2.6.2 Demand side policies

Question 1

What are the 3 categories of macroeconomic policy?

Answer 1

• Fiscal policy: policies that involve government spending, taxation, and/or borrowing to affect AD
• Monetary policy: policies relating to interest rates, the money supply, and/or the exchange rate
• Supply side policy: policies that increase the productive potential of an economy; usually in relation to
  increases in the quantity and/or quality of an economy’s factors of production

Question 2

What is a cyclical fiscal deficit?

Answer 2

The size of the deficit is influenced by the state of the economy: in a boom, tax receipts
are relatively high and spending on unemployment benefit is low

Question 3

What is the national debt?

Answer 3

Debt is the total amount owed by the government sector that has accumulated over the years

Question 4

Explain fiscal policy.

Answer 4

• Fiscal policy involves the use of government spending, direct and indirect taxation and government borrowing
  to affect aggregate demand, output and jobs
• Fiscal policy is also used to change the pattern of spending on goods and services e.g. spending on health
  care and scarce resources allocated to renewable energy
• Fiscal policy is also a means by which a redistribution of income & wealth can be achieved for example by
  changing tax rates on different levels of income or wealth
• It is an instrument of micro-economic government intervention to correct for market failures such as pollution
  or the sub-optimal provision of public and merit goods
• Changes in fiscal policy affect both aggregate demand (AD) and aggregate supply (AS)

Question 5

Explain the justifications for government spending

Answer 5

1. To provide a socially efficient level of public goods and merit goods and overcome market failure
   a. Public goods tend to be under-provided by the private sector (a cause of market failure)
   b. Improved and affordable access to education, health, housing and other public services can help
   to improve human capital, raise productivity and generate gains for society as a whole
2. To provide a safety-net system of welfare benefits to supplement the incomes of the poorest in society –
   this is also part of the process of redistributing income and wealth. Government spending has an
   important role to play in controlling / reducing the level of relative poverty
3. To provide necessary infrastructure via capital spending on transport, education and health facilities – an
   important component of a country’s long run aggregate supply
4. Government spending can be used to manage the level and growth of AD to meet macroeconomic
   policy objectives such as low inflation and higher levels of employment
5. Government spending can be justified as a way of promoting equity.
6. Well-targeted and high value for money public spending is also a catalyst for improving economic
   efficiency and competitiveness e.g. from infrastructure projects

Question 6

Explain direct taxes

Answer 6

• Levied on income, wealth and profit
• Direct taxes include income tax, inheritance tax, national insurance contributions, capital gains tax, and
  corporation tax (a tax on company profits)
• The burden of a direct tax cannot be passed on

Question 6

How has government spending affected incomes

Answer 6

• Welfare state transfers
  o Universal child benefits / unemployment benefit
  o Public (state) pensions
  o Conditional welfare transfers e.g. Conditional on attending unemployment programmes
  o Targeted welfare payments- linked to income
• State-provided services (in-kind benefits)
  o Education - reduces inequality of market incomes
  o Health care – state provided health services
  o Social housing e.g. Provided by local authorities
  o Employment training

Question 7

Explain indirect tax

Answer 7

• Indirect taxes are taxes on spending
• Examples of indirect taxes include excise duties on fuel, cigarettes and alcohol and Value Added Tax (VAT) on
  many different goods and services
• Producers may be able to pass on an indirect tax – depending on price elasticity of demand and supply
• Excise duties are added to “demerit goods” or goods with negative externalities, to deter demand

Question 8

What are the different examples of tax?

Answer 8

Question 9

How can changes in tax rates have effects on AD?

Answer 9

1. Changes in income tax and national insurance have a direct effect on people’s disposable incomes
2. Changes in corporation tax affect the post-tax profit available for businesses to invest
3. Changes in employers’ national insurance affect the cost of employing extra workers in the labour market
4. A change in value added tax brings about changes in retail prices and affects the real incomes of consumers

Question 10

How can changes in tax rates have effects on SRAS and LRAS?

Answer 10

1. Changes in VAT affect business costs e.g. the VAT applied when buying component parts / supplies
2. Changes in direct taxes can influence work incentives
3. Changes in business taxes might affect the level of foreign direct investment into a country
4. Taxes can also affect the incentive to start a business or to spend money on research and development

Question 11

What is public sector borrowing?

Answer 11

• Public sector borrowing is the amount the government must borrow each year to finance their spending
• Usually this borrowing is achieved by the sale of government debt, known as bonds

Question 12

What are causes of a fiscal deficit?

Answer 12

• Recession causing rising unemployment and therefore less taxes paid
• Decrease in consumer spending and profits leading to less tax revenue
• Increase in inactivity leading to rise in welfare benefit spending
• Use of fiscal stimulus by a government to lift aggregate demand
• Increase in interest rates on debt leading to a rise in debt service costs
• Demographic factors causing state pensions to rise

Question 13

What are discretionary fiscal changes?

Answer 13

Discretionary fiscal changes are deliberate changes in direct and indirect taxation and govt spending – for
example, increased capital spending on roads or more resources going into the NHS.

Question 14

What are automatic stabilisers?

Answer 14

Automatic stabilisers are changes in tax revenues and government spending that come about automatically
as an economy moves through the business cycle

Question 15

Give examples of automatic stablisers

Answer 15

1. Tax revenues: When the economy is expanding rapidly, tax revenue increases which takes money out of
   the circular flow of income and spending
2. Welfare spending: A growing economy means that a government does not have to spend as much on
   welfare benefits such as universal credit and unemployment benefits
3. Budget balance and the circular flow: Conversely during a slowdown or a recession, the government
   normally ends up running a larger budget deficit

Question 16

What is austerity?

Answer 16

Austerity is when the Government uses contractionary fiscal policy to decrease their budget deficit. The primary aim
is not to decrease AD but to slow the rate of growth of the national debt

Question 17

What are policies to reduce the size of a budget deficit?

Answer 17

Question 18

Explain what monetary policy is

Answer 18

Monetary policy involves changes in interest rates, the supply of money & credit, and exchange rates. The Monetary
Policy Committee (MPC) of the Bank of England has full operational independence to set monetary policy. In the UK, the current ‘tools’ of monetary policy in use are changes in the interest rate and the supply of money. The exchange
rate of the £ is determined entirely by demand and supply in international foreign exchange markets, and is not directly influenced by the Bank of England.

Question 19

What does the MPC do within monetary policy?

Answer 19

The MPC only sets the Base Rate (also known as Bank Rate). High Street banks and other financial institutions
can set their own interest rates on their products (e.g. savings accounts, mortgages, business loans etc), but often
these interest rates follow changes in the Bank of England’s Base Rate

Question 20

What is monetary stability?

Answer 20

Monetary stability means stable prices and confidence in the currency.
Stable prices are defined by the Government’s inflation target, which the Bank seeks to meet through the decisions taken by the Monetary Policy Committee (MPC).

Question 21

Explain expansionary monetary policy

Answer 21

Fall in nominal and real level of interest rates
Measures to expand the supply of credit from the commercial banking system
Depreciation of the external value of the exchange rate
Leads to an increase in AD
It can also lead to an increase in LAS, if lower interest rates stimulate investment and cause business growth

Question 22

Explain contractionary monetary policy

Answer 22

Higher interest rates on both loans and savings
Tightening of credit supply (i.e. loans become harder to get)
Appreciation of the exchange rate
Leads to a decrease in AD

Question 23

What does the transmission mechanism look like?

Answer 23

Question 24

In the context of the UK, explain what happens when interest rates rise?

Answer 24

• If a central bank raises interest rates, this is an example of a contractionary monetary policy.
• Higher interest rates have the effect of slowing down the rate of growth of demand including consumption:
• There is an increased incentive for people to save
• Mortgage interest rates are likely to rise causing a fall in the effective disposable income of mortgage-payers
• Interest rates on credit cards and other loans will increase making borrowing more expensive
• Higher interest rates might dampen consumer optimism causing people to save more and spend less

Question 25

Explain what happens when the MPC raises the base rate

Answer 25

Question 26

What happens when interest rates fall?

Answer 26

1. Cost of servicing loans / debt is reduced – increasing spending power
2. Consumer confidence should increase leading to more spending
3. Effective disposable income rises – lower mortgage costs
4. Business investment should be lifted e.g. Prospect of rising demand
5. Housing market effects – more demand and higher property prices
6. Exchange rate and exports – cheaper currency will increase exports

Question 27

What are key roles for central banks

Answer 27

Monetary policy function
* Setting of the main monetary policy interest rate (i.e. the base rate or bank rate)
Quantitative easing (QE) - this creates extra credit within the financial system
Exchange rate intervention (only with managed/fixed currency systems)
* Financial stability & regulatory function
o Prudential policies designed to maintain financial stability of banks & other lenders
* Policy operation functions
o “Lender of last resort” to the commercial banking system to provide stability
o Managing levels of liquidity in the commercial banking system e.g. in the immediate aftermath of an
economic shock such as the Global Financial Crisis
* Financial infrastructure function
o Overseeing the payments systems used by banks / retailers / credit card companies including financial innovations such as contactless payments
Debt management (acting as a banker to the government)
o Handling the issue (sale) and repayment of issues of government debt

Question 28

What are Factors Considered When Setting Policy Interest Rates (UK context)?

Answer 28

• GDP growth and spare capacity / estimates of output gap
• Bank lending, consumer credit figures, retail sales data
• Equity markets (share prices) and trends in house prices
• Consumer confidence and business confidence / sentiment
• Growth of wages, average earnings, labour productivity and unit labour costs, surveys on labour shortages
• Unemployment and employment data, unfilled vacancies
• Trends in foreign exchange markets (i.e. is sterling appreciating or depreciation against other currencies)
• International data – e.g. GDP growth rates in economies of major trading partners such as USA and Euro Area

Question 29

What is quantitative easing?

Answer 29

• Quantitative easing (QE) is the introduction of new (electronic) money into the national money supply by a
  central bank, with the purpose of buying assets (i.e. bonds) from financial institutions such as pension funds,
  investment banks and insurance companies.
• One of the main aims of quantitative easing is to increase “liquidity” of financial institutions, making it easier
  for them to lend
• It is an alternative strategy to that of cutting interest rates directly
  o As demand for bonds rises as a result of QE, this pushes down their yield, which in turn causes wider
  market interest rates to fall

Question 30

What are the key channels/effects through which QE operates?

Answer 30

1. Wealth effect – rising demand for bonds leads to higher share and bond prices
2. Borrowing cost effect - QE lowers the interest rate on long term debt such as government bonds and
   mortgages, making it cheaper for the government and businesses to borrow and invest
3. Lending effect - QE increases the liquidity of banks and increased lending from banks lifts incomes and
   spending in the economy
4. Currency effect - lower interest rates has the side effect of causing the exchange rate to weaken (a
   depreciation) which helps exports

Question 31

Explain the process of quantitative easing

Answer 31

Question 32

What is an exchange rate?

Answer 32

An exchange rate is the rate or price at which one country’s currency can be exchanged for other currencies
in the foreign exchange (FX) market.

Question 33

What does SPICEE stand for?

Answer 33

SPICEE – Strong Pound Imports Cheaper Exports Expensive. So, we would expect an appreciation to lead to rising demand for imports and less demand for exports i.e. a worsening trade deficit. Conversely, a depreciation would likely
lead to less demand for imports and more demand for exports i.e. an improving trade balance.

Question 34

What happens when the currency appreciates?

Answer 34

Question 35

Explain currency appreciation using AD-AS graph

Answer 35

Question 36

What were the key origins of the 2007-2009 financial crisis?

Answer 36

1. Sub-prime lending – lending to high risk home-buyers
2. Financial innovation e.g. credit default swaps and collateralized debt obligations
3. Asset price bubble – especially in housing – banks lent out too much
4. Regulatory capture – e.g. failure of the credit ratings agencies

Question 37

How did the macroeconomic policies of many countries respond to the 2007-09 financial crisis?

Answer 37

• Central banks around the world cut interest rates sharply during the 2007-2009 financial crisis. Rates have stayed at historic lows since then, close to or below 0% (zero) in most developed economies.
• Huge fiscal stimulus for a while - especially in China and (to a lesser extent) in the USA
• Backstop and bailout of the private sector (financial system, households, corporations) - including (in the UK) bail-outs and nationalization of some banks such as Royal Bank of Scotland and Northern Rock

Question 38

What are the advantages of expansionary policies in the aftermath of the crisis?

Answer 38

1. Prevent depression
   a. Provide strong monetary & fiscal stimulus – public sector spending is needed when private sector
   demand is weak
2. Create jobs
   a. Labour-intensive infrastructure projects may have a large and positive fiscal multiplier effect
3. Avoid price deflation
   a. Demand side stimulus after a financial shock is needed to stop prices and real wages falling
4. Support confidence
   a. If confidence is stabilized, businesses more likely to invest

Question 39

What are the disadvantages of expansionary policies in the aftermath of the crisis?

Answer 39

1. Keynesian liquidity trap
   a. This is when ultra-low interest rates fail to stimulate consumption and investment because of low
   confidence and high debt
2. Moral hazard
   a. Bailing-out banks might encourage riskier behaviour in the future leading to another financial crisis
3. Impact on savers
   a. Negative real interest rates hits living standards of savers especially older people reliant on savings
4. Rising property prices
   a. QE and low interest rates have contributed to a surge in property prices and housing rents - damaging the geographical mobility of labour by making housing less affordable especially for younger people

Question 40

What is hot money?

Answer 40

Hot money is money that is moved to countries where there are high interest rates, allowing investors to maximise the interest gained on savings. As investors exchange their pounds to another currency, the supply of the pound increases and its value reduces.