Theme 2 Topic 6

Question 1

What are the 4 key objectives used to measure national economic performance and form the basis of the government’s macro economic policy objectives ?

Answer 1

1. Economic growth
2. Low unemployment
3. Low and stable inflation
4. Balance of payments

Question 2

economic growth (objective)

Answer 2

measures rate of change of a country’s output.
key measure is GDP.
in the UK, the long run trend of economic growth is 2.5%.
governments aim to have sustainable economic growth in the long run.
in developing countries, the governments may aim to increase economic development before economic growth.
this would improve living standards, increase life expectancy and improve literacy rates.

Question 3

low unemployment (objective)

Answer 3

high unemployment means poor economic performance.
economies that have strong economic growth have low unemployment.
govern,ents aim to have as near as full employment as possible.
they account for frictional unemployment by aiming for an unemployment rate of around 3%.
the labour force should be employed in productive work.

Question 4

low + stable inflation (objective)

Answer 4

The inflation target has been made independent of the UK government to give a key component of macroeconomic policy more credibility.
Government target is 2% for the UK (measured by CPI).
it aims to provide price stability for firms and consumers and will help them make decisions for the long run.
if the inflation rate falls 1% (+ or -) outside the target, the governor of the BoE has to write a letter to the chancellor of exchequer to explain why this has happened and what the Bank intends to do about it.

Question 5

balance of payments (objective)

Answer 5

Given that deficits have to be funded (often by borrowing) it is assumed that a surplus or equilibrium on the current account is the desired objective.
It’s is important to allow the country to sustainably finance the current account, which is important for long term growth.
The UK economy is heavily skewed towards the tertiary sector, which is a key driver of jobs and income.
It’s viewed by many economists that a deficit overall may not be detrimental to the wider economy.
Consumers have a wider choice of goods (higher quality + lower prices), increasing standards of living and welfare.
Producers can benefit from cheaper + higher quality raw materials which reduce costs.

Question 6

How can the government achieve their objectives ?

Answer 6

Governments are able to manage demand through monetary + fiscal policy.
Recession = increase AD to increase employment + economic growth.
Boom = decrease AD to decrease inflation.
They may also use supply side policies to cause long term growth.

Question 7

Emphasis on each individual government objective changes over time so the current government will focus on :

Answer 7

1. A balanced government budget
2. Protection of the environment
3. Greater income equality

Question 8

Balanced government budget (objective)

Answer 8

Government revenue = government expenditure
No budget surplus (revenue > expenditure)
No budget deficit (revenue < expenditure)
Ensures the government keeps control of state borrowing, so the national debt doesn’t escalate.
Allows governments to borrow cheaply in the future should they need to and make repayments easier.

Question 9

Protection of the environment (objective)

Answer 9

Aims to provide long run environmental sustainability.
Ensures resources used aren’t exploited (e.g. oil and natural gas), and that they are used sustainably so future generations can access them too.
Avoids excessive pollution.
May involve supporting businesses through the form of investment grants.

Question 10

Greater income equality (objective)

Answer 10

Minimises the gap between rich + poor.
Associated with a fairer society.
Extreme income inequality is seen as socially unacceptable.
Society believes all citizens should be able to access fair wages for a fair day’s work.
Many studies suggest that increasing income equality causes higher levels of economic growth + better standards of living and a happier overall society.

Question 11

What are demand side policies ?

Answer 11

Demand side policies are policies designed to manipulate consumer demand.
Expansionary policy is aimed at increasing AD to bring about growth.
Deflationary policy attempts to decrease AD to control inflation.

Question 12

What is the monetary policy ?

Answer 12

Managed by the Bank of England. Controls inflation and AD using interest rates and QE.
Used to influence the level of economic activity.

Question 13

What is the fiscal policy ?

Answer 13

Managed by the government. Changes tax and spending to influence AD.

Question 14

2 types of monetary policy instruments :

Answer 14

1. Interest rates
2. Quantitative easing

Question 15

A rise in interest rates causes a fall in AD through 4 mechanisms

Answer 15

1. Fall in investment + consumption
2. Negative wealth effect
3. Decreased consumer + business confidence
4. Impacts on exchange rates + net trade

Question 16

Negative wealth effect

Answer 16

Higher interest rates reduce the value of assets (stocks, shares, government bonds) due to lower demand.
Consumers experience a negative wealth effect, leading to a fall in consumption.
Firms’ investment becomes less attractive as falling asset prices reduce expected profits.

Question 17

Decreased consumer and business confidence

Answer 17

Higher interest rates lower confidence in borrowing and spending.
Fall in consumer and business confidence leads to reduced consumption and investment, further decreasing AD.

Question 18

Impact on exchange rates and net trade

Answer 18

Higher interest rates attract foreign capital due to higher returns.
Increased demand for pounds causes the currency to appreciate.
Stronger pound makes imports cheaper and exports more expensive, reducing net trade and AD.

Question 19

positive effects of QE on the economy

Answer 19

1. Positive wealth effect
2. Increased money supply
3. Lower commercial bank interest rates

Question 20

Positive wealth effect (QE advantage)

Answer 20

Bank buys assets, increasing demand and causing asset prices (e.g., shares, houses) to rise.
Wealth effect: As asset values rise, people feel wealthier and increase consumption.
Lower Borrowing Costs: Higher asset prices reduce yields (returns on assets), making borrowing cheaper for households and businesses.

Question 21

Increased money supply (QE advantage)

Answer 21

More money enters the economy as private sector companies receive funds, which they can spend on goods, services, or financial assets.
This can increase consumption and investment, boosting aggregate demand (AD).
Higher reserves in banks enable more lending, increasing both consumption and investment through credit.

Question 22

Lower commercial bank interest rates (QE advantage)

Answer 22

Banks receive more money from the Bank of England, allowing them to offer lower interest rates to customers.
Lower interest rates reduce the cost of borrowing, encouraging more borrowing, investment, and consumption, thus increasing AD.
If many banks lower their interest rates, similar effects are seen as when the base rate is reduced.

Question 23

Problems with QE :

Answer 23

1. It is very risky and, if not controlled properly, could cause high inflation and even hyperinflation.
2. There is no guarantee that higher asset prices lead into higher consumption through the wealth effect, especially if confidence remains low.
3. It was not meant to be permanent and there are concerns that banks and economies are too dependent on QE, particularly within the Eurozone.

Question 24

How effective is the monetary policy ?

Answer 24

1. Size of Interest Rate Changes: The impact of monetary policy depends on how large the interest rate changes are.
2. Timing of Rate Changes: The effectiveness depends on when the changes are made in relation to the economic cycle.
3. Stage of the Economic Cycle: The effectiveness varies depending on whether the economy is in a boom, recession, or stagnation.
4. Inflation Control: The primary target of monetary policy is inflation control, but it may conflict with other objectives like economic growth.

Question 25

Link between interest rates and exchange rates

Answer 25

Global investors seek the best return, so they move money to countries with higher interest rates. If the UK raises interest rates, investors will move their money to the UK, increasing demand for UK pounds. This increases the exchange rate, making UK exports more expensive and imports cheaper. As a result, the balance of payments on the current account worsens. This is called Hot Money, as funds move globally in search of the best interest rates.

Question 26

Difference between budget deficit and surplus ?

Answer 26

- **Budget Deficit**: - Occurs when the government **spends more** than it **receives** (through taxes and other revenues). - Leads to **increased government debt** that must be repaid in future years. - **Budget Surplus**: - Occurs when the government **receives more** than it spends. - Allows the government to **reduce its debt burden** and **lower interest payments**.

Question 27

What is the difference between direct and indirect taxes?

Answer 27

Direct Taxes: Paid directly to the government by the individual taxpayer. Examples: Income tax, National insurance, Corporation tax. Indirect Taxes: The person charged with the tax (e.g., supplier) can pass on the cost to someone else (e.g., consumer). Examples: VAT, Excise duties, Council tax, Capital gains tax, Inheritance taxes, Stamp duty land tax.

Question 28

What are the key issues when evaluating demand side policies

Answer 28

Classical vs Keynesian Debate: Classical economists argue that demand management policies (fiscal and monetary) will not affect long-run output, only prices. They believe the economy naturally returns to equilibrium. Keynesians disagree, arguing that the economy can remain in disequilibrium for a long time, and demand-side policies can help boost output and reduce unemployment in the short-to-medium term. Impact Depends on Economic Conditions: Keynesians: At full employment, a rise in AD will increase prices (inflation) rather than output. In times of high unemployment, boosting AD can lead to higher output without causing inflation, especially if there is spare capacity in the economy.

Question 29

Monetary vs fiscal

Answer 29

Monetary policy is useful as the government is able to increase demand without having to increase their spending, which would result in a larger fiscal deficit. Classicists argue that if demand management is going to be done only monetary policy should be used. Fiscal policy can have significant impacts on the supply side of the economy, for example increases in spending on education to increase AD will also increase LAS. Moreover, it is more effective at targeting specific groups and reduce poverty, for example by increasing benefits it can increase AD and reduce inequality.

Question 30

What is stagflation ?

Answer 30

when an economy experiences both high inflation and high unemployment at the same time.

Question 31

What are the monetary policy goals ?

Answer 31

1. Primary target : low inflation rate (2%) (+1/-1) 2. Managed by the BoE and controls inflation and AD.

Question 32

Monetary policy committee

Answer 32

Responsibility of the MPC is to set interest rates. 9 members 4 independent 5 from within the bank. Chaired by the Governor of the BoE = Andrew Bailey Meets monthly to assess the state of the economy + decide whether they should increase or decrease interest rates from their existing level. Independent from the government, giving it more credibility (free from political influence).

Question 33

Interest rates :

Answer 33

Cost of borrowing and reward of saving (price of money). High rates : decrease borrowing and increase spending, lowering AD

Question 34

Quantitative easing

Answer 34

2008 recession: BoE would have expected to cut interest rates to help stimulate economic activity. However, rates were already at 0.5% so couldn’t decrease further. Banks were nervous to lend money so £375 bn was raised in QE to boost funds to lend.

Question 35

QE process

Answer 35

1. Central bank creates digital money (not printed) 2. It goes to banks + buys off bonds, the banks get money. 3. Increases the bank’s money supply 4. Banks lend more, so interest rates fall 5. Cheaper loans means more spending 6. Binds mature and are replayed over time

Question 36

Expansionary fiscal policy

Answer 36

Trying to increase economic activity + AD. 1. Cutting taxes (withdrawal in CFI): decrease income tax, increases disposable income, increases consumption. decrease corporation tax, increases available profits for firms, increases investment. 2. raises government spending: government increase spending on core infrastructure projects or increase the pay of public sector workers (injection). more jobs for infrastructure workers and higher pay for public workers. increases consumer incomes and feeds through the CFI.

Question 37

contractionary fiscal policy

Answer 37

trying to decrease AD, debt, and control inflation. 1. increasing taxes : increases income tax, discourages spending and consumption. decreases the level of AD + keeps inflation under control. 2. cutting government spending : the government can decrease expenditure on public projects or cut government budgets if it considers excess government spending to be inflationary. benefits BoP as less income spent on imports. however, this reduces RNO so damages economic growth. falling consumption and less AD means increases cyclical unemployment.

Question 38

national debt

Answer 38

total amount of money owed by the government

Question 39

limitations of fiscal policy

Answer 39

takes a long time before it affects output or employment. has some built in trade offs - expansionary : higher output and lower unemployment. causes higher inflation and worsens BoP. - contractionary : controls inflation causes higher unemployment and damages GDP

Question 40

Great Depression (1930s)

Answer 40

demand collapsed, unemployment soared. US initially used laissez faire, later used large public works (New Deal). Keynes argued government spending should rise in recessions. Key Causes: Stock market crash, banking failures, collapse in international trade, and deflation. Interpretations: Some argue that lack of government intervention worsened the depression. Others believe market forces would have led to recovery without intervention.

Question 41

Global financial crisis (2008)

Answer 41

1. Borrowing was cheap, bank gave loans to people who couldn't afford them. 2. Since everyone was borrowing, demand for houses increased, and prices kept rising. Banks gave loans to people who couldn't afford them. 3. People couldn't pay back the loans they had borrowed, especially risky borrowers, causing prices to fall back down and banks lost a lot of money and began failing. House prices went up a lot 4. Caused the economy to crash, where businesses, jobs, and spending all dropped.

Question 42

demand side policies advantages (4)

Answer 42

lowers unemployment fast. stimulates growth in a recession fiscal good for targeting monetary policy flexible

Question 43

demand side policies disadvantages (4)

Answer 43

causes inflation if used too much time lags (takes time to see full effects) increases budget deficit QE causes asset bubbles or weakens the currency

Question 44

multiplier effect

Answer 44

creates a virtuous cycle of spending and income causes a greater overall impact on the economy it can increase LRAS tax cuts may incentivise work + increase the labour force investment increases quantity and quality of capital government spending on education and infrastructure improves productivity

Question 45

drawbacks of expansionary monetary policy (1)

Answer 45

1. potential risk of lowering interest rates. demand pull inflation widens current account deficit interest rates have a lower bound (liquidity traps) negatively impacts savers.

Question 46

drawbacks of expansionary monetary policy (2)

Answer 46

2. effects on savers and borrowing lower returns on savings accounts returns can become negative if inflation exceeds interest rates. incentivises borrowing over saving reduces financial safety nets for households

Question 47

drawbacks of expansionary monetary policy (3)

Answer 47

3. time lags and effectiveness full effects take 18-24 months in the UK effectiveness depends on size of output gap consumer + business confidence is crucial banks must be willing to lend

Question 48

supply side policies

Answer 48

policies that seek to improve the long run productive potential of the economy. successful policy shifts a country’s PPF to the right

Question 49

what are free market policies

Answer 49

allows the free market to operate, with the government reducing its role in the market. encourages the private sector to be more efficient.

Question 50

what are interventionist policies

Answer 50

involved government intervention to tackle market failure

Question 51

types of free market policies

Answer 51

1. reduces income tax (creates incentives for people to work harder, leading to more output). however, lower taxes don’t always increase work incentives. 2. reduces power of trade unions (increases efficiency of firms due to less time lost in strikes, and reduces unemployment if labour markets are competitive) 3. promotes competition deregulation (opening markets to freer competition and removing barriers to entry should help to increase productivity gains and boost supply) privatisation (minimise state control can be inefficient, yet it has been pursued by governments to privatise key areas of the economy to drive efficiency)

Question 52

types of interventionist policies

Answer 52

1. improves skills and quality of labour force (training and education, improves productivity, mobility, and flexibility of the workforce) 2. improves infrastructure transport network (improves speed of connections e.g. rail, road) provision of information (ensures access to fast information e.g. broadband)

Question 53

supply side policies disadvantages (3)

Answer 53

1. expensive + time lags (in terms of effectiveness) (training and education take several years for the full effects to be felt) 2. may not help in a deep recession (AD is needed) 3. effects are uncertain and uneven

Question 54

supply side policies advantages (4)

Answer 54

1. lower inflation (makes economy more efficient, policies reduce cost push inflation) 2. reduces unemployment (reduces structural unemployment + helps reduce the natural rate of unemployment) 3. improved economic growth (increase the sustainable rate of economic growth by increasing AS) 4. improves BoP and trade (makes firms more productive + competitive so exports rise)

Question 55

Conflicts between objectives

Answer 55

Growth vs Inflation: fast growth can cause inflation. Low unemployment vs Inflation: Phillips curve shows a trade-off. Environmental protection vs Growth: stricter rules may reduce output. Equality vs Efficiency: redistributing income may reduce work incentives. + fall in interest rates negatively impacts savers. they are more wealthy so there is some redistribution of income. however, lower rates cause inflation (higher spending)

Question 56

Short run Phillips curve

Answer 56

Shows inverse relationship between inflation and unemployment. As AD increases, inflation rises but unemployment falls In the long-run, curve is vertical (no trade-off). When unemployment is low, inflation tends to be high because workers demand higher wages, which pushes up prices. When unemployment is high, inflation tends to be low as wage pressures are weaker. This reflects demand-side relationships. BUT - in the 1970s, this broke down (e.g., stagflation: high unemployment + high inflation). Shows a potential conflict between objectives: reducing unemployment might cause inflation to rise

Question 57

expansionary vs deflationary (trade off)

Answer 57

Expansionary Policies: Increase AD, boosting growth and employment but causing inflation and worsening the balance of payments due to more imports. Deflationarv Policies: Reduce AD to control inflation but lower growth and increase unemplovment. Trade-Off: Expansionary policies stimulate growth but risk inflation; deflationary policies control inflation but harm short-term arowth.

Question 58

supply side policies (trade off)

Answer 58

Goal: Increase long-term growth and reduce inflation. Trade-Offs: May raise AD in the short term, causing inflation. Policies like cutting benefits may increase income inequality. Trade-Off: Boosts growth long-term but mav harm low-income groups in the short term.

Question 59

interest rates (trade off)

Answer 59

Raising Interest Rates: Controls inflation but discourages investment, reduces exports (stronger currency), and increases income inequality (benefits savers, harms borrowers). Trade-Off: Higher rates control inflation but slow growth and worsen inequality.

Question 60

fiscal deficit (trade off)

Answer 60

Reducing Deficits: Involves cutting spending and raising taxes, which reduces AD, slows growth, and increases unemplovment. •Trade-Off: Deficit reduction hurts short-term growth, especially for low-income people who rely on government services. Trade-Off: Necessary for long-term stability but harms short-term growth and equality.

Question 61

US policy response to Great Depression

Answer 61

New Deal (1933): Massive public works, Social Security (financial support), banking reforms. Monetary policy: Lowered interest rates, however full recovery came when US entered WW2 and began production + boost in job creation.

Question 62

UK policy responses to great depression

Answer 62

The UK helped its economy recover by printing more money, building things to create jobs, and protecting its own. businesses from imports.

Question 63

UK + US policy responses to global financial crisis

Answer 63

United States: Bank rescues, quantitative easing, lowered interest rates - all to boost demand. United Kingdom: Low interest rates, quantitative easing to stimulate growth + boost demand.

Question 64

Difference between Global Financial crisis and Great depression

Answer 64

Both crises involved heavy government intervention and monetary policy to stimulate demand. The Great Depression had long-term institutional reforms, while the 2008 crisis focused on financial stabilization and liquidity support.