Fiscal policy: involves the government changing the levels of taxations and government spending in order to influence aggregate demand and the level of economic activity

• AD is the total level of planned expenditure in an economy

Purpose of Fiscal policy:

1. Stimulate economic growth during a period of recession

2. Keep inflation low

3. Stabilise economic growth

   • Often simultaneously used monetary policy

   • Governments prefer using monetary policy to stabilise the economy

   • Fiscal policy depends on size of multiplier

Expansionary fiscal policy:

• Involves increasing AD

• Government will increase spending and cut taxes

• Lower taxes increase government spending → more disposable income

• Will worsen the government budget, governments will need to increase borrowing

Deflationary Fiscal policy:

• Decreasing AD

• Governments will cut government spending and increase taxes

• Higher taxes → reduce consumer spending

• Improves government budget deficit

Fine tuning: maintaining a steady rate of economic growth using fiscal policy

• If growth is below the trend rate of growth, governments cut taxes to boost spending and economic growth → tax increases, consumption decreases

• If growth is too fast + inflationary, governments increase tax to decrease/slow down consumer spending and reduce economic growth

Limitations of fine tuning:

• Time lags: government spending takes several to integrate in the economy

• Political costs: increasing taxes imposes problems on consumers

• Difficulty forecasting: predicting the state of the economy requires the government to have plenty of info on the likeliness of growth

Demand Management policies: efforts to influence the level of aggregate demand (AD) in an economy. Main types: monetary and fiscal policy

• Consumer confidence is an indirect factor since it helps encourage investments and encourage consumers to spend

Monetary policy: involves cutting or raising interest rates

• Lower interest rates make it cheaper to borrow leading a boost in consumer spending and investment

• Lower interest rates reduce the value of the exchange rate (making exports more competitive and boosting export demand)

• Set by banks

• Independent in selling rates but have to meet the government inflation target

• Cutting interest rates may fail to boost spending, some banks could be unwilling to offer loans which makes lowering interest rates ineffective

Quantitative easing: when banks buy bonds to lower the interest rates on savings and loans

• Reduces long term interest rates and boosts the money supply

Aim of monetary policy:

• Low inflation: enables higher investments in the long term

• Stable economic growth maintains a sustainable rate of economic growth +keeps unemployment low

Based on the trends of the banks, they can choose:

• Higher inflation + higher growth → increase interest rates

• Lower growth + decrease in inflation rates → lower interest rates

Expansionary monetary policy: expands monetary supply faster than usual or lowering short term interest rates

• If central bank predicts inflation rates dropping below the government’s target, they will cut interest rates

• Lower interest rates stimulate economic activity

• Lower interest rates reduce borrowing costs

  • Increases disposable income of consumers

Contractionary monetary policy:

• Central bank increases interest rates to reduce rate of economic growth and reduce inflationary pressure

• Increase in interest rates causes fall in consumer spending and investment leading to lower inflation

Cost push inflation: occurs when the economy experiences rising prices due to higher costs of production and higher costs of raw material

Demand pull inflation: occurs when aggregate demand grows faster than aggregate supply