2.6.2 Demand-side policies

What is the distinction between monetary and fiscal policy?

Monetary policy controls the money flow using interest rates and QE, conducted by the independent Bank of England. Fiscal policy uses government spending and taxation to influence AD, conducted by the government.

What are the objectives of monetary policy?

To control inflation, maintain employment, and achieve economic growth by influencing money and credit availability.

What are the main instruments of monetary policy?

Interest rates, asset purchases (quantitative easing), and currency market intervention.

How do interest rates affect the economy?

Lower rates encourage borrowing/spending, raising AD; higher rates discourage borrowing/spending, lowering AD and controlling inflation.

What is an example of interest rate policy?

U.S. Federal Reserve (2008-2015) reduced the federal funds rate to near zero during the Global Financial Crisis.

What is quantitative easing (QE)?

A non-traditional monetary tool where central banks buy financial assets to inject liquidity into the economy.

What is an example of QE?

Bank of England (2009-2012) bought £375 billion of assets to support the UK economy during the financial crisis.

How does QE influence the economy?

By increasing bank reserves, lowering interest rates on bonds, and encouraging investment and spending.

What is currency market intervention?

Central bank buys/sells domestic currency to influence its value and stabilize the exchange rate.

Example of currency intervention?

Swiss National Bank (2011-2015) capped Swiss franc against the euro to protect exports.

Who sets UK interest rates and how?

The Monetary Policy Committee (MPC), a 9-member independent group, meets monthly to set the base rate.

Transmission mechanisms of interest rate cuts?

Cheaper borrowing, increased consumption, rising asset prices (wealth effect), lower saving returns, weaker pound boosts net trade

When is QE used?

When standard monetary policy (e.g., interest rate cuts) is ineffective, usually during low inflation and when rates are already low.

What is a possible risk of QE?

Higher inflation due to increased money supply.

How can the Bank of England reduce inflation caused by QE?

By selling assets to reduce money supply and lower spending.

Limitations of monetary policy?

Banks may not pass rate cuts on; banks may be unwilling to lend; low confidence may reduce spending regardless of low rates.

What are the instruments of fiscal policy

Government spending and taxation.

How can fiscal policy influence the economy?

By altering government budgets and targeting spending/tax changes to stimulate specific sectors.

What does the UK government spend most on?

Pensions and welfare, followed by health and education.

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

Income tax.

What is expansionary fiscal policy?

Increases AD by raising spending or cutting taxes; worsens budget deficit and may increase borrowing.

What is deflationary fiscal policy?

Reduces AD by cutting spending or raising taxes; improves budget deficit.

What is a budget deficit?

When government spending exceeds tax revenue.

What is a budget surplus?

When tax receipts exceed government spending.

What are direct taxes?

Taxes on income paid directly by individuals or firms, e.g., income tax, corporation tax, NICs.

What are indirect taxes?

Taxes on goods/services that increase production costs and market prices, reducing demand.

Limitations of fiscal policy?

Imperfect info, time lags, crowding out, multiplier uncertainty, high interest rates, debt repayment issues.

What caused the Great Depression?

1929 crash, loss of confidence, unsustainable 1920s boom, unstable banks, protectionism, UK overvalued currency.

How did Keynesian economics shift thinking during the Great Depression?

Emphasized AD over AS and advocated demand-side policies to close output gaps.

What were USA's responses to the Great Depression?

Roosevelt's New Deal: public investment, work schemes, fiscal stimulus; mixed success, war ended depression.

What caused the Global Financial Crisis?

Asset bubbles, risky loans, subprime mortgage defaults, bank losses, required bailouts

Policy responses to the Global Financial Crisis?

Nationalized banks, guaranteed savings, QE, low interest rates, UK cut VAT, USA used more fiscal policy.

Why did the USA recover faster from the 2008 crisis?

Used more expansionary fiscal policy earlier than the UK, which focused on reducing National Debt sooner.

What microeconomic impacts can macro policies have?

Higher post-tax profits increase firm investment and efficiency.

What is the primary aim of monetary policy?

To control inflation, maintain employment, and support economic growth through tools like interest rates and quantitative easing.

What does raising interest rates do?

Discourages borrowing and spending, helping to control inflation.

What does lowering interest rates do?

Encourages borrowing and spending, stimulating economic growth.

xWhat is quantitative easing (QE)?

When a central bank buys financial assets to inject liquidity into the economy and lower long-term interest rates.

What is the goal of QE?

To increase the money supply, encourage investment, and boost economic activity.

How does buying domestic currency affect its value?

It reduces the money supply and increases the currency’s value.

Why might a central bank sell its own currency?

To increase the money supply and lower the currency’s value, boosting exports.

What is the main goal of the UK’s MPC?

To maintain price stability by targeting a 2% inflation rate.

How often does the MPC meet, and how are decisions made?

Eight times a year; decisions are made by majority vote.

What are the main tools used by the MPC?

Bank Rate, Quantitative Easing (QE), and Forward Guidance.

What is a budget deficit?

When government spending exceeds tax revenue in a given fiscal year.

What is a budget surplus?

When government tax revenue exceeds spending in a fiscal year

How can a deficit stimulate economic growth?

By increasing public spending during a recession to boost demand.

How can a surplus affect economic growth?

It can slow growth if achieved through spending cuts or tax increases.

What are demand-side policies?

Government spending and tax policies aimed at influencing aggregate demand.

What was the purpose of the U.S. New Deal (1933–1939)?

To restore economic stability during the Great Depression through public works and social programs.

How did the UK respond to the Great Depression?

Initially with austerity, later shifting to public works after leaving the gold standard.

What was the U.S. response to the 2008 Global Financial Crisis?

A stimulus package (ARRA) including tax cuts and infrastructure spending.

What was the UK’s response to the 2008 crisis?

Bank bailouts and fiscal stimulus, including VAT cuts and infrastructure spending.

What is the Keynesian view on monetary and fiscal policy?

Supports active policy use to stimulate demand during recessions

What is the Monetarist view on economic policy?

Focuses on controlling the money supply to manage inflation.

What is the Austrian school’s stance on intervention?

Opposes intervention, favoring minimal government and sound money principles.

What is the Classical perspective on fiscal policy?

Advocates for balanced budgets and limited government intervention.

What is a counter-cyclical fiscal policy?

A policy that boosts demand during downturns and restrains it during booms.

What is aggregate demand?

The total demand for goods and services in an economy at a given time

What are austerity measures?

Government policies aimed at reducing deficits via spending cuts or tax hikes.

What is a stimulus package?

Government measures, such as spending and tax cuts, to boost economic activity.

What are demand-side policies?

Policies designed to manipulate consumer demand to influence economic activity.

What is the difference between expansionary and deflationary demand-side policies?

Expansionary policy increases Aggregate Demand (AD) to stimulate growth, while deflationary policy decreases AD to control inflation.

What are the two main types of demand-side policies?

Monetary policy and fiscal policy.

What is monetary policy?

Central bank actions to control AD by changing base interest rates or money supply.

How does an increase in interest rates affect AD?

It reduces AD by increasing borrowing costs, decreasing consumption and investment, lowering asset prices (negative wealth effect), reducing confidence, raising mortgage repayments, and appreciating the currency, which lowers net exports.

What is the “repo rate”?

The rate at which the Bank of England lends to other banks; changes here influence market interest rates.

What are some limitations of using interest rates to manage demand?

• Exchange rate effects may cause trade deficits.

• Time lag of up to 2 years for full effect.

• Interest rates may already be too low to reduce further (“liquidity trap”).

• Different interest rates exist, not all controlled by Bank of England.

• Lack of confidence can reduce borrowing despite low rates.

• Prolonged high rates can harm long-run aggregate supply (LRAS).

What is quantitative easing (QE)?

The central bank buying assets to increase money supply and encourage lending and spending when interest rates are very low.

How does QE stimulate AD?

By raising asset prices (positive wealth effect), increasing money supply, boosting bank reserves to increase lending, and lowering interest rates.

What are risks and problems associated with QE?

• Risk of high inflation or hyperinflation.

• Increased demand for second-hand goods without increasing new production.

• Unequal benefits, increasing wealth inequality.

• Dependency risk on QE, especially in Eurozone.

Who controls monetary policy in the UK?

The Bank of England’s Monetary Policy Committee (MPC)

What is the inflation target of the Bank of England?

2% Consumer Price Index (CPI), with a tolerance band of 1-3%.

What are fiscal policies?

Government use of borrowing, spending, and taxation to influence AD.

How do increases in taxes affect AD?

Higher income or corporation tax reduces disposable income or profits, lowering consumption and investment, thus decreasing AD.

How does government spending affect AD?

Increasing government spending raises AD since it is a component of AD.

Define budget deficit and budget surplus.

• Deficit: Government spends more than it receives.

• Surplus: Government receives more than it spends.

What is the difference between direct and indirect taxes?

• Direct taxes: Paid directly by individuals (e.g., income tax).

• Indirect taxes: Passed on to consumers by suppliers (e.g., VAT).

What are some evaluation points for fiscal policy?

• Can impact LRAS if it affects education, R&D, etc.

• May increase inequality or reduce incentives.

• Political constraints can limit tax increases.

• Effectiveness depends on the multiplier.

• Austerity limits expansionary fiscal policy.

What are some overall evaluation points of demand-side policies?

• Classical economists argue demand management only affects prices in the long run, not output.

• Keynesians believe demand management can impact output, especially when there is unemployment.

• Time lags are significant.

• Expansionary policies often cause inflation; deflationary policies increase unemployment.

• Monetary policy is less fiscally burdensome but fiscal policy can target specific groups and also affect supply-side.

Compare monetary policy and fiscal policy.

• Monetary policy can adjust demand without increasing government borrowing.

• Fiscal policy can also influence supply-side factors and reduce inequality.

• A combination is often needed alongside supply-side policies for overall economic goals.

What caused the Great Depression?

Multiple factors including loss of confidence, US banking failures, protectionism (Smoot-Hawley Tariff), and the UK’s overvalued currency due to the gold standard.

How did the UK respond to the Great Depression?

Emergency budget cuts, high interest rates, defending gold standard until forced to leave it, leading to devaluation and eventual recovery.

What was the US response to the Great Depression?

Initially balanced budget focus, later Roosevelt’s New Deal with fiscal stimulus and public works.

What caused the 2008 Global Financial Crisis?

Poor mortgage lending practices, moral hazard, sub-prime mortgage failures, and loss of confidence causing banking system stress.

How did the UK and US respond to the Global Financial Crisis?

Nationalisation of banks, guaranteeing savers, expansionary monetary policies with low interest rates and QE, US used more expansionary fiscal policy than UK.