates.

The policy’s incremental nature enables fine-tuning in response to ongoing economic changes, allowing for targeted adjustments to interest rates.

Central bank autonomy minimizes political influence, preventing the misuse of monetary policy for short-term economic gains before elections. This independence helps maintain credibility and focus on long-term economic stability rather than short-term political pressures.

Question 9

Weaknesses of expansionary monetary policy

Answer 9

Inflation Risk:

Expansionary monetary policy can potentially lead to an inflationary gap, raising the average price level if aggregate demand exceeds productive capacity.
In extreme cases, too much demand can lead to significant inflation, as depicted in economic models like diagram 3.41.

Limited Scope at Low Interest Rates:

Near-zero interest rates limit the central bank’s ability to use rate cuts as a tool to stimulate the economy further.
This scenario, often referred to as a liquidity trap, restricts monetary policy effectiveness.

Commercial Banks’ Response:

There’s no guarantee that commercial banks will pass on the benefits of reduced rates to consumers or businesses.
Banks might choose to increase profits instead, by maintaining higher rates for borrowers despite the central bank’s cuts.

Consumer and Business Confidence:

In a recession, low confidence can negate the intended effects of lowered interest rates as firms and households might still restrict spending.
This reluctance can particularly affect large-scale investments and expensive consumer purchases.

Time Lags:

The impact of interest rate changes can take up to 18 months to fully materialize in the economy, complicating timely policy adjustments.
Misjudgment in the timing of policy changes can result in overstimulation and lead to inflation.

Exchange Rate Impact:

Lower interest rates can cause the domestic currency to depreciate, making imports more costly and contributing to inflation.
Currency devaluation through monetary expansion can lead to adverse inflationary pressures.

Question 10

What is and how does an contractionary monetary policy work?

Answer 10

Contractionary Monetary Policy:

Governments and central banks utilize contractionary monetary policy by increasing interest rates and reducing the money supply to combat inflation.

How the Policy Achieves Economic Goals:

Increased Interest Rates: The central bank raises its base rate, leading to higher interest rates across the economy. This makes borrowing more expensive for consumers and businesses.

Reduced Money Supply: By reducing the amount of money in circulation, the central bank aims to decrease spending and investment.

Impact on Consumption and Investment: Higher borrowing costs lead to reduced consumption and investment, lowering aggregate demand in the economy.

Reducing Inflation: As aggregate demand decreases, the pressure on prices eases, leading to a reduction in inflation. This process helps stabilize the economy by bringing inflation to a target level.

Question 11

Strengths of contractionary monetary policy

Answer 11

Contractionary monetary policy can be applied quickly which gives it flexibility as a policy. If the rate of inflation rises the central bank can react almost immediately to increase interest rates to reduce aggregate demand and inflation.

Contractionary monetary policy can be applied incrementally so it can be adjusted to changes in the inflation rate. If the inflation rate is rising month by month, interest rates can be continuously increased to tackle the problem.

Because central banks are independent of governments in most countries they have some freedom to apply contractionary monetary without political influence. For example, a rise in inflation might need a rise in interest rates but the government might not want to do this for political reasons, but an independent central bank can still increase the rate of interest to reduce inflation.

No budget deficits or debt: It does not lead to budget deficits or increased levels of debt as fiscal policy does in the case of expansionary policy

Interest rates changes are reversible: Interest rate changes can also be easily reversed if necessary. An expansionary policy can easily be reversed into a contractionary policy and vice versa.

Monetary policy is flexible: Interest rates can be changed often according to needs.

Question 12

Weaknesses of contractionary monetary policy

Answer 12

Risk of Slower Economic Growth: The policy can decrease aggregate demand, potentially slowing economic growth and triggering recession, increasing unemployment.

Impact on Lending: Commercial banks may not fully pass on higher interest rates set by the central bank due to competitive lending markets, which can undermine the policy’s effectiveness.

Time Lags: It can take around 18 months for the full effects of an interest rate increase to permeate the macroeconomy, leading to potential policy missteps.

Exchange Rate Appreciation: Higher domestic interest rates may attract foreign investment, strengthening the domestic currency, which can make exports more expensive, imports cheaper, and potentially worsen the current account deficit.

Question 13

What is a fiscal policy?

Answer 13

Fiscal policy refers to manipulations by the government of its own expenditures and taxes to influence the level of aggregate demand (like C+G+I)

Question 14

what are the sources of government revenue?

Answer 14

Direct taxation on household incomes in the form of income tax and tax on business profits in the form of corporation tax.

Indirect taxation such as VAT and specific duties on goods and services.

Profit from the operations of state-run organisations. Many governments own organisations in the transport and energy sectors and make a profit from them.

Asset sales when governments privatise industries. When governments sell the assets of state-owned enterprises it leads to an inflow of funds to the state.

Question 15

What are the three types of government expenditure

Answer 15

Current expenditure: on the day-to-day running of the government sector such as paying the wages of teachers, doctors and military personnel.

Capital expenditure: on investment projects financed by the government such as building roads, bridges and schools.

Transfer expenditure: on welfare payments such as unemployment and housing benefits.

Question 16

How does an expansionary fiscal policy work

Answer 16

Expansionary Fiscal Policy:

The government employs expansionary fiscal policy by decreasing taxation and increasing government spending to boost aggregate demand.

How the Policy Achieves Economic Goals:

Decreased Taxation: Reducing direct and indirect taxes increases disposable income for households and profits for firms, which can lead to increased consumption and investment.

Increased Government Spending: An upsurge in government expenditure directly amplifies aggregate demand.

Impact on Consumption and Investment: With more disposable income, households are likely to spend more, and firms may invest more, collectively elevating aggregate demand.

Stimulating Economic Growth: By stimulating aggregate demand, this policy aims to counteract economic downturns, such as the decrease in growth due to the Covid-19 crisis.

Diagrammatic Representation: Economic models typically demonstrate this policy’s effect by showing a shift in the aggregate demand curve to the right, indicating increased economic activity and growth.

Question 17

How does an contractionary fiscal policy work

Answer 17

Contractionary Fiscal Policy:

The government enacts contractionary fiscal policy by increasing taxation and decreasing government expenditure to curb inflation and close an inflationary gap.

How the Policy Achieves Economic Goals:

Increased Taxation: Higher taxes on households and businesses lead to reduced consumption and investment.

Decreased Government Spending: A cut in government spending contributes to a decline in aggregate demand.

Impact on Aggregate Demand: The combination of increased taxes and decreased spending results in a fall in aggregate demand.

Reducing Inflation: As aggregate demand decreases, the average price level in the economy falls, which helps to reduce inflation.

Closing the Inflationary Gap: The policy aims to bring real GDP down from an elevated level (Y) to the full employment level (YFE), effectively closing the inflationary gap.

Diagrammatic Representation: In economic diagrams, this shift in policy is illustrated by the aggregate demand curve shifting left from AD to AD1, leading to a lower average price level and real GDP, indicating a reduction in inflationary pressures.

Question 18

Explain impact on labour market using labour diagram of an impact of expansionary fiscal policy

Answer 18

As aggregate demand increases there is a rise in real GDP which means businesses might produce more and employ more workers to do this. This is illustrated in the labour market diagram where the demand for labour increases from ADL to ADL1 and the rise in employment reduces unemployment.

Question 19

Strength of expansionary fiscal policy

Answer 19

Targeting Unemployment: It is especially effective in addressing demand-deficient unemployment during recessions by stimulating aggregate demand and thereby reducing unemployment.

Direct Economic Impact: The policy has immediate effects on the economy; reducing taxes boosts consumer income, and increasing government spending directly lifts aggregate demand.

No Adverse Exchange Rate Impact: Unlike expansionary monetary policy, which can lead to depreciation of the exchange rate due to lowered interest rates, expansionary fiscal policy does not directly impact the exchange rate in this manner.

Question 20

Weakness of expansionary fiscal policy

Answer 20

Budget Deficit and Debt: Tax cuts and increased government spending can significantly increase the budget deficit and national debt, which is a concern, especially during recessions when deficits tend to naturally widen.

Questionable Effectiveness of Tax Cuts: In recessions, tax cuts may not stimulate demand as intended since households might save the extra income due to employment uncertainty.

Potential for Inefficient Spending: Government projects may not always be efficient or necessary, potentially leading to wasteful use of resources and bureaucratic expenses.

Lack of Flexibility: Fiscal policy changes are typically less frequent and more time-consuming due to the complexities of tax law and the need to coordinate with various government and administrative bodies.

Inflation Risks: If the economy is near or at full employment, expansionary fiscal policy can exacerbate inflation rather than address unemployment.

Limited Scope: While effective against demand-deficient unemployment, expansionary fiscal policy does not address other forms of unemployment like structural or frictional, which are not directly linked to aggregate demand.

Question 21

Advantages of contractionary fiscal policy

Answer 21

Direct Impact on Aggregate Demand: Unlike monetary policy, which works through a transmission mechanism, fiscal policy has a more direct and immediate effect, with measures like increased taxation directly reducing household income.

Shorter Time Lag: The effects of fiscal policy changes tend to be felt more quickly than those of monetary policy, due to its direct influence on the economy.

No Direct Exchange Rate Impact: Adjustments in taxes and government spending do not have the same direct effects on a country’s exchange rate as monetary policy changes do; for instance, raising interest rates can cause an exchange rate appreciation, which isn’t a concern with fiscal policy.

Targeted Inflation Control: Fiscal policy can be designed to specifically address certain economic sectors, which can be useful for managing inflation, such as by reducing indirect taxes to lower the price level of goods and services directly.

Question 22

Weaknesses of contractionary monetary policy

Answer 22

Reduced Incentives for Workers and Entrepreneurs: Higher taxes may demotivate workers and discourage entrepreneurial activities due to lower potential income and profits.

Risk of Cost-Push Inflation: An increase in indirect taxes can escalate business costs, which may contribute to cost-push inflation if businesses raise prices to maintain profit margins.

Negative Social Impact: Austerity resulting from lower government expenditure can deteriorate the quality of public welfare services, such as education and healthcare, adversely affecting societal well-being.

Lack of Flexibility: Fiscal policy is not as flexible as monetary policy; tax rates and government spending are harder to adjust frequently within a year.

Potential for Reduced Economic Growth: Higher taxes and reduced government spending can suppress aggregate demand, potentially triggering a slowdown in economic growth, recession, and increased unemployment.

Question 23

What is cost push inflation and what curve does it shift and where

Answer 23

Cost push inflation= shift left of the aggregate supply curve to the left because overall prices rise (inflation) due to increases in production costs such as wages and raw materials.