(2015) A Level H2 Econs Essay Q5 Suggested Answer by Mr Eugene Toh (A Level Economics Tutor)

(2015) A Level H2 Econs Paper 2 Essay Q5

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5. During the recent world-wide recession many European countries choose low interest rates as a monetary policy approach rather than adopting demand-led fiscal policy stimulation. At the same time, with most of these countries’ governments introducing large cuts in government expenditure in order to reduce their budget deficits, a fiscal contraction actually resulted.

Discuss which policy approach is appropriate for a country during a world-wide recession. [25]

What happens during a world-wide recession

  1. During a worldwide recession, countries can suffer a fall in aggregate demand due to varying causes such as fall in consumer confidence resulting in fall in C, increased investors pessimism causing a fall in I, fall in (X-M) caused by falling trading partners’ incomes

  2. A fall in AD → Fall in real NY → lower economic growth

  3. As real output declines, firms also cut back in hiring of factor inputs such as labour → causing increased cyclical unemployment

Low interest rates as a monetary policy approach

Explain policy workings

  1. In times of economic recessions, Central Banks generally opt to carry out expansionary monetary policy

  2. This involves buying of government bonds through open market operations to increase the supply of loanable funds available → resulting in a fall in interest rates

  3. As interest rates fall → opportunity cost of spending decreases, consumers may find it cheaper to borrow to purchase large ticket items (like cars) → increase Consumption

  4. At lower interest rates, more investments also become profitable (according to MEI) → increase Investments

  5. An increase in C & I → increase AD → increase real NY → higher economic growth (and reduces cyclical unemployment)

Possible limitations

  1. After multiple rounds of interest rate cuts, a country can end up being in a liquidity trap where interest rates are already zero or close to zero. At this point, increasing money supply any further may serve little cause since interest rates cannot fall any further and thus there’s no further stimulation of C & I.

  2. If consumers & investors are pessimistic about economic prospects, C & I may be interest rates inelastic i.e. they do not respond significantly to interest rate cuts

Large cuts in government expenditure vs demand-led fiscal policy stimulation

Large cuts in government expenditure

  1. When faced with significant & persistent budget deficits, a country can face growing debt where interest repayments requirements increase over time and places a growing burden on future generations of taxpayers

  2. Thus, a government may opt to embark on fiscal austerity - which is to cut government expenditure and/or raise taxes in order to reduce the budget deficit

  3. Yet, the processes associated with fiscal austerity, which is to cut G & increase taxes - are akin to that of contractionary fiscal policy & can result in a fall in AD → fall in real NY resulting in fall in economic growth

Demand-led fiscal policy stimulation

  1. Conversely, what most countries actually do during a world-wide recession, would be to carry out expansionary fiscal policy, that is to

  2. Increase Government expenditure, for example through embarking on public infrastructure projects (building schools, highways, railway lines) or directly increase hiring → increase AD

  3. Or cut taxes

    1. Cutting personal income taxes → increases after tax disposable income → increase purchasing power → increase Consumption

    2. Cutting corporate income taxes → increases after tax profits → firms will increase Investments

  4. An increase in AD → increase real NY → higher economic growth (and lower cyclical unemployment

Which is most ideal?

  1. If a country is not experiencing any form of persistent budget deficit issues, it can opt to employ both expansionary fiscal & monetary policy to address negative impacts of a worldwide economic recession. The only potential problem to look out for is doing it too excessively may instead cause demand-pull inflation - which is what appears to be partly causing high inflation in many countries like U.S. in 2022

  2. Alternatively, a country facing persistent budget deficits can opt to simultaneously employ fiscal austerity to reduce the budget deficit and expansionary monetary policy to offset the fall in AD caused by the contractionary stance caused by a policy of fiscal austerity

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