Chapter 17 - Demand Side Policies

What is Monetary Policy

the set of official policies governing the supply of money and level of interest rates in a country

Who uses MP

a central bank (the bank for banks and the G)

two types of MP

Expansionary MP - raises AD and lowers IR

Contractionary MP - lowers AD and raises IR

how has monetary policy evolved over time in the UK?

1980s - German mark was shadowed to control inflation + strong belief in monetarist theories

‘90 - UK entered EU ERM

‘92 - ‘97 - UK leaves EU ERM (Black Wednesday) and moves back to floating xchange rates set by the G

‘97 - now - The BofE set up to be independent to the G and MPC set up to set IR

How did the European Union Exchange Rate Mechanism (EU ERM) work

Worked by setting an agreed upon central xchange rate for partaking currencies against the ECU and allowing fluctuations (+ or - 6%) in the UK’s case

What happened on Black Wednesday?

• 16th Sept 1992

• the £ fell by >6% against the ECU

• The govt tried to perk up the GBP by buying it up with foreign currency reserves and raising IR upto 12% in a day

• to no avail as the UK left the EU ERM

Strengths of MP

• easily implemented (IR can be altered quickly by BofE)

• The BofE is independent - politics don’t impede its function

• There’s no crowding out (only IR is affected)

• Precise changes can be made - IR can be altered by as little as +- 0.25% (fine tuning)

Weaknesses of MP

• time lags - AD takes time to reply to changes in IR

• If IR is already low its ineffective at raising AD

• if confidence is already low (esp in a recession) lowering IR does nothing

What is credit creation

credit creation occurs when banks lend money to customers, they’ll receive a deposit and loan out more as a multiple of the deposit

what is the minimum reserve requirement (MRR)

the % of a deposit that banks are legally required to hold in reserve incase the depositor needs it (the uk doesn’t have one)

how does credit creation work

• someone deposits 100k into my bank (MRR is 20%)

• i divide it into 5 packets of 20k (the mrr)

• i keep one for the depositor

• the remaining 4 i use as the MRR and grant 4 ×100k loans

(I just created 400k)

money multiplier formula

1/mrr

How is the MRR used to control the money supply

if the BofE raises the MRR the multiplier decreases (inv. proportional) this will lower credit creation which lowers money supply which raises IR - (this is contractionary MP)

how do open market operations to control money supply

• this involves buying&selling of govt securities (bonds) by the BofE (low risk and redeemable after a few years)

• If the BofE wants contractionary MP they’ll sell the securities - decreases funds and lowers money supply (IR rises and C+I fall)

(expansionary MP is the opposite)

what does the open market operations diagram look like

did you get it?

what are 3 ways of saying the base rate

• minimum lending rate

• refinancing rate

• discount rate

How does the BofE alter the base rate to control money supply

• this is the IR for banks and it influences our own IR

• If the BofE wants CMP they’ll raise base rate which raises commercial IR which decreases borrowing snd raises savings so c+i fall as does AD

(EMP the opposite of what i just said)

What is Quantitative Easing (QE)

• the introduction of new money into an economy

• Expansionary MP

• a common form of EMP since ‘08 when IR was low and demand wasn’t rising

steps to QE

• Central bank buys securities off of financial institutions

• this gives them more reserves - more liquidity (encourages more lending as IR is low too)

• C+I rises as does AD

• low IR = low xchange rates which raises (x - m)

Interest rates are

The price (opportunity cost) of having money OR the reward for saving

Real IR =

Nominal IR - inflation rate

money market diagram

did you get it?

What is fiscal policy (FP)

When tax revenue and government expenditure are used to influence an economy

the 3 types of public spending

• Capital spending (investing in Capital stock)

• Current spending (ongoing payments)

• Transfers (benefits and other things which the G doesn’t expect back)

Aims of FP

• maintain a low and stable rate of inflation

• a low unemployment rate

• stable environment for long term growth

• promote an equitable distribution of income

What is Expansionary FP

• The G can lower income tax which raises disposable income which raises consumption

• The G can lower corporate taxes which increases profit and increases investment

• the government can raise their own spending which increases AD

(EFP is a trade off between lower unemployment and inflation

expansionary FP diagram

did you get it

aims of contractionary FP

• control economic growth

• curb inflation

• lower a budget deficit

Strengths of FP

• Great at dealing with recessions (Great Depressions and 2008 World Depression)

• Govt expenditure can be used to target certain sectors

• Tax cuts can also be targeted

Constraints of FP

• Time lags (Tax cuts have to be changed democratically and once changed it takes a while to see effects)

• Political pressure (the govt won’t raise taxes if they wanted to keep power)

• Too much EFP leads to unsustainable debt

• crowding out - a rise in The G borrowing leads to them monopolising the available funds so the rise in G spending is negated by the fall in investment

What is Government (national) debt

the accumulation of all the budget deficits over the years & [as a % of GDP] , the amount owed to creditors

what are Debt Servicing costs

the amount of money needed to make payments on the principal & interest of a loan in a given time period

what are the costs of running high government debt

• crowding out

• rising debt servicing means the G will cut back in other sectors

• and if they don’t cut back they’ll raises taxes which leads to falling income and output

• Govts with large debts have fewer options when it comes to responding to crises

What is the multiplier effect

an injection of g. spending leads to a larger final increase in national income and GDP. one person's spending becomes another person's income, triggering multiple rounds of subsequent consumption.

how does the multiplier effect work

• G. spending and Business investments are injections into the circular flow

• these injections are then multiplied through the economy

• people receive a share and then spend a part of what they receive

what is the Marginal propensity to consume

the proportion of an extra unit of income that will be spent as opposed to saved

what are the two keynsian multiplier formulae

multiplier = 1/1-mpc or 1/mpw (

what is the MPW

MRT + MPM + MPS