A) Distinction between monetary and fiscal policy
Monetary policy involves using interest rates and quantitative easing to affect aggregate demand within the economy, whereas fiscal policy involves using taxation and government spending to affect aggregate demand within the economy. Furthermore, in the UK fiscal policy is controlled by the government, whereas monetary policy is controlled by the Bank of England Monetary Policy Committee. In some countries, fiscal policy may change automatically through the use of automatic stabilisers.
B) Monetary policy instruments:
Interest rates
Interest rates are set by the Bank of England and are mostly influenced by the current inflation rate. The bank sets the base rate which determines the interest rates across the country. If the inflation rate is too high, or getting out of control, then the government will raise interest rates in order to try and reduce the amount of spending within the economy, ensuring price stability. This is due to the fact that higher interest rates encourage consumers to save their money, as the reward for doing so (interest) has increased. As a result of this, aggregate demand decreases/doesn’t increase as rapidly, moving the economy further away from full capacity, reducing the amount of pressure on existing factors of production and therefore the price level to. On the other hand, the Bank of England may decide to reduce interest rates in times of low/negative economic growth. This encourages consumers and firms to spend/invest more money, as they are now able to borrow at a lower rate of interest. Furthermore, current loans that consumers/firms have taken out can now be paid back with a lower rate of interest (assuming that the interest repayments are variable and not fixed). As a result of this, consumers and firms will now have more money to spend/invest.
Transmission mechanism
This diagram explains the lag time that can take place from the monetary policy being set, to the desired impact it has on the economy. The base rate that the Bank of England decides to set will affect market rates, house prices, expectation/confidence and the exchange rate.
A cut in the base rate will allow commercial banks to offer loans at a lower rate of interest, thus affecting other market interest rates. This affects a number of people such as borrowers (consumers and businesses), savers and mortgage payers. Interest rates can also affect asset prices, the most sensitive asset to a change in interest rates being house prices. If interest rates are cut then mortgage repayments will be lower. As a result of this, there will be an increase in the demand for house, thus pushing up the price of houses. Expectations/confidence can also be affected by interest rate changes. For example, expansionary monetary policy such as a cut in interest rates is used to spur on economic growth. Therefore, if consumer and businesses see that interest rates are going down, they’re more likely to be optimistic about the future of the economy, knowing that the policy change is likely to result in an increase in economic growth and therefore reduced unemployment, increased incomes etc. A change in interest rates can also affect the exchange rate. For example, a cut in the interest rate can cause a reduction in inflows of hot money and an increase in outflows of hot money. Hot money is money that is moved to countries where there are high interest rates, allowing investors to maximise the interest gained on savings. As investors exchange their pounds to another currency, the supply of the pound increases and its value reduces.
Market rates, asset prices and expectations/confidence will all affect domestic demand. For example, a change in the market interest rates will affect consumer spending and business investment. A decrease in market interest rates will encourage consumer spending and business investment and therefore domestic demand for goods/services within an economy. Changes in asset prices can also affect domestic demand. For example, an increase in the price of houses or stocks will cause an increase in consumer spending for those who have either/both of those assets. This is due to the wealth effect whereby a rise in asset prices can increase a consumers/firms wealth increasing their confidence and therefore their willingness to spend/invest. Furthermore, high confidence levels will also affect consumer spending and investment. If consumer and business confidence is high then there will be increased consumer spending and business investment. A change in the exchange rate will affect net external demand. For example, if the value of the pound were to decrease then exports would become more competitive, as the price of exporting goods/services has decreased in comparison to other countries. As a result of this, the demand for domestic exports from foreign countries will increase (an increase in external demand).
The change in domestic demand and net external demand will then go on to effect total demand for domestic goods/services.
This will then affect domestic inflationary pressure as an increase in total demand will cause an increase in pressure on existing factors of production.
The overall, effect of this will then be an increase in inflation.
As well as effecting net external demand, changes in the exchange rate will also affect import prices. A decrease in the value of the domestic currency will cause an increase in the cost/price of imports. This will then go onto effect the level of inflation within the economy. For example, an increase in the cost/price of imports caused by a decrease in the value of the domestic currency would result in an increase in cost push inflation.
Asset purchases to increase the money supply (quantitative easing)
Quantitative easing was used as a tool for recovery from the 2008 recession after the reduction in interest rates to 0.5% failed. There are a number of reasons why lowering the interest rate may not have the expansionary effect that is intended. One of the reasons for this is the availability of credit.
During the financial crisis, the availability of credit for banks was very low. As a result of this, banks did not have much credit to issue loans out to consumers.
The second reason is due to the low consumer and business confidence during the 2008 recession. This meant that despite 0.5% interest rates, firms and consumers were still unwilling to take out loans and therefore consumer spending and investment didn’t increase.
The final reason is around the willingness of banks to lend money. During the 2008 recession, banks didn’t want to take risks when giving out loans out of fear that the client wouldn’t be able to pay them back + interest.
All of this caused the cut in interest rates to be ineffective at increasing aggregate demand during the 2008 financial crisis.
Quantitative easing works in the following way: Firstly the Bank of England Monetary Policy committee decides how much money to create and does so electronically.
This money is then used to buy financial assets from financial institutions such as banks, the main asset being government bonds, thus increasing the liquidity of banks.
As a result of this, the demand for government bonds increases, causing an increase in the price of government bonds. A bond is essentially a promise to pay a certain amount of money to the buyer at a certain time in the future and the yield is the money gained from that bond.
The increase in the price of government bonds reduces the yield/interest rate. For example, if the government promises to pay the investor £150 in a year from now and the government bond was bought for £100 then the yield would be 150% (150/100×100).
However, if the price of the government bond increased to £1000, because of the increase in demand, the yield would decrease to 15%. This explains the inverse relationship between bond price and yield. The yield represents the return for an investor (the banks) and the cost of borrowing to issuer (the government). Therefore as the government bond yield decreases, it becomes cheaper for the government to raise finance.
Furthermore, as the yield goes down in value, it now makes it less profitable for banks to invest in government bonds. This causes banks to invest in riskier assets that now have a higher yield, such as company shares and corporate bonds. As the demand for these assets increase, the price of these assets also increases and therefore their yield reduces. The increase in the price of these bonds or shares can also encourage increased consumer spending from individuals that own corporate bonds or shares as a result of the wealth effect.
The reduction in corporate bond yield causes the cost of borrowing for the issuer (the bank) to decrease. Therefore it is easier for banks to access credit by issuing corporate bonds. As the availability of credit for the bank increases, it is easier for them to loan money to consumers and firms. The lower rate of borrowing for the issuer (the bank) will also be passed onto consumers and firms in the form of lower interest rates, causing market rates within the economy to decrease. This will bring down market rates to a percentage closer to the base rate set by the Bank of England.
C) Fiscal policy instruments:
Government spending and taxation
The government can either use expansionary or contractionary fiscal policy in order to influence levels of aggregate demand within the economy. An increase in government spending will increase aggregate demand and may even increase the long run aggregate supply of the economy. For example, an increase in spending on education will not only increase AD (consumer expenditure +investment + government spending +net trade), but it will also increase the quality of labour. This will increase the maximum level of output within the economy when using factors of production sustainably, as a higher quality labour force will be more productive and efficient. A decrease in government spending will cause aggregate demand to fall. Government spending often changes automatically as a result of the implementation of automatic stabilisers. This causes government spending to rise during times of low growth and high unemployment (increased spending on welfare benefits). On the other hand, during times of high economic growth and low unemployment, government spending will fall (reduced spending on welfare benefits). The majority of the UK government’s budget is spent on pensions and welfare benefits.
The government also has control over taxation. An expansionary fiscal policy would include a reduction in taxation, the main tax cut being for income tax. This would result in an increase in the amount of income that is kept by consumers. As a result of this, their disposable income will increase and therefore consumer spending within the economy will increase. This will cause an increase in the total demand for goods/services within an economy, shifting AD outwards and increasing economic growth. An increase in taxation (part of contractionary fiscal policy) would have the opposite effect (a decrease in AD and economic growth).
As government spending increases, the budget is likely to worsen, whereas decrease in government spending is likely to improve the budget. However, this is dependent on the overall impact that the policy has. For example, an increase in government spending is likely to lead to a decrease in unemployment which will cause an increase in income tax revenue, thus offsetting some of the cost of increased government spending. Furthermore, a reduction in taxation is likely to cause an increase in consumer spending, thus increasing government revenue from sources such as VAT. This concept can be shown by using the Laffer curve which will be taught in theme 4.
D) Distinction between government budget (fiscal) deficit and surplus
A government budget deficit occurs when government expenditure is greater than the revenue it receives from taxation. On the other hand a government budget surplus occurs when revenue the government receives from taxation exceeds government expenditure. A government budget deficit will lead to an increase in the amount of national debt.
E) Distinction between, and examples of, direct and indirect taxation
Direct taxes are paid directly by individuals or firms e.g. people that are employed pay income tax, firms making a profit pay corporation tax.
On the other hand, indirect taxes are levied on goods/services rather than on income or profits. e.g. VAT, alcohol duty. Producers decide how much of this tax they want to absorb themselves and how much they want to pass onto consumers. They are called indirect taxes as the consumer doesn’t directly pay the tax; instead it is added onto the price of the good/service.
There are two types of indirect tax:
Specific – The amount of tax paid is the same (a fixed sum) regardless of the price of the good/service e.g. excise duties on tobacco and alcohol.
Ad valorem – These taxes are percentages which are added to certain products. For example VAT in the UK is 20% which is then added onto the original price.
F) Use of AD/AS diagrams to illustrate demand-side policies
Demand side policies can either be expansionary, where the aim is to increase aggregate demand within the economy or contractionary, where the aim is to decrease aggregate demand within the economy. Expansionary demand side policies are used in times of low/negative economic growth e.g. a recession. On the other hand, contractionary demand side policies are used in times of high economic growth e.g. a boom.
Expansionary demand side policies cause an increase in aggregate demand (AD1 to AD2) e.g. a reduction in taxation, an increase in government spending (expansionary fiscal policy), a reduction in interest rates, quantitative easing (expansionary monetary policy). This causes an increase in real GDP (Y1 to YFE) moving the economy to an equilibrium of full employment (YFE). As a result of this, there is a significant increase in the pressure on existing factors of production; this causes the price level to rise from P1 to P2.
Contractionary demand side policies cause a reduction in aggregate supply (AD1 to AD2) e.g. an increase in taxation, a decrease in government spending (contractionary fiscal policy), and an increase in interest rates (contractionary monetary policy). This causes real GDP to fall from YFE to Y2, thus increasing the amount of spare capacity within the economy. As a result of this, the pressure on existing factors of production within the economy is reduced, causing a decrease in the price level of goods/services within the economy (P1 to P2).
G) The role of the Bank of England:
The role and operation of the Bank of England’s Monetary Policy Committee
The Monetary Policy Committee meets on a monthly basis in order to set a bank rate and discuss whether quantitative easing is necessary and if so, the amount of money that should be spent buying assets. When making these decisions, the committee look at a range of different factors and data. The main piece of data looked at is the inflation rate. If inflation is getting out of control or is above the inflation target rate (UK inflation target rate is 2% CPI), then the committee may decide to implement contractionary monetary policy (increase in interest rates) to reduce AD and therefore price levels also.
H) Awareness of demand-side policies in the Great Depression and the Global Financial Crisis of 2008
Different interpretations
Classical economists were more focused on balancing the government budget during the great depression despite the economic downturn. This is because classical economists believed that in the long run wages would become variable and therefore the economy would move back to a point of equilibrium at full employment. On the other hand, Keynes argued that the current output of the economy would stay the same in the long run unless there is active government policy put in place to move the economy closer to full capacity. Therefore, without expansionary demand side policies, the depression would continue.
Policy responses in the Great Depression:
Monetary policy
The overall effectiveness of monetary policy in the US during the great depression is a widely debated topic by economists. In the early 1930s authorities were reluctant to cut interest rates out of fear of inflation.
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