Chapter 5: Government Macro Intervention

Question 1

objective of macroeconomic policies (4)

Answer 1

1. low inflation
2. stable exchange rate
3. full employment
4. economic growth
5. equal income distribution

Question 2

what is fiscal policy

Answer 2

a policy to change aggregate demand through government spending and tax

Question 3

what does government do in reflationary fiscal policy

Answer 3

1. raises spending
2. lower income tax → income ↑ → consumption ↑
3. lower business tax → profit ↑ → investment ↑

Question 4

effectiveness of reflationary fiscal policy (3)

Answer 4

1. if confidence level remains low, spending may not rise
2. does not solve low economic growth/unemployment caused by fall in aggregate supply
3. crowding out effect (resource and financial)

Question 5

what is crowding out effect (resource and financial)

Answer 5

1. resource crowding out - the government uses resources that would have been used by the private sector
2. financial crowding out - funds in banks are reduced because of government borrowing → banks increase interest rates → firms borrow less → less investment

Question 6

advantages (1) and disadvantages (2) of reflationary fiscal policy

Answer 6

good - able to target specific areas in need of government help

bad

1. implemented only once a year
2. policies may be for political reasons
3. higher inflation due to higher aggregate demand
4. balance of payments may worsen - firms import more & higher inflation makes export more expensive

Question 7

effectiveness of deflationary fiscal policy (3)

Answer 7

1. spending may not fall if consumers are still optimistic
2. the fall in income may cause workers to demand higher wages → firms production cost rise → cost push inflation
3. rise in income tax may not be enough to reduce spending

Question 8

limitation of deflationary fiscal policy (1)

Answer 8

short term measure to reduce inflation. it does not solve cost push inflation

Question 9

what is monetary policy

Answer 9

a policy to change aggregate demand through interest rates, money supply and exchange rate

Question 10

what does government do in deflationary monetary policy

Answer 10

1. raise interest rates → people save more money → consumption ↓, borrowing cost ↑ → C & I ↓
2. reduce money supply → banks are required to reserve more cash → banks have less funds to lend → interest rates ↑ → C & I ↓
3. revalue currency → make exports more expensive → less export demand → AD falls

Question 11

advantages (2) and disadvantages (2) of deflationary monetary policy

Answer 11

1. can be quickly implemented
2. no political reasons because central bank is independant

disadvantages

1. cannot target specific groups
2. lowers economic growth (firms reduce production as consumption falls)

Question 12

what is expenditure switching policy

Answer 12

policies to redirect spending to encourage consumers to buy more local goods and overseas buyers to buy more of the country’s exports

Question 13

effectiveness of expenditure switching policy in reducing current account deficit (3)

Answer 13

1. may not be effective if: the PED for exports and imports is inelastic
2. effectiveness of devaluation depends on
   - combined PED of exports and imports
   - quality of exports and domestic subsitutes
3. would not be effective if balance of payment deficit is caused by financial account deficit or income outflow from current account

Question 14

what is expenditure dampening policy and how is it done

Answer 14

policies that reduce spending for all goods

using fiscal and monetary policy

Question 15

ways to correct balance of payments surplus (2)

Answer 15

1. revalue currency
2. reflationary fiscal and monetary policy

Question 16

what is done in labour market reform (2)

Answer 16

1. reduction in unemployment benefits - unemployed will want to look for work
2. income tax reduction - workers will have more incentive to work
3. education opportunities - improve workers skills
4. raise minimum wage - increase incentive for the unemployed to look for work

Question 17

what is done in capital goods market reform (2)

Answer 17

1. subsidy - reduce cost of investment in capital goods
2. lower business tax - firms will have more money to invest
3. encourage banks to reduce interest rates

Question 18

advantages of supply side policy (3)

Answer 18

1. increase productivity
2. more employment
3. less inflation
4. improve balance of payments

Question 19

disadvantages of supply side policy (3)

Answer 19

1. long impact lag (long run only)
2. expensive to implement - cost of subsidy, training, infrastructure
3. reforms are likely to create unemployment
4. firms may not respond positively to incentives