2.6.2 Demand Side Policies

Question 1

Demand side policies

Answer 1

• Monetary policy
• Fiscal policy

Question 2

Fiscal policy

Answer 2

involves the government changing the levels of government spending & taxation to affect AD (strong and fast)

Question 3

Monetary policy

Answer 3

• involves the Bank of England using interest rates and the money supply to affect AD (slow and weak)

Question 4

Monetary policy instruments

Answer 4

• interest rates
• asset purchases to increase the money supply (quantitative easing)

Question 5

Transmission mechanism involved with changes in the Bank Rate

Question 6

Fiscal policy instruments:

Answer 6

government spending and taxation

Question 7

Ways to expand the economy (fiscal)

Answer 7

• decrease interest rates
• use quantitative easing
• lower taxes
• increase government spending

Question 8

How does decreased interest rates expand the economy?

Answer 8

cheaper borrowing encourages businesses to expand = more jobs and more income

Question 9

How does quantitative easing expand the economy?

Answer 9

involves increasing the money supply and buying bonds to keep interest rates low.
- The hope is that the increase in the money supply and lower interest rates will boost investment and economic activity.

Question 10

How does increased government expand the economy?

Answer 10

• improving infrastructure = business are better connected = more exports = increased AD

Question 11

Budget (fiscal) deficit

Answer 11

• during a recession
• when government spending is bigger than tax revenue
• injections are high and withdrawals are low
• to encourage AD
• expansionary fiscal policy

Question 12

Budget (fiscal) surplus

Answer 12

• during a boom
• when government spending is smaller than tax revenue
• injections are low and withdrawals are high
• austerity

Question 13

Expansionary policies effect of AD

Answer 13

• increase AD = incentive for businesses to produce more = increase sales and profit
• also means more labour needed = decreased unemployment

Question 14

Why might expansionary policies lead to inflation?

Answer 14

• high levels of investment and low unemployment = businessses find it hard to recruit people = compete for peoplewith scarce skills offering higher pay

Question 15

Contractionary policies effect on AD

Answer 15

• reduces AD since prices would increase from the reduction of output = redundancies and increased unemployment

Question 16

Expansionary policy

Answer 16

• the govt coordinates factors to increase AD and grow the economy (deacresed taxes, increase govt spending)

Question 17

Contractionary policy

Answer 17

the govt change certain factor to slow the growth of the economy through decreasing AD (increased taxes, decreased govt spending)

Question 18

AD diagram for effects of demand-side policies

Question 19

AS diagram for effects of demand-side policies

Question 20

How has quantitative easing been used in the UK?

Answer 20

• when central banks buy illiquid assets (govt bonds) from banks paying for them upfront in cash
• this increases banks liquidity and banks then use this money to lend to borrowers

Question 21

Role of the Bank of England (monetary fund)

Answer 21

• The Bank’s monetary policy committee meet on a monthly basis to set the Bank rate and (maybe) the level of the asset purchase facility (quantitative easing)

Question 22

Types of government spending in fiscal policy

Answer 22

• Discretionary fiscal spending
• Automatic stabilisers

Question 23

Discretionary fiscal spending

Answer 23

choosing to spend money on something (political priorities)

Question 24

Automatic stabilisers

Answer 24

• automatically spend money/ elss on welfare depending where you are in the business cycle ie boom = low, slump = high

Question 25

Effects of demand-side policies

Question 26

Strengths of demand side policy

Question 27

Monetary policy evaluation

Answer 27

- In a liquidity trap, lower interest rates may not increase spending since ppl are trying to pay back debts - therefore might not lead to econ growth

Question 28

Monetary policy evaluation (banks not passing it off to consumers) example

Answer 28

in 2009, UK interest rates were cut to 0.5% but spending remained subdued. - Banks were unwilling to lend because of liquidity shortages so though cheap to borrow, head to create credit

Question 29

Monetary policy evaluation (housing bubble)

Answer 29

- cutting interest rates very low = distort future economic activity - e.g can contribute to a future housing and asset bubble = destabilise econ growth

Question 30

Monetary policy evaluation (housing bubble) example

Answer 30

- the US cut interest rates following the econ uncertainty of 9/11 - these low interest rates encouraged ppl to take on ambitious loans/mortgages = US housing bubble

Question 31

Fiscal policy evaluation

Answer 31

it leads to an increase in govt borrowing - to finance this extra spending = govt need to borrow from private sector - if the economy is already growing, then higher govt borrowing = crowd out the private sector

Question 32

How might fiscal policy not cause crowding out?

Answer 32

However, if the economy sees a rapid fall in private spending, and a rise in saving ratio, expansionary fiscal policy can help provide a boost to demand in the economy without causing crowding out.

Question 33

Fiscal policies in the US

Answer 33

- Roosevelt’s new deal in 1933 (the Great Depression) involved increased govt spending on public infrastructure and employing people - Smoot-Hawley tariff act in 1930 (protectionist policies)

Question 34

Fiscal policies in the UK 1931

Answer 34

- efforts to balance the govt budget - In 1931, Emergency Budget cut public sector wage and unemployment pay by 10% - ths was deflationary and reduced PPP in the economy worsening the situation

Question 35

Fiscal policy in the Global Financial Crisis (US)

Answer 35

- In 2008, the govt had the Economic Stimulus Act of $152 billion fiscal package - followed by the American Recovery and Reinvestment act of 2009, a 4787 billion bill which involved govt spending over several years

Question 36

Fiscal policy in the Global Financial Crisis (UK

Answer 36

- in 2008 they introduced tax cut for basic rate taxpayer, temporary 2.5% point cut in the VAT rate, £3 billion worth of investment spending from 2010 - in 2009 budget included training help for young unemployed

Question 37

Monetary policy in the Global Financial Crisis (US)

Answer 37

- the Federal Reserve cut interest rate from 5.25% to 4.25% in 2007 - they did 3 rounds of quantitative easing to boost the money supply

Question 38

Monetary policy in the Global Financial Crisis (UK)

Answer 38

- the MPC cut the Bank rate from 5.75% to 5.5% in 2007 - it was cut a further 5 times by the end of the year at ended at 2.0% - it was cut even further to 0.5% in March 2009

Question 39

Why might quantitative easing not work?

Answer 39

The fear is that increasing the money supply could cause inflation.

Question 40

Example of quantitative easing working

Answer 40

Though evidence from 2009-12 suggests that the inflationary impact was minimal. - Without quantitative easing, the recession was likely to be deeper, though QE alone failed to return the economy back to a normal growth projection.

Question 41

Example of demand side policy causing unsustainable boom in UK

Answer 41

- in 1972, the UK chancellor, announced a ‘dash for growth’. - Taxes were cut against a backdrop of rising house prices and inflation = Barber boom (rapid economic growth) - However, it also caused a spike in inflation, and the growth proved unsustainable.

Question 42

Using the classical long-run aggregate supply curve, explain what will happen in the long run to real output if aggregate demand increases.

Answer 42

There would be no change in real output (1) Analysis (1): E.g. since classical economists believe the economy will be at full employment in the long run