Paper 2 Essay Plans
Expansionary Demand Side Policies:
Expansionary Fiscal Policy:
Intro: Fiscal policy is the manipulation of government spending, borrowing and taxation
which aims to influence aggregate demand to stimulate growth and boost the economy.
P1 : Government spending:
Point:
The UK government attempted to boost the economy through large amounts of
government spending and borrowing in order to achieve economic growth.
After the recession the UK increased their government spending by investing £3
Billion into capital.
Cause:
Capital Spending is where the government spend money on public goods that don’t
need renewing in the short term (shifting LRAS curve rightwards).
This was very important as unemployment sky rocketed after 2008 from 5% to 8% in
early 2009.
This investment into infrastructure projects meant that in the short term, AD shifts
to the right and hence output and so employment increased, as more workers are
needed to provide goods and services at this higher output, easing the issue of a rise
in unemployment.
Consequence:
Furthermore, due to this rise in employment, more people would have disposable
incomes from being employed and so consumption in the economy would increase,
which is an effect of the multiplier of an injection of government spending into the
circular flow of income.
In the long run it would also mean that the productive capacity of the economy
increased due to better transport and capital, perhaps meaning that further
expansionary fiscal policy could occur without inflationary pressure.
Evaluation:
However, this government spending was financed through government borrowing,
and this could lead to crowding out of the private sector.
This is where the government borrows excessively to finance its investment projects,
and so the supply of loanable funds decreases and their demand increases.
This leads to higher interest rates on the loans and investment from private firms
may be reduced due to this, hence employment may not actually increase as much
as predicted, meaning the unemployment issue could be still an issue.
Furthermore, there is no guarantee that capital spending will work, and it may be
assumed a short term policy, yet there is a significant time lag associated with capital
spending. This takes time and effort as capital tends to be rather inflexible and
infrastructure takes a long time to build. And so it may not have the direct impact on
AD as expected.
P2: Cut in taxation:
, Point:
After the UK suffered an annual economic growth of -6.7% in early 2009, the
government decided to cut VAT from 17.5% to 15% and reduce the top band of
income tax from 50% to 45%. Aimed to boost AD after low consumer confidence.
Cause:
A decrease in a tax such as VAT, a tax on expenditure, would see everyone
disposable incomes rise, as the cost for goods and services would decrease.
Furthermore an increase in peoples incomes due to less tax would further increase
incentives to spend.
Consequence:
Therefore this lead to a large increase in consumption due to this boost in disposable
incomes and consumer confidence as people felt it was time to spend on bigger
things due to lower prices, seeing a large increase in their consumer surplus.
Also attracted FDI, raising value of pound as more demand for it.
Consumption being the largest component of AD lead to a £2.1 billion of retail
turnover.
Overall this cut in VAT and income tax lead to a great boost in economic growth and
lead to increased output.
Evaluation:
This cut may appear strong however, this cut was made during a period of very slow
economic growth and low consumer confidence.
Therefore the multiplier may have been weak and so there may have been less
spending within the economy than expected leading to lower growth than predicted.
Furthermore, a cut in tax had a very negative impact on the budget deficit, as
spending rose much faster than tax revenues.
Therefore, after the government saw government spending rise due to automatic
stabilisers, such as an increase in unemployment benefits , the budget deficit
reached 12% of GDP.
This could have been an issue for the long run as if it became uncontrollable it could
lead to austerity measures, which it did in 2010 under David Cameron’s government
which only lead to less economic growth and many investors may have seen this
large budget deficit as a deterrent.
Conclusion:
However, these two policies were effective in stimulating economic growth. A cut in
taxes and increase in capital spending helped stimulate the economy after a difficult
period and were the very much needed boost and injection into a depressed
economy. Although the budget deficit rose, these policies were seen as a necessity
in achieving economic growth, and lead to 2.9% growth in 2014.
Expansionary Monetary Policy:
, Intro: Monetary Policy is the process by which a central bank changes the money supply and
manipulates interest rates in order to stimulate aggregate demand leading to economic
growth.
P1: Point – Quantitative Easing:
Point:
QE was introduced by the Central bank to stimulate growth, and used to pump
money directly into economy. £375 Billion of QE.
Cause:
BoE buys assets in form of government bonds using money it has created.
It buys them off the private sector to increase the supply of money, increasing
liquidity.
Encouraging more lending amongst banker in particular.
The demand for these bonds increase -> so do their prices -> meaning that the bond
yields fall -> This has the effect of lowering IR.
Banks have now greater incentive to lend and boosts: investment, spending and
growth.
Consequences:
Raised consumer confidence in economy and stimulated banks to loan again after
recession -> Higher consumption and investment in economy -> Higher output and
employment.
Evaluation:
As QE is a new policy there may be unintended effects that we are not aware yet
and so uncertainty lies underneath its effectiveness.
If increase money supply too quickly -> inflation -> Depends on spare capacity in UK
if operating near FE then injection only leads to inflation -> Inflation not only rises
prices for consumers, but makes UK internationally uncompetitive -> Lowers value
of pound -> increase price of imports -> higher prices -> low growth.
P2: Cut in IR:
BoE sets Base rate, above this rate is the rate commercial banks lend to each other.
Point:
BoE slashed IR from 5% to 0.5% to boost economic growth.
Cause:
Lower IR -> lower cost of borrowing -> makes investment projects more profitable ->
greater incentive to spend/invest -> disincentivises saving as less reward for saving
-> encourage more borrowing and investment.
Consequences:
More consumption and investment as people spend money on goods with a high
proportion of their income as expectations rise of economy and goods are bought
on credit, and with a lower IR it is much cheaper to purchase these goods.
-> boost revenues for firms -> increased incomes -> greater disposable incomes, due
to lower mortgage repayments(70% of mortgage rates are variable) (which take up
a large proportion of income of low income earners) -> increased house prices ->
positive wealth effect -> high consumer confidence -> output and employment ->
economic growth.
