1 Demand Side Policies

What impact would the Queen’s death have on our economy?

Policy ConflictsWhat would be the conflict between the following?

Inflation vs. Unemployment: e.g. if Low UE or High UE what’s the impact on inflation.Dilan and EmilJay and Alfie

Economic growth vs. BoP equilibriumAbhishek and SulemanBilly and Adam

Full employment vs. sustaining the environmentFuad and TamanaNicholas and Sufian

Economic growth vs. income redistributionHashim and Ben

Macroeconomic Policy Instruments I: Demand-Side Policies

Unit 2 – Managing the Economy

Textbook pages 261-287

What are Policy Instruments?

• A set of measures designed to help Gvt achieve its policy objectives

• Two types of PI:1) Demand-side policies

Fiscal policy Monetary policy

2) Supply-side policies

Fiscal Policy

• What is Fiscal Policy?• What is the Budget?• What is the difference between public sector borrowing (i.e. budget

deficit) and the national debt?• Why might a government want to run a budget deficit? Why might it

want to run a budget surplus?• What is expansionary/contractionary fiscal policy? What are the

transmission mechanisms that ensure output is affected?• How are the concepts of an expansionary/ contractionary fiscal

policy and a budget deficit/surplus interlinked?

Fiscal Policy (Pages 261-267)

FP is the use of Gvt spending and taxation in order to influence AD

Breakdown of Government Revenue 2013/14

Breakdown of Government Spending 2013/14

What is The Budget?

• An estimate of government spending and revenue for the coming year• Budget deficit: G > T• Budget surplus: G < T• Balanced budget: G = T

Public Sector Borrowing versus The National Debt• Public sector borrowing is what the government

borrows in one year when it is running a budget deficit.

• In 2013-14 the government plans on running a budget deficit of £120bn.

• National debt is the accumulation of all previous public sector borrowings that have not yet been repaid

• At the end of November 2013, general government debt was £1,231.7bn, 76.6% of GDP (up from £889.1bn/59.3% GDP in 2010).

• Read: UK debt and deficit – All you need to know

Expansionary FP

G, T Leads to a budget deficit Hence Gvt may need to borrow Evaluation: Does expansionary

fiscal policy always worsen the budget deficit?

Shifts AD to the rightTransmission mechanisms?

• AD = C + I + G + X – M G will directly shift AD right T Yd C AD shifts rightAD shifts right

Question: Why would Gvt want to run a budget deficit? Think about the policy objectives that would be achievedEvaluation: which policy objectives would be undermined?

AS

PL

ROY1 Y2 YFE

P1

P2

AD1AD2

2) Contractionary FP G, T Reduces the budget deficit (or leads to

budget surplus in some economies). Shifts AD to the left

Note: The transmission mechanism is simply the reverse of

an expansionary FP

EVALUATION: FP may also have an incidental effect on the AS curve, but only in the long-run

Question: Why would Gvt want to run a budget surplus? Again, think about the policy objectives that would be achievedEvaluation: which policy objectives would be undermined?

AS

PL

ROY2 Y1 YFE

P2

P1

AD2AD1

What is the Role of the Multiplier in Fiscal Policy?

•Multiplier: An increase in an injection…directly adds to AD……and triggers multiple rounds of repeat spending (C)……such that the final increase in GDP is far greater than

the initial injection (i.e. GDP > G)And as K = 1 / MPW, the size of the multiplier – and

therefore the impact of G on GDP – will be greater when the withdrawals (i.e. taxes) are smaller

(in this case, G)…

•With an expansionary FP:G will initiate a multiplier effect T will increase the size of that multiplier by:

• Withdrawing less money at each round of repeat spending (i.e. smaller MPW)…

• …thus leaving more disposable income for further rounds of spending

•With a contractionary FP:G will cause a reverse multiplier effect T will increase the amount by which spending

falls at each successive round of spending cuts

• Read “Fiscal Policy: An Evaluation”, and rewrite the four evaluation paragraphs into three distinct bullet points

• One that states the point• Another explaining the point• A final one that concludes the point

• Read article about Brazil economy.

To what extent might rapid economic growth conflict with at least two other macroeconomic objectives? (30)

Fiscal Policy

• What is Fiscal Policy?• What is the Budget?• What is the difference between public sector borrowing (i.e. budget

deficit) and the national debt?• Why might a government want to run a budget deficit? Why might it

want to run a budget surplus?• What is expansionary/contractionary fiscal policy? What are the

transmission mechanisms that ensure output is affected?• How are the concepts of an expansionary/ contractionary fiscal

policy and a budget deficit/surplus interlinked?

Exam style Question

“Evaluate the use of Fiscal Policy to achieve economic growth” – 30 Marks

Breakdown of Marks

• KAA = 18 Marks• Definition (2)• Labelled diagram (4)• Analysis of the effect of a change in Government Spending/Taxation on AD

(Transmission mechanisms are VITAL here!) (2 x 6 marks) (Most Qs would also offer 3 x 4 marks)

• To achieve 12/12 marks there must be a reference to economic growth. If not, cap at 8/12.

Breakdown of Marks

• Evaluation – 12 Marks• Award three points up to 4 marks each or two very well developed points up

to 6 marks each.• Any of the evaluation points that we have considered would be acceptable

here.

Monetary Policy

• What is monetary policy? What is its objective?• How frequently is monetary policy decided in the UK? Who decides

it?• What is meant by loose/tight monetary policy?• Explain the transmission mechanisms through which a cut in interest

rates will increase AD and hence inflation.• Why might a change in interest rates have an impact on AS?

Monetary Policy (Pages 276-282)

MP is the use of interest rates and the money supply in order to influence AD and to achieve price stability

1) Deflationary / tight MP IR Increases the ‘price of money’ Shifts AD to the left

Transmission mechanism?

Task

• Read the BoE’s explanation of how monetary policy works. In particular, look for the transmission mechanisms described and any possible evaluation points.

•IR will:monthly mortgage repayments Yd C AD

Cost of credit C (esp. cons. durables) AD

Reward for saving S, hence C AD

Cost of borrowing for firms I AD

Inflows of hot money ER S P I C E D PX thus X…PM thus M AD

AS

PL

ROY2 Y1

P2

P1

AD2AD1

2) Reflationary / loose MP IR Decreases the ‘price of money’ Shifts AD to the right

Note:

The transmission mechanism is simply the reverse of a tight MP

2) EVALUATION: MP may also have an incidental effect on the AS curve, but only in the long-run

AS

PL

ROY1 Y2

P1

P2

AD1AD2

Question: Why would the MPC want to run a deflationary or reflationary MP?

Clue: remember, there is only one policy objective which the BoE is required to meet

Monetary Policy in the UK

In the UK, MP is used for one purpose only: Price Stability

Gvt sets the inflation target;

Monetary Policy Committee (MPC) of the BoE sets IR every month to achieve this target:

Target measure: CPITarget rate: 2%Target range: ± 1%

Task: The MPC’s Use of Data

• Read the Governor’s opening remarks from the February Inflation report press conference.

• Then complete the following:

Identify each factor / piece of data which the MPC takes into account when making its monthly decision on IR

Explain how each one affects inflationSee next slide for example…

Type of Data How it Affects the Price Level

“Jobs are being created at the quickest pace

since records began”(Paragraph 1)

If employment is rising then domestic spending is likely to be increasing; this will cause consumption, and hence AD, to rise. Consequently, there is a greater

pressure on UK inflation.

etc etc

etc etc

Add any other factors which you think the MPC would need to consider when deciding interest rates.

What does the MPC take into account when determining interest rates?

• General prospects for domestic economic growth• Level of consumer spending• Asset prices• The exchange rate• Global economic growth (affects ability to export goods)• Global inflation, particularly in commodities (affects import prices –

imported inflation)• Changes to government policy e.g. VAT• Availability of credit• Stability of global financial markets – affects business confidence as well

as bank willingness to lend• Level of spare capacity in the economy

Evaluation of Monetary Policy

• Read through ‘Evaluation of Monetary Policy’, then write six paragraphs evaluating UK monetary policy, using the prompts given at the end of the article

Quantitative Easing

• The injection of money into the economy, via the purchase of assets by the Bank of England, to change the quantity of money and hence alter inflation.

• Remember: MV = PT

“Inflation is always and everywhere a monetary phenomenon” – Milton Friedman

http://www.bankofengland.co.uk/education/inflation/qe/video.htm

Exam style questions

Typical questions regarding the MPC and its use of monetary policy:•“Assess the usefulness of the information provided in the extract to the MPC when making interest rate decisions” (e.g. June 2011)•“With reference to the extract, to what extent has monetary policy, as conducted by the Monetary Policy Committee, been a success?” (e.g. January 2011)

See question sheet.

Homework – SSP preparation

• Read through ‘Supply Side Policies in the UK’

• For each SSP:Write a brief three-point analysis (including one or two real world examples from the

article) on how the policy causes a rightward shift of the AS curve; and

Write a brief three-point evaluation, remembering to state, explain, then conclude