Macroeconomic

Policy
Bellwork

– What is fiscal policy? What is monetary policy? What is one specific example of
each?
– Fiscal policy is the use of taxation and government spending to influence AD.
– A government might increase transfer payments or raise the rate of income
taxes.
– Monetary policy is the use of interest rates and the money supply along with
credit regulation and the exchange rate to influence AD.
– We might increase interest rates in order to reduce aggregate demand.
What are the Aims of Macroeconomic
Policy?
– Full Employment
– Low and Stable Inflation
– Balance of Payments Equilibrium
– Steady and Sustained Economic Growth
– Avoidance of exchange rate fluctuations
– Sustainable economic development
Fiscal policy

– Fiscal policy is manipulation of taxation and government spending in order

manage aggregate demand in order to achieve the government’s
macroeconomic aims.
– Any macroeconomic policy can be either reflationary (expansionary) policy or
deflationary (contractionary) policy. Expansionary refers to policies meant to
stimulate aggregate demand.
Bellwork

– What is the difference between discretionary fiscal policy and automatic

stabilizers?
– Pick an example of an automatic stabilizer. Using diagrams, explain how the
automatic stabilizer works and why.
Types of Fiscal Policy

– Broadly, there are two types: Discretionary policy and automatic stabilizers.
– When the government deliberately changes spending and taxation in order to
manipulate AD. Examples: Raising taxes on the highest income people, spending
less money on policing and hospitals, spending more money on tanks and
weapons and military equipment.
– Automatic stabilizers refer to laws and spending/taxation policies that are
constant and lead to changes in AD without a deliberate change from the
government. We set it up and then it automatically influences aggregate
demand without further input over time. Examples: Progressive taxation
system, temporary unemployment benefits.
Automatic Stabilizers

– In addition, aggregate demand can be

influenced by automatic stabilizers,
which work to reduce the size of
economic fluctuations.
– Since they operate automatically, they
are termed non-discretionary policy.
– Fiscal and monetary policies that attempt
to reduce the short-run fluctuations of
the business cycle, are called stabilization
policies, because they try to ‘stabilize’ the
economy.
How does this actually result in less
variation in AD?
– Let’s take the example of progressive taxation.
– Think about what happens when there is a negative shock to AD. (this means
there is natural variation in AD which results in a short run equilibrium output
which is too low compared to LRAS) What happens to each individual’s tax
burden if AD has fallen?
– Tax burdens will fall for some consumers and firms in the economy; they will be
knocked into lower tax brackets. The consumer loses income but regains some
of that lost income because they now pay a smaller tax rate as a direct result of
that lost income.
– The consumer loses some income from the fall in AD but regains some non 100%
portion of that lost income from moving to a lower tax rate.
– This means that some of that refunded income will be spent on C or I resulting in AD
recovering some (but never all) of its initial negative shock.
– What about if we go in the opposite direction? There is a positive shock to AD, how
does a progressive taxation system result in a reduction in the amount or magnitude of
that positive shock to AD? As incomes rise, some people get into higher tax brackets.
This means the average tax burden goes up and reduces disposable income by some
amount much less than the initial gain in disposable income from the positive shock to
AD. This results in some of the gained income being paid in taxes and thus reduces the
magnitude of the increase in AD.
Bellwork

– Explain what an automatic stabilizer is and use an AD/AS diagram (neoclassical

or Keynesian variant, both fine) to illustrate how it works step by step.
Automatic stabilizers are systems or policies that help to reduce fluctuations in
the economy through changes in government spending or taxes that occur in
response to those natural fluctuations in AD.
– What is “discretionary policy” and how is it different from automatic stabilizers?
How to unemployment benefits
work?
– IN COOL COUNTRIES, like the USA and China, unemployment benefits are temporary
and basically give the worker a % of their income for some fixed duration usually
between 6-18 months. You receive unemployment benefits if you lose your job
through no fault of your own; perhaps a workplace injury or the firm goes out of
business or the firm is making bad profits or there’ s macroeconomic downturn etc. If
you go punch your boss and get fired, you don’t get unemployment benefits.
– Layoff or Lay-off (noun or verb): When workers lose their jobs but it’s not b/c they did
something, it’s because the firm couldn’t afford to continue employing them or the
firm went out of business
– Fired/Firing: The worker loses their job and it was because they did something wrong.
– What is a reflationary fiscal measure?
A reducing interest rates
B increasing the money supply
C increasing taxes
D increasing government spending
– Why is it more effective to increase regressive taxes rather than progressive
taxes when pursuing a deflationary fiscal policy?
– A Changes in VAT have minimal effect on consumers’ spending.
– B It is much more unfair to increase progressive taxes.
– C Many workers reduce the hours they work when income taxes are raised.
– D Low income households spend a larger proportion of their incomes.
– What is most likely to be increased by a policy of increased direct taxes and
lower government spending?
A the balance of payments deficit
B the budget deficit
C the rate of inflation
D the level of unemployment
Bellwork

– 1. If a government reduces it’s budget deficit, what kind of fiscal policy has it
engaged in?
– Contractionary fiscal policy, this could be higher direct taxes or less spending
on public schools or unemployment benefits.
– 2. How does a government actually spend more money than it collects in
taxes? What future costs may this have? By borrowing. Government issues
bonds （国债） and investors will buy them. Governments use the money
from the bond sale to finance government spending. The future costs are the
interest payments on this debt which need to be funded with tax dollars that
could have been used for something else.
The Budget Position

– Every year, the government has a

budget which states all intended
fiscal policy; how much tax
revenue are we likely to earn,
how much will we spend, and
what will we spend it on?

Budget Puzzle: You Fix t

he Budget
– A government budget is a type of plan of a country’s tax revenues and expenditures over a
period of time (usually a year).
– If the tax revenues are equal to government expenditures over that period, the government is
said to have a balanced budget.
– If expenditures are larger than tax revenue, there is a budget deficit; if expenditures are smaller
than tax revenues, there is a budget surplus. When there is a budget deficit, the government
finances (pays for) the excess of expenditures over revenues by borrowing.
Deficits

– Cyclical deficit: A deficit occurring because of increased spending from

stabilizers. EX: In a time period of high recession, more people must collect
unemployment benefits. Without the government taking any action, G
increases because of more payouts to the unemployed. In essence, the deficit is
caused by changes in economic activity.
– A structural budget deficit is caused by the government voluntarily and more
acutely chooses to outspend it’s earnings.
4. Explain the relationship between budget deficits/ surpluses and the
public (government) debt.
4. Explain the relationship between budget deficits/ surpluses and the
public (government) debt.
Net Interest on Debt

– A lot of national debt is done through international

investors. The main holder of American debt are Chinese
institutional investors and central banks. America is also
owed debt by China and other country’s who’s debt
Americans have purchased. NET interest on debt would be
the interest our government pays on debts it owes to
everyone minus the interest payments American investors
receive for holding foreign bonds.
– What do governments need to do to allow automatic stabilisers to work?
A adjust taxes in order to achieve a balanced budget
B keep welfare benefit rates and tax rates unchanged
C lower both taxes and government expenditure in a slump
D lower taxes in a boom and raise taxes in a slump
– A government responds to cyclical fluctuations in output by keeping tax rates
and benefit rates unchanged. What is the government seeking to achieve by
adopting this fiscal policy?
– A to allow automatic stabilisers to work
– B to keep output at the full employment level
– C to maintain a constant balanced budget
– D to ensure that its budget is in surplus over the trade cycle
– How do automatic stabilisers work?
A by reducing government deficits in times of recession
B by reducing fluctuations in disposable income
C by reducing fluctuations in the exchange rate
D by increasing the size of the investment multiplier
What does a government need to do to maintain a balanced budget?
– A keep tax rates and benefit rates unchanged in a slump
– B raise taxes in a slump and lower taxes in a boom
– C raise both tax rates and benefit rates in a boom
– D raise both tax rates and benefit rates in a slump
– Other things being equal, what will result in a decrease in aggregate demand?

A a decrease in interest rates

B a decrease in the balance of trade deficit
C a decrease in the government’s budget deficit
D a decrease in the household saving ratio
AD= C + I +G + (Export Revenue-Import Spending)
Monetary Policy

– These are policies used by central banks in order to influence aggregate

demand (and occasionally LRAS, but control over this is somewhat limited).
There are three broad ways that central banks can influence AD; changes in
interest rates, the money supply (often through the interest rate), and the
exchange rate (for fixed+managed float).
How does the central bank increase
the money supply?
How does the central bank actually
increase the money supply?
– The central bank can influence the money supply by modifying reserve
requirements, which generally refer to the amount of funds banks must hold
against deposits in bank accounts.
– Raising reserve requirements decreases the money supply, and lowering
reserve requirements increases the money supply.
– Liquidity ratio
– This means that if an American commercial bank handles 124 million dollars
worth of deposits or more, it must hold at least 10% of these deposits as cash.
– 14.5% for large banks and 12.5% for smaller banks in China as of January 2019.
– What do they do with the rest?
01/07/2020 Bellwork

– How can automatic stabilizers cause a government budget deficit?

How does the central bank raise or
lower interest rates?
– Through reserve requirements mentioned above, but also through buying and selling
government securities from member banks.
– Commercial banks all hold some amount of gov’t debt (bonds). If the central bank wants
to increase interest rates (what influence does this have on AD?), they will SELL
government bonds to commercial banks. Commercial banks have less cash on hand and
thus lend more carefully and at higher interest rates.
– If the central bank wants to LOWER interest rates, they can BUY government bonds;
giving commercial banks cash for bonds allows the commercial banks to lend out more
money at lower interest rates.
– When the bank has more cash, they lend out at lower interest rates. When commercial
banks have less cash, they lend out at higher interest rates.
– What exactly is a bond? It’s a type of debt.
– Instead of applying for a loan, a really large institution might sell bonds. This includes
governments (national and local) as well as corporations and larger businesses.
– Bonds are typically denoted in $1000 increments, ex: 1 bond = $1000.
– When somebody buys a bond, what do they get? They get a guaranteed fixed interest
payment every month or every year. In addition to that, they also get back their initial
price of the bond at the end of the bond. Each bond has a specific number of years.
– Example: If a buy a 10 year government bond which pays 2% interest annually and it
costs $1000, then I receive a $20 interest payment every single year for 10 years AND
at the end of ten years I also get back my initial $1000.
– Bonds can actually be traded after you buy them. Their prices do vary with
current interest rates. Remember that the interest rate of the bond was fixed at
the start.
– A bond that initially cost $1000 might sell for considerably less in 2 years
because 2 years of interest payments might have already passed.
– If I buy a bond on a secondary market, I am buying the rights to the interest
payments and the repayment of the initial amount.
– There’s a huge secondary market for gov’t bonds and there are equilibrium
prices for bonds of different durations and different interest rates.
– When the central bank wants to buy bonds from commercial banks in order to lower interest rates,
what price do you think they will pay for these bonds? Will they pay higher or lower than the price
on the secondary market? The central bank will give a LARGER amount of money for the bonds than
the market price when they want to do this in order to guarantee the desired result for the interest
rate.
– For example, perhaps a commercial bank could sell the 10 year bond on financial markets for $970. If
this is the going market price, when the central bank wants to lower interest rates, they will maybe
pay $975.
– Since the bond trades on financial markets for $970, the bank will ALWAYS sell for any price >970
because even if they want to keep the interest payments from the bond, they can just sell at $975
and buy at 970 until the market price of the bond reaches 975 from more demand. This is called
“arbitrage”, where I buy something in one market for a lower price and then resell it for a higher
price at the same time in another market.
Fiscal and Monetary Policy: Time
Lags
– In reality, collecting economic data is a very intense process that requires lots of
labor.
– The data regarding things like GDP, unemployment, and inflation is often
subject to further revision after it’s initial collection, processing, and
publication.
– Essentially, this means we cannot even identify what economic problems we are
even actually facing in “real-time”, only looking backward.
– There is therefore a “time lag” between when a macroeconomic problem
occurs and when it is actually identified.
– Identification lag
Fiscal and Monetary Policy: Time
Lags
– There is an additional time lag: Once the actual problem is identified, can new
laws or policies immediately be created to address the problem? No, it will take
a lot of debate, disagreement, and careful analysis. If we are dealing with fiscal
policy, we must also consider the length of time required by the legislative
process (the process by which new laws are made). This is generally less of a
concern for monetary policy in countries where the central bank maintains
some autonomy, but even central banks cannot make policies instantaneously.
Fiscal and Monetary Policy: Time
Lags
– Once the problem has been identified and a new policy or policies for
addressing the policy have been created and agreed upon, we have a third time
lag to deal with. How long until the policy starts to actually have the desired
impact? Will lowering interest rates result in more spending and more jobs
tomorrow? No, it will very likely take a fairly long time. This is a concern for
both monetary and fiscal policy; we won’t see changes in AD immediately from
a change in taxation or spending policy, it will happen gradually, not instantly.
– This is MORE of a concern for monetary policy though, which will experience a
longer time lag between the time a policy is implemented and the desired
effects actually occur.
Types of Time Lags

– 1. Identification Lag: How long it takes to correctly identify the macroeconomic

problem (inflation, unemployment, gdp too low/too high, balance of payments
deficit/surplus etc)
– 2. Policy lag: How long it takes to actually create a new policy to address the
problem.
– 3. Implementation lag: How long after the new policy is passed or implemented
does it take to have its desired effect.
– Fiscal policy: 6-24 months before we accomplish our goal, monetary policy, 18-
48 months. Supply side policy 1-20 years.
Fiscal and Monetary Policy: Time
Lags
– Recall back to the FRED data for quarterly GDP change in USA from 1949-2019.
Given the very long length of time between when a macroeconomic problem
occurs and when the effects of a policy actually go into effect, and given that AD
is independently random, we have great possibility for policies to do more harm
than good as the problems they were meant to correct may have disappeared
and even reversed by the time the policy designed to address the original
problem has palpable effects.
Fiscal and Monetary Policy: Time
Lags
– This is overall a strong argument in favor of a non-interventionist policy in which
governments and central banks should mostly do nothing but set up automatic
stabilizers and engage in discretionary policy in the case of absolute
emergencies only.
Bellwork 01-08-2020

– Explain why governments may choose to rely more on automatic stabilizers than
discretionary policy in dealing with short run GDP/inflation/unemployment fluctuations. (3
sentences, 5 minutes)
– Because aggregate demand is fundamentally random and subject to frequent change, and
because discretionary fiscal policy is subject to multiple time lags, any potential
discretionary policy may affect the desired change very far in the future well after aggregate
demand has already changed in the opposite direction. It takes a long time to identify
disequilibria and enact new discretionary policy, and because of the speed at which AD can
independently shift, it may be too late once the discretionary policy actually has the
originally desired impact. This is not a problem with automatic stabilizers; in response to a
given shock to AD, they will “automatically” and relatively quickly produce the desired
change to offset the aforementioned shock to AD.
The monetary authorities increase interest rates in order to control inflation. What
is likely to increase as a result of this?
– A firms' sales revenue
– B investment expenditure
– C net capital outflows
– D the exchange rate
– Which combination of policy measures is most likely to reduce unemployment?
A lowering both the exchange rate and domestic interest rates
B lowering the exchange rate and increasing direct taxation
C raising both the exchange rate and domestic interest rates
D raising both the exchange rate and direct taxation
Supply Side Policies

– Policies designed to increase (long run) aggregate supply. Though usually fiscal,
monetary supply side policy is possible.
– Examples include reduced corporate tax, cutting income taxes, reducing welfare
payments, increasing spending on education and training, spending more on
public infrastructure, deregulation, privatization, or reform of labor/labor union
laws.
– Why can each of these result in growth in LRAS?
More supply side policies

– Widespread subsidies for key industries might reduce the cost of production to
an extent sufficient to lower the cost of production across the economy.
– Lower interest rates will result in more borrowing from firms who will then
invest in more capital/technology, which is what drives growth in LRAS.
– What would be classified as a supply side policy measure?
– A additional legislation to restrict the power of trade unions
– B a reduction in the government’s fiscal deficit
– C an open market sale of securities
– D the imposition of a tariff on imported goods
01/10/2020 Bellwork AS Economics

– As a supply side policy, a government increases

spending on education and training programs.
Using diagrams, explain both the short and long
run effects.
– What is meant by expenditure switching policy?
What is meant by expenditure dampening policy?
Bellwork Answer

– Long Run: LRAS, but NOT SRAS will shift to the right to reflect the increase in
productivity brought about by the increase in spending on education and
training, which should improve human capital and make workers more efficient.
SRAS does not change because it takes a long time for the increase in spending
on education and training to actually result in more productivity.
– Short run: AD will shift to the right to reflect the increase in government
spending.
Asymmetric information

– Asymmetric information refers to any situation where one party to a

transaction has more information than the other party.
– A homeowner selling their house maybe knows more about the house than
the buyer. It may have structural flaws or a termite infestation
Asymmetric Information: Moral
Hazard
– In a moral hazard situation, one party entering into the agreement provides
deliberately incorrect information to mislead the other party or changes their
behavior after the agreement has been made because they believe that they
won't face any consequences for their actions. When a person or entity can
transfer the negative risks of their actions to someone else, they often behave
much more riskily. A fund manager might invest other people’s money in a much
riskier way trying to chase higher returns knowing that he won’t lose his personal
money (although he may lose his job)
– This can occur in the financial industry in contracts between a borrower and
a lender. Maybe a lender provides false information in order to be deemed more
credit worthy to get better terms for a loan
Other moral hazard examples

– A motorcycle driver without insurance might drive very carefully. He knows that he
will pay his own hospital bills if there is an accident, so he is very cautious on the road.
– After purchasing insurance, his behaviour changes completely. He drives recklessly
knowing that the implicit and explicit costs of being in an accident are now lower
– A man who wants to marry a woman may treat her extremely well while they are first
dating. He buys her gifts, remembers anniversaries, and prioritizes her over his male
friends. After they are married, however, he starts gambling/drinking and hanging out
with his male friends more and treats her much worse (or we could reverse the
genders, especially in the west)
– “Too big to fail” in banking
– “Too big to fail” in banking
Banks in the financial crisis from 2006-2008 were perhaps subconsciously aware
that they were so central to the global financial system that if they failed it would
cause severe economic collapse. They could then predict that if they were to fail,
the government would “bail them out”, or in other words use tons of tax dollars to
compensate any lost profits and keep them in operation. They can’t actually fail
because the government will rescue them. Knowing they can’t actually fail changes
their behaviour and makes them take on more risk.
Adverse Selection

– For example, assume there are two sets of people in the population: those
who smoke and do not exercise, and those who do not smoke and who
exercise. It is common knowledge that those who smoke and don't exercise
have shorter life expectancies than those who don't smoke and choose to
exercise. Suppose there are two individuals who are looking to buy life
insurance, one who smokes and does not exercise, and one who doesn't
smoke and exercises daily. The insurance company, without further
information, cannot differentiate between the individual who smokes and
doesn't exercise and the other person.
– The insurance company asks the individuals to fill out questionnaires to
identify themselves. However, the individual that smokes and doesn't exercise
knows that by answering truthfully, they will incur higher insurance
premiums. This individual decides to lie and says they don't smoke and
exercises daily. This leads to adverse selection; the life insurance company will
charge the same premium to both individuals. However, insurance is more
valuable to the non-exercising smoker than the exercising non-smoker. The
non-exercising smoker will require more health insurance and will ultimately
benefit from the lower premium.
– Other examples of adverse selection include the marketplace for used cars,
where the seller may know more about a vehicle's defects and charge the
buyer more than the car is worth
Policies to correct BOP disequilibria

– Expenditure Switching policies: an action taken by government to

induce consumers both at home and abroad to buy our country’s
goods (“our” being the government passing the legislation)
– Expenditure dampening (reducing) policies. These are designed to
reduce the total level of spending in an economy; this will
hypothetically reduce spending on imports more than those on
exports.
– Either of these may be pursued via fiscal or monetary policy.
Bellwork 01/14/2020

– What are the differences between switching and dampening policies to resolve
a current account deficit.
– Explain by what mechanism devaluation acts as a switching policy
– Explain how increasing interest rates acts as a dampening policy.
Fiscal Policy options to correct BOP:
Expenditure Dampening
– If a country has a deficit on the current account, it can
use an increase in income taxes or reduce government
spending. An increase in income taxes will reduce
disposable income. We assume that YED of imports will
be relatively more elastic than for that of domestically
produced goods if using expenditure dampening policies
in the first place.
Fiscal Policy options to correct BOP:
Expenditure Dampening
– Another way that dampening policies create positive movement in the current
account is by encouraging firms to export instead of sell domestically.
– With less income and thus reduced AD, price levels are lower domestically. As a
result, firms can hypothetically earn more money selling the same outputs
abroad. So in response to the fall in domestic purchasing power, firms attempt
to sell more of their outputs abroad instead of domestically.
Which policy would reduce a balance of payments
deficit on the current account in the short run?
A a reduction in government subsidies to exporters
B a reduction in the rate of interest
C a rise in direct taxation
D incentives to attract foreign capital
To reduce a deficit on the current account of the balance of payments, a
government imposes a limit on the foreign exchange its people and firms can
purchase. Why may this increase the country’s inflation rate?
A Firms may have to purchase more expensive, domestically-produced raw
materials.
B Firms may have to sell more of their output on the domestic market.
C The change in demand for foreign currency on the foreign exchange market may
lead to an appreciation in the exchange rate.
D The change in supply of the domestic currency on the foreign exchange market
may reduce the money supply in the domestic economy.
Fiscal Policy options to correct BOP:
Expenditure Switching
– To encourage domestic consumers and firms to buy domestic products,
government might engage in some sort of protectionist policy (a tariff or quota,
for instance).This is more likely to work when there’s a relatively high quality
domestically produced substitute.
– A subsidy might serve the same purpose with the added benefit of encouraging
consumers abroad to buy our domestically produced good.
– Manipulating exchange rate (depreciation if mlc holds) in order to encourage
people to buy our exports and encourage domestic consumers to buy
domestically produced goods instead of imports is also a switching policy.
5. What is an expenditure-switching policy
measure?
A decreasing income tax
B decreasing the money supply
C devaluing the currency
D increasing government spending
– Which component of its current account balance will be made less favourable
as a direct result of a decision by the central bank to increase interest rates?
A net investment income
B net current transfers
C the balance of trade in goods
D the balance of trade in services
 In an attempt to correct a balance of trade deficit the government of Indonesia
has decided to employ expenditure-dampening methods. Which policy would best
fit this description?
– A introducing quotas on imported goods
– B raising income tax rates
– C subsidising home-produced goods
– D taxing imported goods
Bellwork 01/10/2020

– Why might a government want to avoid the use of expenditure switching policy
if they are currently facing high rates of inflation coming from demand-pull
factors?
Bellwork 1/13/2020

– What are some weaknesses of using fiscal policy as a method of correcting a

balance of payments current account deficit? Why do we NOT want to do
reductions in government spending, increases in direct taxation, protection, or
subsidization of importing/exporting industries?
Is fiscal policy effective for managing
a current account deficit?
– In the short run, yes, but generally poor in the long run. These policy measures
often have a fixed duration, and once they are discontinued it’s likely that the
same consumer behavior that lead to a deficit will re-emerge.
– Raising taxes has obvious adverse effects.
– Imposing tariffs on other countries involves the risk of retaliation as well as
relieves the pressure on domestic firms to operate efficiently.
Monetary Policy for correcting the
BOP
– Reducing the money supply can be used as either an expenditure damping or
switching measure. Changing the interest rate to influence the current account
is somewhat complex where either a rise or a fall in the interest rate may have
the desired effect on the current account.
– As an expenditure switching policy: If a country has current account deficit, a
reduction in interest rates may result in depreciation (why?). This may then
result in the familiar process of more export sales and less import spending,
subject to MLC from last chapter.
Monetary Policy and BOP

– A HIGHER interest rate might paradoxically also reverse a current account

deficit, acting this time as expenditure dampening policy rather than switching.
Spending falls overall because of higher interest rates, but falls more heavily for
(likely elastic) imports, resulting in higher NX.
Bellwork 1/14/2020

– Explain how monetary policy can be used to correct a balance of payments

current account deficit.
– What are some general weaknesses of monetary policy for correcting a BOP
deficit?
– Decreasing the interest rate acts as expenditure
switching policy. If our interest rate falls, this
causes devaluation for two reasons. Inflation goes
up due to the increase in price levels from the
increase in AD
– Inflation causes depreciation for three reasons:
– 1. As our currency inflates, input prices also go up. Faced with higher input prices,
exporting firms charge MORE for their outputs abroad. If MLC is met, this means
less export revenue as our goods become less competitive abroad, prompting
overseas consumers to purchase fewer units of our currency.
– 2. Import prices do not immediately react to the increase in price levels. So
domestic consumers switch to buying imports, thus raising demand for foreign
currency.
– 3. Higher inflation rate means less attractive financial investments because real
interest rates are reduced by the inflation rate.
– Why else do lower interest rates result in depreciation: A lower interest rate
means less money coming into our financial account; nobody wants to buy our
stocks/bonds/savings accounts when our interest rates are lower.
– Both decreasing interest rates and devaluation ultimately cause depreciation.
Why does this result in positive current account movement? Because if MLC is
met, then when our currency becomes cheaper; this results in relatively more
export revenue because exports themselves are cheaper and relatively elastic.
Simultaneously, import spending falls because effective price is more expensive
and it is relatively elastic thus spending falls.
Bellwork

– What are the weaknesses of using monetary policy to correct a current account
deficit?
Weaknesses of using monetary policy
to correct BOP.
– It can be very hard to reduce the money supply in practice; commercial banks
make their profit through lending and will always seek to do so despite central
bank actions (this is a claim made in your textbook, but we can find many
examples where this is objectively untrue)
– Interest rate changes suffer from the problem of time lags. Changes in interest
rates will take a long time to actually influence their desired variables, around
18 months for AD, much longer for LRAS.
Weaknesses of using monetary policy
to correct BOP.
– Higher interest rates create problems with unemployment and economic
growth. Lower interest rates may create or worsen inflation.
– With the increasingly globalized world, lowering interest rates to something
significantly different from geographically near countries may just result in
many consumers investing abroad instead of engaging in more consumption
spending.
Sample Essay Question

– PYP book page 13

2013 Nov Q.4

(a) Explain, with the help of a diagram, how a policy of
expenditure dampening in an economy would affect aggregate
demand, prices and output in that economy. [8]
(b) Discuss whether a policy of expenditure switching is more
appropriate than a policy of expenditure dampening in an
economy with a large balance of payments current account
deficit and a high rate of inflation. [12]
(a) Explain the difference between fiscal policy and
monetary policy. Show how each can be used to
increase aggregate demand. [8]
(b) Discuss whether supply side policy is more likely
to be successful than fiscal policy when an economy
is faced with inflation. [12]
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– 1. How does inflation cause depreciation? (3 ways)

– 2. How exactly are dampening policies different from switching policies in terms
of the way they influence the current account balance?