Demand-side Policy

• What is the definition of a bond?

  A bond is a specific type of security that is sold by firms or governments. It is a way for the firm or government to borrow money at a certain interest rate.

  A.k.a. A government bond is a type of debt- based investment, where you loan money to a government in return for an agreed rate of interest.
• What do governments use bonds for?

  To raise funds that can be spent on new projects or infrastructure, and investors can use them to get a set return paid at regular intervals.
• What is the definition of an asset?

  An asset is a resource with economic value that an individual, corporation or country owns or controls with the expectation that it will provide a benefit.
• What is quantitative easing?

  Quantitative easing is when the Bank of England buys assets (e.g. government bonds) in exchange for money in order to increase money supply and get money moving around the economy during times of very low demand.

  QE is usually where inflation is low and it is not possible to lower interest rates further.
• When was quantitative easing first launched?

  It was first launched in 2009 and wasn’t designed to be a persistent policy but is has become one.
• How is quantitative easing supposed to work?

  • Central bank creates money electronically - adds money to their balance sheet.
  • This money is used to buy financial assets - mainly the purchase of government bonds.
  • More demand leads to higher prices for assets e.g. bond prices. Rise in price of bonds leads to a lower yield (%) on government bonds.
  • Can feed through to fall in long term interest rates e.g. mortgages and corporate bonds.
  • Lower interest rates and increased cash in the banking system should stimulate the economy.
• What are the main evaluation points of quantitative easing (1)?

  • It is very risky and if not controlled properly, could cause high inflation and even hyper-inflation.
  • If consumer confidence is low, AD won‘t rise.
  • May only lead to increased demand for second hand goods, which pushes up prices but does not increase aggregate demand.
  • It had a large effect on the housing market by stimulating demand and leading to rapid rises since 2013, helping to worsen the issues of geographical immobility.
• What are the main evaluation points of quantitative easing (2)?

  
  

  • No guarantee that higher asset prices lead to higher consumption through the wealth effect, especially is confidence remained low.
  • Also led to rising share prices which increases inequality, since the rich grow richer whilst the poor see none of the gains.
  • Was not meant to be permanent and there are concerns that banks and economies are too dependent on quantitative easing, particularly within the Eurozone. If QE is expanding, this may be an indication that it is not working.
  • Time Lags
  • multiplier effect
  • ceteris paribus?
• What is the process of quantitative easing?

  • Money created by central banks
  • New money used to buy bonds from financial institutions.
  • Interest rates fall
  • Consumers and firms borrow more
  • Spending rises and jobs are created
  • AD rises, leading to economic growth
• How does quantitative easing relate to interest rates?

  Quantitative easing also helps lower interest rates further and is a strategy used when interest rates are already very low.
• What is meant by expansionary fiscal policy?

  A fiscal policy used to stimulate AD (increase spending and lower taxation) is referred to as expansionary fiscal policy.
• What is meant by contractionary fiscal policy?

  A fiscal policy used to reduce the budget deficit an lower pressure on prices is referred to as a contractionary fiscal policy.

  A.K.A measures the government to reduce their spending and increase taxes leading to a decrease in economic growth and can result in a lower standard of living for consumers and producers.
• What is meant by demand side fiscal policy?

  Changes in the level or structure of government spending and taxation aimed at influencing one or more components of aggregate demand.

  This could be in the form of:

  • discretionary fiscal policy
  • expansionary fiscal policy
  • contractionary fiscal policy
• What is meant by discretionary fiscal policy?

  The deliberate manipulation of government spending and taxation to influence the economy.
• What is meant by expansionary monetary policy?

  It is a policy by monetary authorities to expand the money supply and boost economic activity by keeping interest rates low to encourage borrowing by companies, individuals and banks.
• What is meant by contractionary monetary policy?

  It is a type of monetary policy that is intended to reduce the rate of monetary expansion to fight inflation.

  A rise in inflation is considered the primary indicator of an overheated economy, which can be the result of extended periods of economic growth.
• What are the elements of expansionary monetary policy (loosening)?

  
  

  • Reducing interest rates or QE
  • The aim is to increase consumption, investment and exporting and therefore cause a rise in AD. The increase in AD will cause the price level to rise and real GDP to increse,The aim is to increase the CPI price level by 2%.
• Explain expansionary monetary policy in terms of the Keynesian LRAS diagram?

  • Assume government wants to stimulate economic growth.
  • It may decide to cut taxation, which will boost AD to AD1 (shift right), as consumption rises.
  • This has the effect of increasing real national output from Y to Y1 (to the right).
  • There will also be the added benefit of creating employment.
  • However, this has come at the expense of an increase in the price level to P1, which may limit the inflation target.
  • Additionally if additional consumption is spent on imports, this will worsen the BOP on current account.
• What are the elements of contractionary monetary policy (tightening)?

  • Increasing interest rates or reversing QE policy
  • Increasing interest rates to reduce consumption, investment, and exporting and therefore cause a fall in AD. The decrease in AD will cause the price level to fall and real GDP to decrease. However, the aim is not to reduce the price level but to stop it rising by more than 2%. This is described as reducing inflationary pressures.
• Explain contractionary monetary policy in terms of the Keynesian LRAS diagram:

  • Assume government wants to use fiscal policy to maintain its inflationary target of 2%, because the economy is running up against capacity constraints.
  • It may decide to increase taxation, which will cut AD to AD1, as consumption falls.
  • This has an effect of reducing inflationary pressure as the price level falls from P to P1.
• Explain contractionary monetary policy in terms of the Keynesian LRAS diagram:

  • Will also be added benefit of improving the BOP on the current account as less income is spent on imports.
  • However, comes at the expense of a reduction in real national output from Y to Y1, which damages economic growth.
  • Also, falling consumption and lower AD is likely to increase cyclical unemployment.
• What is meant by Bank of England?

  The central bank of the UK. Its role is to monitor the banking system and to be a banker to the banks. It is responsible for setting interest interest rates in the UK.
• How does the Monetary Policy Committee make decisions?

  They look at a wide range of economic indicators from both the demand and the supply side of the economy. Then they have to make a judgement about what this evidence says about inflationary pressures over a two year forecast horizon.
• Why does the Monetary Policy Committee have to look up two years ahead when making a judgement about inflationary pressures?

  
  

  • Because when interest rates are changed, it takes time for them to have an effect on aggregate demand and prices.
  • Uncertain time lags in a world of many external economic shocks make the handling of monetary policy a difficult Job
• If the Bank of England anticipates inflation is falling below the government‘s target of 2% and economic growth is sluggish or the economy is facing a recession, what is likely to happen to interest rates?

  They are likely to cut interest rates.
• What does lower interest rates stimulate and why?

  Lower interest rates stimulate economic activity, as it reduces borrowing costs. This increases the disposable income of consumers with mortgage interest payments and should encourage spending.
• If the Bank feels the economy is growing too quickly and inflation is expected to exceed the government‘s target of 2%, then what is likely to happen to interest rates and why?

  They are likely to increase interest rates to reduce the rate of growth and inflationary pressures.
• How often do the Bank of England’s Monetary Policy Committee (MPC) meet and to discuss what?

  They meet on at least a monthly basis to set the bank rate and, if applicable, the level of the asset purchases (quantitative easing).
• What are the strengths of monetary policy?

  • By changing interest rates, the Bank of England can monitor inflation. -> Contractionary monetary policy raises interest rates and therefore reduces demand-pull inflation.
  • Support national debt -> buying bonds.
  • Interest rates target everyone - impacts all consumers.
  • Expansionary policy stimulates AD.
• What are the weaknesses of monetary policy?

  • Quantitative easing is risky - can cause high inflation/hyperinflation.
  • Time lag.
  • Depends on the size of the multiplier.
• What is meant by speed of adjustment (evaluation point)?

  How quickly an economy can revert to long-run equilibrium.
• What is meant by conflicting policies regarding fiscal and monetary policies using an example (evaluation point)?

  If there is high unemployment and the economy is in a recession, Keynesian economists would argue that the government should use both expansionary fiscal and monetary policies.
• What is meant by the rate of interest (evaluation point)?

  In a recession, economists agree the central bank should cut interest rates to stimulate AD. If the economy is growing too quickly and inflation is exceeding the target, the central bank should raise interest rates to reduce inflationary pressures.
• How can the national debt be used as an evaluation point for fiscal policy?

  In a recession, expansionary fiscal policy can be used as a demand-side policy to increase AD. This increases the budget deficit, and consequently, increases the national debt.
• How can quantitative easing be used as an evaluation point?

  In a recession, economists disagree about the effectiveness of quantitative easing. It significantly boosts aggregate demand.
• How can the size of the multiplier be used as an evaluation point?

  Classical economists tend to argue that it is virtually zero even in the short term.
• How can time lags be used as an evaluation point?

  Demand-side policies have significant time lags. For example, if the UK government announces plans to build new motorways, high speed rail links or nuclear power stations to reutilise a stagnant economy.
• How can fine-tuning be used as an evaluation point?

  Keynesian economists think that the demand-side could nudge the economy to a very precise level of national income.