2.6.2 policy instruments

Question 1

What does the budget position refer to?

Answer 1

Whether the government has a deficit, surplus or if the budget is balanced.

Question 2

When does a government have a budget surplus?

Answer 2

When tax receipts exceed expenditure.

Question 3

When does a government have a balanced budget?

Answer 3

When expenditure is equal to revenue.

Question 4

When does a government have a budget deficit?

Answer 4

When expenditure exceeds tax receipts in a financial year.

Question 5

What is the difference between government debt and deficit?

Answer 5

Debt is the accumulation of the government deficit over time, it is the amount the government owes.

The deficit is the difference between expenditure and revenue at any one point.

Question 6

What is the national debt?

Answer 6

The amount of money the government has borrowed at one time through issuing securities by the Treasury.

Question 7

What is discretionary fiscal policy?

Answer 7

Involves deliberate changes in government expenditure and taxes with the intention of influencing AD.

Question 8

What does the UK government spend most of their budget on?

Answer 8

Pensions and welfare benefits, followed by health and education.

Question 9

What is the biggest source of tax revenue in the UK?

Answer 9

Income tax.

Question 10

What is expansionary fiscal policy?

Answer 10

This aims to increase AD. Governments increase spending or reduce taxes to do this.

Question 11

What are the limitations of fiscal policy? [6]

Answer 11

• May have imperfect information about the economy, leading to inefficient spending
• Significant time lag
• If government borrows from private sector, fewer funds available for the private sector which could lead to crowding out
• Bigger the size of the multiplier, bigger the effect on AD and the more effective the policy
• If interest rates are high, might not be effective for increasing demand
• If government spends too much there could be difficulties paying back the debt

Question 12

What methods does monetary policy use?

Answer 12

Interest rates and quantitative easing to control money flow of the economy.

Question 13

Why does quantitative easing have inflationary effects?

Answer 13

Increases the money supply and it can reduce the value of currency.

Question 14

When is Quantitative easing usually used?

Answer 14

Where inflation is low and it is not possible to lower interest rates further.

Question 15

What is quantitative easing?

Answer 15

A method to pump money directly into the economy. The bank buys assets in the form of government bonds using the money they have created. This is then used to buy bonds from investors, which increases the amount of cash flowing in the financial system, encouraging more lending to firms and individuals since it makes cost of borrowing lower.

If inflation gets high, the Bank of England can reduce supply of money by selling their assets.

Question 16

What are the limitations of monetary policy? [3]

Answer 16

• Banks might not pass the base rate onto consumers, which means that even if the central bank changes the interest rate, it might not have the intended effect
• Even if the cost of borrowing is low, consumers might be unable to borrow because banks are unwilling to lend. After the 2008 financial crisis banks became more risk averse
• Interest rates will be more effective at stimulating spending and investment when consumer and firm confidence is high.

Question 17

What do supply side policies aim to do?

Answer 17

Improve the long run productive potential of the economy, increasing the quantity or quality of the factors of production.

They aim to increase AS instead AD.

Question 18

What are some examples of supply side policies? [9]

Answer 18

• Education and training
• Reforming tax and benefits, or reducing marginal tax rates
• Improving labour market flexibility
• Immigration
• Privatisation and deregulation
• Trade union reform
• Infrastructure development
• R&D incentives
• Subsidies

Question 19

How is education and training a supply side policy?

Answer 19

The government could subsidise training or spend more on education. This makes quality of labour better, resulting in a more productive workforce, increasing potential output of an economy.

By improving access to training + education, it becomes more convenient for people to improve their skills which is likely to encourage them to do so.

Question 20

How does reforming tax and benefits help supply-side?

Answer 20

Reducing income and corporation tax, governments could encourage spending and investment.

Tax reforms could also encourage more people to work, and can also encourage entrepreneurship.

Question 21

How is improving labour market flexibility a supply side policy?

Answer 21

Reducing National Minimum Wage will allow free market forces to allocate wages and labour market should clear.

Governments could try and improve geographical mobility of labour by subsidising the relocation of workers and improving availability of job vacancy information.

Question 22

How can Immigration be a supply side policy?

Answer 22

Migration can fill skills gaps and reduce the unemployment rate, could result in higher productivity among labour force.

Question 23

How is privatisation and deregulation a supply side policy?

Answer 23

By deregulating or privatising the public sector, firms can compete in a competitive market, which should help improve economic efficiency.

Question 24

How is trade union reform a supply side policy?

Answer 24

Reducing trade union power make employing workers less restrictive and it increase mobility of labour, making the labour market more efficient.

Question 25

How is infrastructure development a supply side policy?

Answer 25

Governments could improve roads, which could make transport more efficient and since it will take less time and cost less to move between places. It might also contribute to geographical mobility of labour.

Question 26

How is R&D a supply side policy?

Answer 26

Can encourage more investment, which can benefit the economy in the long run by helping firms find more efficient methods of production and innovating.

Question 27

How are subsidies a supply side policy?

Answer 27

Could be directed towards small businesses to encourage them to expand, or to lower training costs for firms.

Question 28

What is the strenght of supply side policies?

Answer 28

The only policies which can deal with structural unemployment, because the labour market can be directly improved with education and training.

Question 29

What are the weaknesses of supply side policies? [3]

Answer 29

- Demand-side are better at dealing with cyclical unemployment since they can reduce the size of a negative output gap and shift the AD curve to the right - Significant time lags - Some policies, such as reducing tax rates, could lead to a more unequal distribution of wealth

Question 30

What is the value of exchange rate determined by in a floating system?

Answer 30

The forces of supply and demand.

Question 31

What is demand for a currency equal to?

Answer 31

Exports + Capital inflows

Question 32

What is supply of a currency equal to?

Answer 32

Imports + Capital outflows

Question 33

What is depreciation?

Answer 33

When the value of a currency falls relative to another currency, in a floating exchange rate system.

Question 34

What is appreciation?

Answer 34

When the value of a currency increases. Each pound will buy more dollars, for example.

Question 35

What are the causes of exchange rate changes? [9]

Answer 35

- Inflation - Interest rates - Speculation - Other currencies - Government finances - Balance of payments - International competitiveness - Government intervention - Quantitative easing

Question 36

How does inflation cause exchange rate changes?

Answer 36

Lower inflation rate means exports are relatively more competitive, increasing demand for the currency and causes the currency to appreciate.

Question 37

How do interest rates cause exchange rate changes?

Answer 37

Increase in interest rates, relative to other countries, makes it more attractive to invest funds in the country as the rate of return on investment is higher. This increased demand for the currency, causing an appreciation. Is known as hot money.

Question 38

How does speculation cause exchange rate changes?

Answer 38

If speculators think a currency will appreciate in the future, demand will increase in the present, since they believe a profit can be made by selling the currency in the future. This can cause an increase in the value of the currency.

Question 39

How do other currencies cause exchange rate changes?

Answer 39

If markets are concerned about major economies, such as the EU, the currency might rise. This happened with the Swiss Franc in 2010 when markets were worried about the EU economy.

Question 40

How do government finances cause exchange rate changes?

Answer 40

A government with a high level of debt is at risk of defaulting, which could cause the currency to depreciate. This is since investors start to lose confidence in the economy, so they sell their holdings of bonds.

Question 41

How does balance of payments cause exchange rate changes?

Answer 41

When the value of imports exceeds exports, there is a current account deficit. Countries which struggle to finance this, such as through attracting capital inflows, have currencies which depreciate as a result.

Question 42

How does international competitiveness cause exchange rate changes?

Answer 42

An increase in competitiveness increases demand for exports, which increases demand for the currency.

Question 43

How does government intervention cause exchange rate changes?

Answer 43

Governments might try and influence their currency, such as by maintaining a fixed exchange rate. For example, China has previously kept the Yuan undervalued by buying US dollar assets to make their exports seem relatively cheaper.

Question 44

What impact does a reduction in the exchange rate cause?

Answer 44

Exports become cheaper, which increases them. This assumes that demand for exports is price elastic. It also causes imports to become relatively expensive, and that the UK current account deficit would improve. However, this is inflationary due to the increase in the price of imported raw materials. Production costs for firms increase, which causes cost-push inflation.

Question 45

What does the Marshall-Lerner condition state?

Answer 45

That a devaluation in a currency only improves the balance of trade if the absolute sum of long run export and import demand elasticities is greater than or equal to 1.

Question 46

What is the J-curve effect?

Answer 46

Describes the initial worsening of a country's trade balance following a depreciation in the currency, followed by a subsequent improvement as the effects play out. Since devaluing the currency causes imports to become more expensive, at first the total value of imports increases and outweighs benefits of cheaper exports, worsening trade balance at first. Over time, lower prices of exports lead to increased demand from foreign buyers and higher prices of imports reduce domestic demand for them.

Question 47

What does SPICED mean?

Answer 47

Strong Pound Imports Cheap Exports Dear