One of the most significant roles of a modern government is to ensure that the economy performs to its full capacity. The government has to consider the performance indicators like inflation, unemployment and economic growth and devise policies to achieve their aims. In this session we will consider the options that fall into the fiscal and monetary policy portfolio.

1. MANAGING THE
ECONOMY
GEOFF RILEY
ETON COLLEGE
Session 3
10:06:11 PM

2. 10/04/2014

3. Define Fiscal and Monetary Policy
You have 1 minute
Changes in taxation,
government spending and
borrowing to achieve
macroeconomic objectives
The manipulation of interest
rates, money supply and
exchange rates to achieve
macroeconomic objectives.
10:06:15 PM
AD = C + I + G + X - M

4. Building levels of response
• Knowledge and understanding – what are
fiscal and monetary policy?
• Application – how and when might active use
of these policies be helpful?
• Analysis – how do the policies work? How do
changes to policy lead to effects?
• Evaluation – do the policies always work well?
What might undermine their effectiveness?
10:06:19 PM

5. Application: Engine Failure
The UK economy is recovering from a deep recession,
mainly caused by falling aggregate demand
10:10:45 PM

6. 10/04/2014

7. Identify 2 reasons for falling AD from
the graph on the right
Investment
Private
Consumption
10:10:55 PM

8. Can you be
an analysis
machine?
Clearly show
the examiner
how causes can
lead to effects
10:11:09 PM

9. Explain how expansionary fiscal
policy affects aggregate demand
You have 3 minutes
10:11:22 PM

10. Increase in Consumption
• A reduction in direct or
indirect taxation can
leave households with
higher levels of
disposable income.
This could translate into
additional purchases.
• Lower taxation could
also generate additional
employment
opportunities.
10:11:44 PM

11. Increase in Investment
• Lower taxation might
prompt firms to
invest in expansion
• Lower taxation can
reduce leakages from
the circular flow of
income, increasing
the size of investment
multiplier effects
10:12:02 PM
UK corporation tax cut from 23%
to 21% in April 2014

12. Increase in Government Spending
• Higher government
spending directly
contributes to AD
• Government
spending also has
supply-side effects!
10:12:21 PM

13. Increase in Net Trade
• Government
support for
exporters might help
boost their
performance
• Lower corporation
tax might attract FDI
from businesses
who then export
from the UK
10:12:24 PM

14. Building up to a strong finish
• Knowledge and understanding – what is fiscal
policy?
• Application – how and when might active use
of fiscal policy be helpful?
• Analysis – how does the policy work? How do
causes (changes to policy) lead to effects?
• Evaluation – does the policy always work well?
What might undermine its effectiveness?
10:12:35 PM

15. To what extent is fiscal policy always
effective at achieving improved
macroeconomic performance?
You have 3 minutes
10:15:21 PM

16. Limits to the government’s fiscal choices
10:15:24 PM

17. 10/04/2014
Net Govt debt expected to peak at
more than 80% of GDP in 2016-17
Government spends
more than £1bn per
week in debt interest

18. Time
Lags
10:15:27 PM

19. Increased inequality
10:15:29 PM

20. Impact on
Confidence
and
Expectations
10:15:31 PM

21. Policy can be affected by
external events
10:15:33 PM

22. 10/04/2014
Since 1923, no country has lost as much wealth as Greece has
during last five years: - 27% of GDP has been lost

23. Evaluation: Taxation and Aggregate Supply
Work incentives /
active labour supply
Inward migration of
key workers
Capital investment
e.g. FDI projects
Enterprise /
Entrepreneurship
Human capital
spending
Tariffs affect import
costs

24. Evaluation: Taxation and Aggregate Supply
Work incentives /
active labour supply
Inward migration of
key workers
Capital investment
e.g. FDI projects
Enterprise /
Entrepreneurship
Human capital
spending
Tariffs affect import
costs

25. Evaluation: Taxation and Aggregate Supply
Work incentives /
active labour supply
Inward migration of
key workers
Capital investment
e.g. FDI projects
Enterprise /
Entrepreneurship
Human capital
spending
Tariffs affect import
costs

26. Evaluation: Taxation and Aggregate Supply
Work incentives /
active labour supply
Inward migration of
key workers
Capital investment
e.g. FDI projects
Enterprise /
Entrepreneurship
Human capital
spending
Tariffs affect import
costs

27. Evaluation: Taxation and Aggregate Supply
Work incentives /
active labour supply
Inward migration of
key workers
Capital investment
e.g. FDI projects
Enterprise /
Entrepreneurship
Human capital
spending
Tariffs affect import
costs

28. Evaluation: Taxation and Aggregate Supply
Work incentives /
active labour supply
Inward migration of
key workers
Capital investment
e.g. FDI projects
Enterprise /
Entrepreneurship
Human capital
spending
Tariffs affect import
costs

29. Monetary Policy
10:16:14 PM

30. Policy Interest Rates in the UK
10/04/2014

31. Interest Rates on Loans
A rise in interest rates increases the cost of paying back loans taken
out by consumers and businesses
In recent years
the average
mortgage
interest rate on
home loans has
fallen, but the
interest rate on
overdrafts and
credit cards has
actually
increased
towards 20%

32. Analyse the effects of tighter monetary policy
You have 3 minutes
10:16:34 PM

33. Impact on Consumption and Investment
• Higher interest rates are
likely to increase saving
and reduce borrowing,
leading to lower levels
of consumption overall.
• Higher rates of saving
might reduce multiplier
effects from injections
elsewhere – like
business investment.
• Higher interest rates are
a disincentive to invest,
since much investment
is financed through
borrowing.
10:16:55 PM

34. Impact on Net Trade
• The tightening effect of higher
interest rates tends to reduce
import demand.
• ‘Tighter’ money (less QE,
higher interest rates) might
increase demand for the £££.
If the value of the £££ rises,
that should mean lower
exports and more imports,
reducing AD.
10:16:57 PM

35. Building up to a strong finish
• Knowledge and understanding – what is
monetary policy?
• Application – how and when might active use
of monetary policy be helpful?
• Analysis – how does the policy work? How do
causes (changes to policy) lead to effects?
• Evaluation – does the policy always work well?
What might undermine its effectiveness?
10:17:59 PM

36. To what extent is monetary policy
always effective at achieving
improved performance in the UK
economy?
You have 3 minutes
10:18:17 PM

37. What really determines the level of saving?
10:18:18 PM

38. Do interest rates strongly influence
business investment?
10:18:30 PM

39. Are higher interest
rates enough to slow
house price increases,
and higher levels of
consumption?
10:18:38 PM

40. House Prices
10/04/2014
House prices in London
have risen by 18% in
the last year

41. Do interest rate
changes have a
significant effect on
the value of the £££?
Furthermore, do
changes in the £££
significantly influence
net trade?
10:19:03 PM

42. Sterling Exchange Rate
10/04/2014

43. And what impact do changes to AD
have on the economy anyway?
There’s a balancing act
here: does the economy
want, or need more AD?
What impact will more
or less AD have on the
broader economy?
The effect depends on the supply side
10:19:03 PM

44. Interest Rates and the Distribution of Income
Incomes of savers
• If the interest on savings is less than
inflation, savers will see a reduction in their real
incomes
Incomes of home-owners with mortgages
• If interest rates fall, the income of home-owners
who have variable-rate mortgages will increase
Interest rates on unsecured debt
• Lower interest rates on loans such as credit cards
and bank loans will fall
When interest rates fall, there is a re-distribution of income away
from lenders and savers towards borrowers with loans / debt

45. Some of the Recent Changes to UK Monetary Policy
• Quantitative Easing (QE) 2009 – buying bonds to
increase deposits and lending by the banking industry –
worth £375bn
• Funding for Lending Scheme (2012) – joint policy
between Treasury and the BoE which provides cheaper
funding to banks that increase their loans to households
and businesses
• Forward Guidance (2013-14) - under forward guidance,
the Bank’s policy rate will remain at 0.5% at least until
unemployment falls to 7% or until there are clear signs
that the amount of spare capacity in the economy has
reached normal levels

47. Show your Awareness in the Exam!
10/04/2014
Main BoE policy
interest rate 0.5%
Quantitative
easing £375bn
Household debt
155% of GDP
House prices rose
8% in 2013
Govt borrowing
£108bn in 2014-15
VAT remains at 20%
Corporation tax cut
to 21%
Lower employment
taxes for businesses

48. 10/04/2014
Twitter: @tutor2u_econ