Monetary and fiscal policies Flashcards
(22 cards)
What happen on ADAS when AD contracts
- initially, when AD shifts left, price and output both fall
- over time, expected prices adjust so AS shifts to the right to return to the natural rate of output
- this causes price to fall again
Explain contractions in aggregate demand (shift to the left)
- caused by pessimism, overseas recessions and such
- leads to falls in price level and output
- in the long run, SRAS shifts right for output to revert to natural rate
Explain contractions in aggregate supply (shift to the left)
- caused by increases in production costs, increase in expected prices and such
- leads to output falling but prices increasing
- in the long run SRAS shifts right to return to natural rate
What happens with expansions instead of contractions
Opposite outcomes of contractions
Give an example of AD driven contraction
- the great depression
- real GDP fell 27%
- unemployment rose 22%
- prices fell 22%
Give an example of AD driven expansion
- early 1940s, boom caused by wartime expenditure
- unemployment dropped 16%
- prices rose 20%
Give an example of AS driven contraction
1970s oil crisis
Give an example of AS driven expansion
More difficult to recognise but new technologies driving expansion in 1990s
Accommodating for an adverse shift in AS
- a leftward shift in SRAS will cause output to return to natural rate and prices to drop back down over time
- to immediately counter the drop in output (and subsequent increase in unemployment), at the cost of inflation, policy makers can shift AD curve to the right
How can policymakers shift the AD curve
- monetary policy: changes in the money supply or interest rates
- fiscal policy: changes in government spending
Explain expansive monetary policy
- an increase in money supply leads to the interest rate falling (as per the quantity of money supply/ interest rate graph)
- the lower interest rates increases demand as borrowing becomes cheaper and savings become less attractive
- companies will also invest more
Reminder of monetary policy tools
- repo rates
- OMOs
Define fiscal policy
Changes in government spending or taxations
What does the effect of fiscal policy depend upon
- multiplier effect (amplifies the effect on AD of an increase in expenditure)
- crowding out effect
(diminishes the effect on AD of an increase in expenditure)
Explain the multiplier effect
Lets say the government purchases £20bn, consumers respond by increasing consumption (spending multiplier) and firms increase investment (investment accelerator) leading to further shifts in AD
What does the size of the spending multiplier depend on?
- the marginal propensity to consumer (MPC)
- this is the fraction of extra income that consumers spend on consumption
Explain the crowding-out effect
- when aggregate demand curve shifts right, this leads to an increase in income which increases interest rates
- thus shifting AD back to the left, partially offsetting the original shift
Define active stabilisation policy
Authorities using fiscal and monetary policy to attempt to stabilise the economy in the face of shocks
How do Keynesians view stabilisation policy
- stress the role of AD in explaining short term fluctuations
- maintain that the government should actively stimulate AD
Reasons against stabilisation policy
- AD is difficult to control with long and variable lags
- corruption
- it is based on unreliable economic forecasts
- hence ‘better’ to leave the market alone and let it adjust
What policies aimed to restore the economy after the recession
- central banks in UK, EU and US cut repo rates to near 0
- started buying bonds via OMOs to give banks more funding
- congress appropriated $700bn to increase government spending to inject into banks, stem the Wall Street crash and make loans easier to obtain
Did the policies reacting to recession work
Arguably yes but we will never know what would’ve happened
