Demand side policies 2.6.2

What are the three broad categories of macroeconomic policy?

• Fiscal policy

• Monetary policy

• Supply side policy

What is fiscal policy?

Policies that involve government spending, taxation, and/or borrowing related to interest rates

What are monetary policy?

Policies relating to interest rates, the money supply, and/or the exchange rate

What are supply side policy?

Policies that increase the productive potential of an economy

What is fiscal policy used for?

Used to change the pattern of spending on goods and services in an attempt to correct market failures and affect aggregate demand.

What are justifications for government spending?

• To provide a socially efficient level of public goods and merit goods and overcome market failure

• To provide a safety-net system of welfare benefits to supplement the incomes of the poorest in society

• To provide necessary infrastructure via capital spending

• Government spending can be used to manage the level and growth of AD to meet macroeconomic policy objectives

• Government spending can be justified as a way of promoting equity

• Well-targeted and high value for money public spending is also a catalyst for improving economic efficiency and competitiveness

What are examples of welfare state transfers?

• Universal child benefits/ unemployment benefits

• Public (state) pensions

• Conditional welfare transfers

• Targeted welfare payments- linked to income

What are examples of state-provided services (in-kind-benefits)?

• Education

• Health care

• Social housing

• Employment training

What are examples of indirect taxes?

• Duties on fuel, alcohol, tobacco

• VAT

What are examples of direct taxes?

• Inheritance tax

• NIC

• Capital gains tax

• Income tax

• Corporation tax

What does a tax being cyclical mean?

They rise when the economy is doing well, but they fall in a slowdown or a recession.

What fiscal policies affect SRAS?

• Changes in VAT

• Changes in environmental taxes

• Changes in import tariffs

• Changes in government subsidies

What fiscal policies affect LRAS?

• Changes in marginal and average income tax rates

• State funding of research and development

• Higher government spending on education and training

• Changes in corporation tax and import tariffs- effecting foreign direct investment

• Government spending on new infrastructure

What are the three main types of government spending?

• Transfer payments

• Recurring spending

• Investment projects

What are transfer payments?

Welfare spending- also know as social transfers

What are recurring spending?

Public services- public and merit goods

What are investment projects?

State investment- capital investment projects

What is covered by current government spending?

Providing public services

What are examples of current government spending?

• Salaries of NHS employees

• Drugs used in public health care

• Road maintenance budget

• Army logistics supplies

What is covered by capital spending?

New public infrastructure

What are examples of capital spending?

• Construction of new motorways and bridges

• New equipment used in NHS

• Flood defence schemes

• Defence equipment

Why is government spending significant in the UK?

• Is a key component of aggregate demand

• Helps to stabilise demand in a recession

• Has a regional economical impact

• Important in providing public and merit goods

• Driver of long run growth

• Can help achieve greater equity in society

When is there a budget (fiscal) surplus?

If total government spending is less than total tax revenue.

When is there a budget (fiscal) deficit?

If total government revenues are less than government spending

What is public sector borrowing?

The amount the government must borrow each year to finance their spending

What are some causes of budget (fiscal) deficit?

• Recession causing rising unemployment and therefore less taxes paid

• Decrease in consumer spending and profits leading to less tax revenue

• Increase in inactivity leading to a rise in welfare benefit spending

• Use of fiscal stimulus by a government to lift aggregate demand

• Increase in interest rates on debt leading to a rise in debt service costs

• Demographic factors causing state pensions to rise

What are discretionary fiscal changes?

Deliberate changes in direct and indirect taxation and government spending

What are automatic stabilisers?

Changes in tax revenues and government spending that come about automatically as an economy

What are the different types of automatic stabilisers?

• Tax revenues- When the economy is expanding rapidly, tax revenue increases which takes money out of the circular flow

• Welfare spending- A growing economy means that a government does not have to spend as much on welfare benefits

• Budget balance and the circular flow- Conversely during a slowdown or a recession, the government normally ends up running a larger budget deficit

What is austerity?

When the government uses contractionary fiscal policy to decrease their budget deficit

What are policies to reduce the size of fiscal deficit?

• Cuts in spending

  • Controlling public sector pay

  • Limit welfare entitlement and privatisation

• Higher taxes

  • Higher indirect taxes (VAT to 20%)

  • Cut tax allowances and new taxes

• Supply side policies to encourage growth

  • Stronger growth increases tax revenues

  • Growth cuts a deficit as a % of GDP

What is monetary policy?

Involves changes in interest rates, the supply of money and credit and exchange rates by the central bank to influence the macro-economy and achieve target outcomes.

What factors are considered when setting a bank rate?

• Rate of growth of real GDP and the estimated size of the output gap

• Forecasts for price inflation

• Rate of growth of wages and other business costs

• Movements in a countries exchange rate

• Rate of growth of asset prices

• Movements in consumer and business confidence

• External factors such as global energy prices

• Financial market conditions including rate of growth of money

What three things can be used by the monetary policy committee to influence monetary policy?

• Interest rate

• Supply of money

• Exchange rate

In the UK what determines the exchange rate?

Determined entirely by demand and supply in international foreign exchange markets, and is not directly influenced by the bank of England

What are the economic effects of higher interest rates?

• Consumer spending: More expansive for households to service their debts, reducing effective disposable income

• Household saving: the return on saving usually rises- leading to an increase in the propensity to save

• Investment; borrowing more expensive for firms, reduce investment in new capital

• Exchange rates: Lead to an appreciation of the domestic currency, making exports more expensive and imports cheaper

• Asset prices: reduce the value of assets leading to a decrease in AD, as household reduce spending

What are the effects of higher interest rates on businesses?- exam points

• Firstly, they increase the cost of borrowing, which can make it more expensive for businesses to invest in new equipment or expand their operations.

• Secondly, they can lead to a decrease in consumer spending, as higher interest rates tend to reduce people’s effective disposable income and make them less likely to spend on non-essential items.

• Thirdly, higher interest rates can make it more expensive for businesses to refinance existing debt. They can increase the cost of working capital, which can put pressure on a business’s cash flow and profitability

• If higher interest rates lead to a currency appreciation, then exporters may find that they become less price competitive in overseas markets.

What are the effects of higher interest rates on households?- exam points

• Firstly they can make borrowing more expensive. This can impact consumers looking to take out a loan or credit card, as well as those with existing variable rate debts like mortgages or car loans.

• Secondly, higher interest rates can lead to lower levels of consumer spending, as consumers may tighten their belts and focus on paying down their debts.

• Higher rates can also lead to a worsening or consumer confidence (or animal spirits) especially if people fear that they might lead to a recession.

• Increase mortgage rates might cause a drop in average house prices.

• Higher interest rates can have an impact on the value of people’s savings, as interest rates on savings accounts increase.

How can higher interest rates affect aggregate supply?- exam points

• When interest rates rise, it becomes more expensive for firms to borrow money for capital investment, causing a decrease in investment and hence a possible decrease in long run aggregate supply.

• A drop in investment means that an economy’s capital stock will age possibly leading to a fall in productivity/ efficiency.

• Higher interest rates can reduce the profitability of businesses (borrowing costs are increased and consumer demand contracts). If profits decline, the businesses may have less to spend on research and development and innovation which might then lead to lower labour productivity.

What are the benefits of higher interest rate on LRAS?- exam points

• Higher interest rates usually cause an appreciation of the exchange rate. This can allow domestic businesses to buy imported capital equipment/software and hardware at a lower price. This might cause capital spending to rise.

• Higher interest rates are designed by a central bank to help control inflation. If this policy is successful, then lower inflation will help to improve macroeconomic stability and business confidence. This in turn can help promote investment demand.

• Higher interest rates can encourage households to save more money, which can increase the pool of fund available for lending to businesses, potentially making it easier and cheaper for them to access financing.

What is deflationary monetary policy?

An approach taken by a central bank to reduce the money supply or raise interest rates with the primary goal of decreasing AD and slowing down economic activity

What is the aim of deflationary monetary policy?

To combat inflation and maintain price stability

What is expansionary monetary policy?

Cuts in interest rates or an increased supply of credit designed to increase AD.

What is the interest rate transmission mechanism?

> Bank cuts their main interest rates

> Sends a signal to financial markets

> Possible change in market interest rates

> Change in components of AD

> Change in demand pull inflationary pressure (output gap)

> Change in the rate of inflation

What is quantitative easing?

A monetary policy tool used by central banks to stimulate the aggregate demand at a time when nominal interest rates have fallen extremely low.

What the the central banks use quantitative easing to do?

Uses QE to increase the supply of money in the banking system designed to encourage commercial banks to lend at cheaper interest rates to small and medium sized businesses.

What are the mechanics of quantitative easing (how it works)?

• The central bank creates new money electronically to make large purchases of assets from the private sector.

• Commercial banks the receive cash from the central bank’s asset purchases, and this increases their liquidly and may encourage them to lend out to customers which will help stimulate an increase in loan-financed capital investment.

• Increased demand for government bonds causes their price to increase, which causes a fall in the yield on a bond (inverse relationship between bond prices and yields). This may cause the currency to depreciate.

• Those who have sold bonds have an increase in their cash reserves. Commercial banks then have more cash available and are encouraged t lend more money, which pushes down long0term interest rates.

• Lowe rates make borrowing cheaper for businesses and consumers, aiming to boost spending and investment.

What is money supply?

The entire stock of currency and other liquid financial instruments circulating in the economy of the country at the point in time.

How can a central bank reduce money supply?

• Raising interest rates- makes it more expensive for banks to borrow money from the central bank, and in turn, they raise the interest rates that they charge their customers, consumers are less likely to borrow, this lower demand for credit means that less new money is created by he banking system.

• Central bank selling government binds through their open market operations- reduced the amount of money that commercial banks have available to lend out

• Central bank can require banks to hold more cash in reserve- reduced the amount of money they have available to lend out

What are bank reserve requirements?

Rules set by the central bank that require banks to hold a certain percentage of their deposits in reserve.

What is the point of bank reserve requirements?

Ensures that banks have enough money to meet the demands of their customers and helps to prevent bank runs.

What is quantitative tightening?

Decreases the money supply by the central bank going into financial markets and selling government bonds

What is the goal of quantitative tightening?

To reduce the amount of money in circulation and to increase market interest rates.