LS12 - Demand Side Policies

Question 1

(Discretionary) fiscal policies definition

demand side policies

Answer 1

• changes to government spending and taxation in order to influence AD
• expansionary to boost AD and contractionary to reduce AD

Question 2

Reasons for expansionary fiscal policy

Answer 2

• boost economic growth
• reduce unemployment (cyclical) as labour is a derived demand
• increase demand pull inflation (may be necessary to reach inflation target)
• redistribute income

Question 3

Reasons for contractionary fiscal policy

Answer 3

• reduce inflation
• reduce budget deficit
• redistribute income
• reduce current account deficit

Question 4

Why is altering inflation only a reason for fiscal policy in theory?

Answer 4

Because it is the central banks job to control inflation, not the governments.

Question 5

Examples of expansionary fiscal policies

Answer 5

• reduction in income tax
• reduction in corporation tax
• incease in government spending

Question 6

Monetary policy

Answer 6

Changes to interest rates, the money supply and the exchange rate by the central bank in order to influence AD.

Question 7

Quantitative easing (QE)

Answer 7

• an unconventional monetary policy tool where a central bank buys assets, like government bonds, to increase the money supply and lower long-term interest rates, aiming to stimulate economic activity when traditional monetary policy measures are ineffective
• increased demand for bonds due to central banks purchase drives up bond prices, reducing yields (interest rates)
• used when interest rates are already near zero and lowering interest rates are no longer effective in stimulating economic growth

Question 8

What are automatic stabilisers?

Answer 8

• fiscal policy tools used to influence GDP and counter fluctuations in the economic cycle

Question 9

What do automatic stabilisers do in a boom?

Answer 9

• push in demand to make sure the economy does not overheat
• in a boom, incomes are higher so workers are pushed into higher tax bands
• progressive taxation means higher average rate of tax -> slows down increases in consumption -> slows down increases in AD
• in a boom, unemployment will be lower so gov spending on benefits decreases further helping to cushion demand
• all of above reduces risk of wild demand pull inflation

Question 10

What do automatic stabilisers to in a recession?

Answer 10

• they support demand/output and to prevent a deep recession
• econ growth negative so incomes falling - workers move into lower tax bands so a.r.t falls, preventing large drop in consumption and therefore AD
• unemployment will be higher so gov spending on benefits increases

Question 11

2 main automatic stabilisers

Answer 11

• progressive income tax system
• welfare benefits (mainly u benefits)

Question 12

Average rate of tax (a.r.t) definition

Answer 12

• amount of income tax paid as a proportion of total income

Question 13

How do automatic stabilisers reduce the need for discretionary fiscal policy?

Answer 13

• automatic stabilisers allow for actual growth to deviate less from the trend rate of growth
• so, gov do not have to change gov spending and taxation levels as much

Question 14

If the economy is in a budget surplus, what kind of policies are likely being used?

Answer 14

• contractionary fiscal policy (austerity policies)

Question 15

Benefits of budget surplus

Answer 15

• confidence in gov finances - allows them to issue lower bond yields as they are more reliable + attracts inwards FDI due to lower credit risk
• less spending on debt interest payments, freeing up gov spending

Question 16

Cons of budget surplus

4 points

Answer 16

• demand side shock by reducing AD so lower growth and higher unemployment (recessionary pressures)
• micro level individual impacts e.g. cuts in healthcare spending -> fall in living standards, or decline in education levels
• fall in spending in micro levels can mean fall in international competitiveness
• risk of income inequality due to e.g. cut in u-benefits

Question 17

Evaluation of budget surplus points (contractionary fiscal policy)

Answer 17

• is it necessary to run a surplus? - depends on how stable gov finances are
• if policies are used so strongly that they shock GDP due to D-side shocks, debt/GDP ratios may rise so gov finances may look worse
• stage of the economic cycle - could argue its good to use when economy booming to cool down

Question 18

Difference between a budget deficit and a current account deficit

Answer 18

• budget deficit - government spending > government revenue
• current account deficit - country’s total imports > total exports (of goods and services)