THEME 2:
THE UK
2.6.2 Demand-side policies
ECONOMY –
PERFORMA
NCE AND
POLICIES
What does the
government tax?
How does the
government spend
the money raised
from taxes?
Edexcel
Economics
2.6 MACROECONOMIC OBJECTIVES
AND POLICIES
2.6.2 DEMAND-SIDE POLICIES
a) Distinction between monetary and fiscal policy
b) Monetary policy instruments:
interest rates
asset purchases to increase the money supply (quantitative easing)
c) Fiscal policy instruments:
government spending and taxation
d) Distinction between government budget (fiscal) deficit and surplus
e) Distinction between, and examples of, direct and indirect taxation
f) Use of AD/AS diagrams to illustrate demand-side policies
g) The role of the Bank of England:
the role and operation of the Bank of England's Monetary Policy Committee
h) Awareness of demand-side policies in the Great Depression and the Global
Financial Crisis of 2008 different interpretations policy responses in the US and
UK
i) Strengths and weaknesses of demand-side policies
MONETARY POLICY: A DEFINITION
“The manipulation of the
rate of interest, the money
supply and exchange rates
to influence the level of
economic activity.”
MONETARY POLICY GOALS
The primary target of monetary policy is to maintain a
low rate of inflation
Target = 2% (CPI) +/- 1%
Monetary policy in the UK has been delegated to the
Bank of England (BoE), who have
responsibility for setting interest rates (also
known as the base rate) and controlling the
money supply
In recent times the Bank has also assumed a degree of
responsibility for assisting in stimulating economic
growth and employment
What are the advantages and disadvantages of Forward
Guidance?
HOW DOES MONETARY POLICY WORK?
The Bank, via the Monetary Policy Committee
(MPC), meet every month to decide the level of interest
rates and any other changes to policy strategy
In order to make their decision the MPC consider a
wide range of macroeconomic variables
including GDP, unemployment, exchange rates, house prices, the
Read this level of investment by firms and GDP growth in other countries
Monetary Policy
outline from the The main tool they have at their disposal is interest rates,
Bank of England although they may also use other tools to influence the money
for more detail.
supply, such as quantitative easing
In theory, if inflation remains around the target level of 2%, then
this will give confidence to
Consumers – as regards to spending decisions
Firms – as regards to investment decisions
Workers – as regards to wage demands
THE MONETARY POLICY COMMITTEE (MPC)
Setting interest rates is the responsibility of
the MPC
MPC: 9 members (4 independent, 5
from within bank)
Read this Chaired by the Governor of the Bank of
information England Mark Carney
from the Bank
of England The MPC meet monthly to assess the state
of the economy and decide whether it is
which gives appropriate to increase, decrease or hold
more detail interest rates from their existing level
on the role of
the MPC. It is independent from government,
which should give it more credibility
(free from political influence) Mark Carney was appointed in June 2013
and was former Governor of the Canadian
Central Bank. CLICK HERE to listen
to more about his appointment.
INTEREST RATES
Interest rates are best described as the “price of
money”
Interest rates are the cost of borrowing and the
reward for saving
Complete the table below as regards to interest rates.
Delete the incorrect answer.
INTEREST RATES IN THE UK
Look at the chart above showing interest rates in the UK over the last decade.
Notice that interest rates have remained unchanged at 0.5% since March 2009.
What impact do you think this might have on aggregate demand?
Why do you think rates have remained so low for so long?
INTEREST RATES AND THE EXCHANGE
RATE
It is important to understand the link between interest rates
and exchange rates
Global investors who have significant sums of money to deposit in banks
will seek to place it in the country where they get the best return i.e. where
the interest rate is highest
If we assume that the UK has the same interest rates as the USA, then for that
investor, the return is the same whether they deposit it in the UK or USA
If the UK raises interest rates, then investors will move their
money to the UK in order to get the best return
This means they will have to sell their $s and buy £s to deposit in the UK
This increased demand for UK pounds increases the exchange rate
This then feeds through to exports, making them relatively less price
competitive, and making imports more attractive
This will have the effect of worsening the balance of payments on
current account
This process is sometimes referred to as Hot Money, as international funds
move around the world chasing the best interest rates
Higher interest rates will lead investors, who seek high returns, to move their savings
into pounds sterling. This increases the demand for £ and therefore increases the
exchange rate. We call this hot money .A reduction in the interest rate will have
the opposite effect.
RECAP: ASSET PURCHASES TO INCREASE
THE MONEY SUPPLY
1.
1. Quantitative Easing (QE)
When the recession began in the UK in 2008, the BoE would
have been expected to cut interest rates in order to help
stimulate economic activity
However, with interest rates at 0.5%, they had very little
downwards movement to manipulate the economy with
In addition, banks were nervous about lending money to
firms and individuals, so the BoE sought to boost the funds
available for lending to businesses and firms
In total, £375bn has been raised in QE
Watch this video How effective this has been is a matter of debate, but it
clip that explains could be argued that the recession may have been worse
how QE works.
had the BoE not intervened in this manner
MONETARY POLICY AND AGGREGATE
DEMAND
SPICED 1. Consumption
Strong Pound Low interest rates = less incentive to save, more incentive
Imports Cheap to borrow and therefore higher consumption
Exports Dear
This affects general spending and consumer durables
especially
Higher interest rates = vice versa
2. Investment
Low interest rates = investment projects become less
costly/more profitable thus more attractive, so investment
should rise
High interest rates = vice versa
3. Net Exports
Low interest rates = weaker £ as less attractive to currency
investors
Weak £ = Stronger Exports, fewer Imports
High rates = vice versa
EXPANSIONARY MONETARY POLICY
1) If the Bank of England is concerned that slow
economic growth is likely to feed through
to lower inflation they may cut interest
rates. LRAS
Price
Level
2) This reduces the savings
ratio and makes borrowing
more attractive so
consumption rises.
3) This has the effect of increasing
P1 real national output from Y
P to Y1.
AD 4) There will also be the added
AD 1 benefit of creating
employment.
Y Y1 FE Real National Output
CONTRACTIONARY MONETARY POLICY
1) If the Bank of England is concerned that
inflation is running above the 2%
target they may increase interest
rates to reduce inflationary
pressure. LRAS 2) This makes saving more attractive and
Price will reduce consumption in addition to
Level reducing investment from firms.
P 3) This has the effect of reducing
inflationary pressure as the
price level falls from P to P1.
P1
AD 4) However, this has come at
the expense of a reduction
in real national
AD output to Y1, which
1 damages economic growth
and employment.
Y1 FE
Real National Output
THE SUPPLY SIDE EFFECTS OF MONETARY
1) Whilst monetary policy has numerous
POLICY
effects on AD, it can also influence 2) A cut in interest rates might
LRAS. stimulate businesses
LRAS LRAS1 investment into capital
Price process to improve their
Level productivity and efficiency,
which will shift LRAS to LRAS1.
3) As Investment is a component
of AD, AD will shift to AD1.
4) Productive
P capacity has now
increased to FE1
and increases in AD can
feed through to higher
AD1 growth and employment.
AD In this example, there has
been no change in
the price level.
Y FE Y1 FE1 Real National Output
SO, IS MONETARY POLICY EFFECTIVE?
It depends!
The size of the change in interest rates will vary
the impact
Timing of rate changes
The size of the multiplier
The stage of the economic cycle the economy is at
Time – How long rate changes take to work
Primary target is control of inflation, but may conflict
with other objectives
BoE might be hampered by poor/inaccurate data
Interest rates helps to solve demand-pull, but may be
less effective with cost-push causes
MULTIPLE CHOICE 1
Which one of the following is most likely to be
classified as an instrument of monetary policy?
a) Taxation
b) The inflation rate
c) The exchange rate
d) Government spending
a)
b)
Can you explain your answer?
MULTIPLE CHOICE 2
All other things being equal, a large increase in an
economy's rate of interest will cause
a) Both its aggregate demand curve and its short-run
aggregate supply curve to shift to the right
b) Its aggregate demand curve to shift to the right and its
short-run aggregate supply curve to shift to the left
c) Both its aggregate demand curve and its short-run
aggregate supply curve to shift to the left
d) Its aggregate demand curve to shift to the left and its
short-run aggregate supply curve to shift to the right
Can you explain your answer?
MULTIPLE CHOICE 3
All other things being equal, a large rise in interest
rates is most likely to lead to an increase in
a) economic growth
b) investment
c) unemployment
d) aggregate supply
a)
b)
Can you explain your answer?
MULTIPLE CHOICE 4
If an economy is operating with a negative output gap,
which is expected to worsen, what combination of fiscal
and monetary policies is the government most likely to
implement?
a) Higher taxes with lower interest rates
b) Higher taxes with higher interest rates
c) Lower taxes with lower interest rates
d) Lower taxes with higher interest rates
a)
b)
Can you explain your answer?
MULTIPLE CHOICE 5
The consequence of increasing the interest rate when
the exchange rate is rising is likely to be an increase in
a) aggregate demand
b) aggregate supply
c) the current account surplus
d) the level of unemployment
a)
b)
Can you explain your answer?
FISCAL POLICY: A DEFINITION
“The manipulation of government
spending, taxation and
government borrowing to
influence the level of economic
activity.”
FISCAL POLICY GOALS
Fiscal policy is used to achieve a wide variety of objectives
Keep inflation on target (2%)
Stimulate economic growth and employment during times of
recession
Maintain a stable economic cycle that minimises “boom and
bust”
Note however, that fiscal policy can have supply side effects too
Any change in the balance between government spending and
taxation, will impact upon the 4 macroeconomic targets
However, fiscal policy has a wide variety of goals and may have
microeconomic targets in addition to this, which can include
improving education, health and the redistribution of income
FISCAL POLICY INSTRUMENTS
Fiscal policy is said to be “expansionary” if the government is trying
to positively stimulate economic activity.
Possible methods include:
Cutting taxes
A cut in income tax may give consumers more disposable income,
thus raising consumption
A cut in corporation tax may increase available profits for firms
which may stimulate investment
Raising government spending
The government may increase its spending on core infrastructure
projects or increase the pay of public sector workers
Increasing the budget deficit
Another way of increasing spending if the government do not wish
to raise taxation is to increase borrowing
This can be spent on a variety of projects nationally
However, this adds to the national debt, and must be repaid with
interest
FISCAL POLICY INSTRUMENTS
Fiscal policy is said to be “contractionary” if the government is trying to
constrain aggregate demand, reduce debt or control
inflation.
Possible methods include:
Increasing taxes
If income tax is raised this may discourage spending and reduce consumption
This will reduce aggregate demand and may help to bring inflation under
control
Cutting government spending
The government may decide to reduce expenditure on public projects or cut
key government budgets if it considers excessive government spending to
be unaffordable or perhaps inflationary
Cutting the budget deficit
The UK budget deficit is large and thus must be repaid with interest
Cutting the governments long term borrowing commitments may help to
stabilise economic growth as reduced debt repayments in future can be
reinvested back into the economy
DIRECT AND INDIRECT TAXATION
Direct tax is imposed on the income of individuals or profits of businesses
This type of tax is paid directly to the government
Examples include:
Corporation Income tax
tax levy Corporation tax
Inheritance tax
National Insurance contributions
Indirect tax is imposed on goods or services
This increases the price of that good or service
Income tax
allowance Examples include:
Value Added Tax
Excise duty
Customs duty China cuts
import tax
VAT
GOVERNMENT BUDGET (FISCAL)
DEFICIT AND SURPLUS
A budget deficit occurs when a government receives less
income through tax receipts and other government revenue
than it spends
This will lead to increased government debt that will have to
UK budget paid off in future years
deficit
compared
with Europe A budget surplus occurs when a government receives
more income through tax receipts and other government
revenue than it has to pay out in its spending plans
This will allow the government to reduce its debt burden and
therefore reduce interest payments
EXPANSIONARY FISCAL POLICY (1)
1) Assume the government would like to
stimulate economic growth.
LRAS 2) It may decide to cut taxation,
Price
Level which will boost AD to AD1, as
consumption rises.
3) This has the effect of increasing
real national output from Y
P to Y1.
1
P 4) There will also be the
added benefit of creating
AD employment.
AD 1
Y Y1 FE Real National Output
5) However, this has come at the 6) In addition, if additional consumption is spent on
expense of an increase in the imports, then this will worsen the balance of
price level to P1, which may payments on current account.
hamper the inflation target.
EXPANSIONARY FISCAL POLICY (2)
1) Imagine the government would
like to stimulate the
supply-side of the economy. 2) They may cut corporation
LRAS LRAS1
tax in order to boost firms’
Price profits, which can then be
Level reinvested in capital projects.
3) LRAS will shift to the
right to LRAS1.
P
P1 4) Productive capacity
has now increased to
FE1 and there has been a
AD fall in the price level from P to
P1, helping to soften
inflationary pressure.
Y FE Y1 FE1
Real National Output
5) However, if AD remains unchanged, spare capacity has
now increased in size from Y-FE to Y1-FE1,
indicating a waste of economic resources.
CONTRACTIONARY FISCAL POLICY
1) Assume the government would like to use
fiscal policy to maintain its
inflationary target of 2%, because the
economy is running up against capacity
constraints.
Price 2) It may decide to increase
LRAS taxation, which will cut AD to
Level
AD1, as consumption falls.
3) This has the effect of reducing
inflationary pressure as the
price level falls from P to P1.
P
P1
4) There will also be the added
benefit of improving the
AD balance of payments
AD on current account as
less income is spent on imports.
1
Y1 Y FE Real National Output
5) However, this has come at the expense
of a reduction in real national 6) In addition, falling consumption and lower aggregate
output from Y to Y1, which damages demand is likely to increase cyclical
economic growth. unemployment.
The Chancellor of the Exchequer
outlines the governments future
spending plans in March each year.
It is at this time that key
announcements regarding tax and
spending are made.
Do you think that his polices will positively impact on the UK’s
ability to meet its macroeconomic objectives?
FISCAL POLICY IN THE UK
Source:
The
Guardian
Look at the summary above of planned government revenue and spending in
the UK in 2013/14.
What might you change and why?
STRENGTHS AND WEAKNESSES OF FISCAL
POLICY
Economic Growth
Expansionary policy alone won’t increase the long-run growth rate, but will
act as a short-run stimulus to economic growth
However, fiscal stimulus through tax cuts and increasing government
spending may be employed to help lift a country out of recession, therefore
smoothing out fluctuations in the economic cycle
Keynesian economists favour this approach and might consider increasing
the governments budget deficit in the short-run - a necessary requirement
to put an economy back on target in terms of economic growth
Unemployment
Higher government spending should lead to higher levels of employment if
there are good polices to support training programmes and back to work
schemes
The use of fiscal policy to improve employment statistics is a vital part of
economic policy
Tax credit and welfare changes are on-going – keep up to date with these!
STRENGTHS AND WEAKNESSES OF
FISCAL POLICY
Inflation
Fiscal policy is a fairly blunt instrument with which to seek to control the price
level
In theory, expansionary policy will boost AD and create inflationary pressure,
whilst contractionary policy will do the opposite
In reality, it is very difficult to ‘fine tune’ the economy towards a 2% inflation
target using broad instruments such as taxation and government spending
In any case, the causes of inflation are varied and come from many sources
which fiscal policy cannot control e.g. increasing raw material costs from
abroad
Balance of Payments on Current Account
The UK has a high propensity to import, so expansionary policy tends to limit
our ability to achieve this target
However, the government could employ expenditure-switching policies by e.g.
taxing foreign imports to make domestic goods more attractive
To what extent is Larry Summers correct to say “UK economic
policy illogical”?
TRADE OFFS
As is now perhaps clear, fiscal policy has
some built in trade-offs
E.g. 1
Expansionary policy higher output + lower U
BUT at expense of high inflation
E.g. 2
Tight fiscal policy control inflation
BUT may increase U and damage GDP
SO, IS FISCAL POLICY EFFECTIVE?
It depends!
The size of the change in government spending
and/or taxation will vary the impact it has
The effectiveness, efficiency and timing of
changes will also influence policy effectiveness
The size of the multiplier will influence the size
of changes in AD
How close to full employment the economy is
Expansionary policy will have different effects if there is
significant spare capacity compared to if it is close to full
employment
Time – It takes time for the full effect of tax cuts or
spending increases to have the desired effect on the economy
MULTIPLE CHOICE 1
Fiscal policy involves changes in both
a) the budget balance and the balance of payments
b) interest rates and the supply of credit
c) the money supply and the exchange rate
d) government spending and tax revenue
a)
b)
Can you explain your answer?
MULTIPLE CHOICE 2
Which one of the following is an example of
expansionary fiscal policy?
a) A reduction in interest rates
b) An increase in the budget deficit
c) An increase in the money supply
d) An increase in tax rates
a)
b)
Can you explain your answer?
MULTIPLE CHOICE 3
All other things being equal, a substantial cut in the rate
of income tax in the short run is most likely to reduce
a) inflation
b) unemployment
c) spending on imports
d) the government budget deficit
a)
b)
Can you explain your answer?
MULTIPLE CHOICE 4
Which one of the following is the best example of fiscal policy
having a direct supply-side effect?
a) An increase in the money supply leading to greater output
b) A reduction in income tax boosting consumption and the supply
of consumer credit from banks
c) A reduction in interest rates boosting investment and the
productive potential of the economy
d) Government expenditure on retraining schemes increasing factor
mobility
a)
b)
Can you explain your answer?
