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The great recession

By on May 16, 2013 in economics

The great recession refers to the period of economic downturn between 2008 and 2013. The recession began after the 2007/08 global credit crunch and has led to a prolonged period of low growth and rising unemployment. In particular, the great recession highlighted problems within the Eurozone and, unlike the US, Europe has experienced a double dip recession.

The main causes of the great recession involve:

  1. Credit crunch and fall in bank lending.
  2. Fall in confidence resulting from the financial instability.
  3. Fall in exports from global recession
  4. Collapse in housing markets leading to negative wealth effects.
  5. Fiscal austerity compounding the initial fall in GDP.
  6. In Europe, the single currency created additional problems because of over-valued exchange rates, and high bond yields.

great recession

Source: Eurostat

The primary cause of the great recession was the credit bubble of 2001-2007 and the resulting global credit crunch (2007-08). This is a short background to why bad debts in the US housing market had such a big effect on economies in US and Europe.

Causes of credit crunch

  1. The period 2000-2007 was a time of strong economic growth, low inflation and falling unemployment. Central Banks appeared to be successful in targeting low inflation and ensuring economic stability. However, underneath the macro-economic stability, there were increasing problems, which only became fully apparent later.
  2. Housing bubble. Many countries experienced a rapid growth in house prices. House price rose faster than inflation and faster than incomes. This boom in housing was encouraged by a growth in bank lending and high confidence. Several countries, such as Ireland and Spain also experienced a boom in  house building.
  3. Bad loans. In the period leading up to the credit crunch, banks became more aggressive and willing to take risks in lending. Especially in America, banks and mortgage companies loosened their criteria for giving mortgages. Many homeowners were given large mortgages, with limited checks on their ability to repay.
  4. Bad loans repacked and resold. These ‘bad’ mortgage loans were sold onto other financial institutions around the world. For example, many UK and European banks bought these mortgage bundles from the US (CDOs) and so were exposed to any potential losses in the US housing market.
  5. Housing Bubble Burst. In 2006, the US housing market bubble burst. House prices started to fall, and there was a rise in mortgage defaults. Banks started to realise they had lost significant sums of money through the US mortgage defaults.
  6. The scale of bank losses started to increase and it became more difficult for banks to borrow money on money markets. This caused banks to reduce loans and mortgages. Because banks were losing money, it became very difficult to get credit and liquidity. Some banks lost so much, they were running out of money. In several countries, such as UK, Ireland and US, major banks had to be bailed out by the government. But, the realisation banks were short of liquidity harmed consumer and investor confidence. The fall in confidence led to lower spending and investment.

The role of the credit crunch and recession

  • In 2008, all major economies experienced a very sharp drop in real GDP. The banking crisis severely curtailed normal bank lending. The result was a fall in investment and consumer spending leading to a sharp drop in real GDP.
  • The fall in house prices was another factor leading to recession. In the boom years, rising house prices (and wealth) underpinned higher consumer spending. When house prices dropped, many homeowners faced negative equity. Therefore, they cut back on spending and could no longer rely on re-mortgaging to gain equity withdrawal.
  • The global nature of the crisis meant that there was also a drop in world trade. Countries, saw a drop in exports as the global downturn led to lower demand.
  • In 2008, there was also a peak in oil prices. This complicated matters because it caused cost-push inflation. This cost-push inflation made Central Banks more reluctant to cut interest rates. Also, higher oil prices reduced discretionary income and led to lower spending. Usually in a recession, oil prices fall. However, because of rising demand in China and India, we saw rising oil prices – even as Europe and the US went into recession. High oil and commodity prices were another factor reducing demand.

Response to the great recession

  • Firstly, governments felt obliged to intervene in the banking sector to avoid banks and financial institutions going bust. However, there was some reluctance to bailout those who were blamed for causing the crisis. In 2008, the US decided to allow Lehman Brothers to go bust. This caused a major loss of confidence. After the panic this created, governments realised they couldn’t allow a repeat of this experience. In the UK, some argue the government were slow to bailout the banks. Though the intervention was sufficient to protect the fundamentals of the banking system.
  • Cuts in interest rates. Towards the latter half of 2008 and early 2009, Central Banks cut interest rates to record low levels. The UK cut base rates from 5% to 0.5%. Usually, a major cut in interest rates would make borrowing cheaper and encourage consumption and investment. (e.g. in 1992, when the UK cut interest rates, the economy recovered fairly quickly.)
  • Expansionary fiscal policy. The deep recession saw a sharp rise in budget deficits because government tax revenues evaporated. This was particularly damaging for countries who relied on stamp duty and tax from the finance sector. However, in the UK and US, there was a moderate degree of fiscal expansion. The UK introduced a temporary cut in VAT. In the US, there was also a moderate fiscal stimulus.
  • It is worth noting that in comparison to the great depression of the 1930s, two things were avoided in the great recession.
  • Large number of banks going bankrupt was avoided (In US, over 500 commercial banks went bankrupt)
  • There was no major trade war. In the 1930s, a tariff war developed as countries tried to protect domestic industries.

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How successful have Central Banks been in managing the economy?

By on May 14, 2013 in economics

Back in February 2007, I wrote an essay – Evaluate the effectiveness of the MPC in controlling inflation.

The last line was:

MPC have done a good job so far. However the real test may come when there is a rise in structural inflation or global instability.

Given the knowledge of the past five years, how should we update this post,?

1. Central Banks should target inflation and growth

In 2007, I wrote The MPC are responsible for setting interest rates and determining UK monetary policy. They seek to keep inflation close to the government’s target of CPI 2% +/-1 %

But, we should start by adding the full remit of the MPC. In their Monetary policy framework, the Bank of England state, their full responsibility is to:

The Bank’s monetary policy objective is to deliver price stability – low inflation – and, subject to that, to support the Government’s economic objectives including those for growth and employment.

By contrast, the ECB seem to give less importance to economic growth, and seem primarily concerned with low inflation.

“The primary objective of the ECB’s monetary policy is to maintain price stability. The ECB aims at inflation rates of below, but close to, 2% over the medium term.”

From: ECB Monetary Policy

A valid criticism of the ECB during the economic crisis has been the fact they have placed too much emphasis on targeting low inflation. For example, the ECB increased interest rates in 2011, even though the European economy was entering a double dip recession. The ECB have been unwilling / unable to consider more unorthodox monetary tools to boost economic growth.

EU inflation

Euro area inflation

From a narrow perspective of keeping inflation close to the target, the ECB have been quite successful. Eurozone inflation is currently 1.7% and is below the target. However, this period has been very disappointing in terms of economic growth. The EU has entered into a double dip recession. If the ECB had given greater importance to economic recovery and willing to tolerate higher short term cost-push inflation, the EU could conceivably have avoided the double dip recession and done more to reduce the record levels of EU unemployment.

  • In evaluation, you could argue that even if the ECB had kept interest rates close to zero, that alone may not have been enough to avoid a double dip recession anyway. However, base rates should not be the only tool that Central Banks consider. Also, the fact that the ECB have been so strident in targeting low inflation, does send signals to European business that policy is more likely to be contractionary.

By contrast, the Bank of England has tolerated much higher headline inflation rates.

cpi-inflation

From the narrow perspective of keeping inflation within target, the Bank of England has frequently missed the target of CPI 2% +/-1. This failure to keep inflation low has also been magnified by the fact that there has been low nominal wage growth. It means that the high inflation rate has led to falling living standards of both those in work, and those on benefits.

However, given the uniquely challenging circumstances of the past five years, it is fair to defend this choice. It made no sense to use interest rates to reduce inflation when the economy was struggling in a prolonged economic stagnation. Firstly this inflation was primarily cost-push. It was due to the effects of devaluation, rising raw material prices and higher taxes. There is also evidence that prices were sticky downwards; the fall in demand didn’t lead to the fall in prices we might have expected.

But, the fact that wage growth was very low, showed there was no underlying demand pull inflation. To religiously keep inflation close to 2%, would have required a potentially very sharp contraction. Given the prolonged recession, you could argue the Bank of England have been too timid in targeting economic recovery. E.g. direct lending to business may have been more successful.

In evaluation, you could argue this might involve the Bank of England extending its original remit, and it would require the government to play a greater role.

2. Limitations of Traditional Monetary Policy

The other lessons of the past five years is the limitations of traditional monetary policy. In normal circumstances a cut in base interest rates from 5% to 0.5% would ensure economic recovery. However, in the great recession, cutting bank base rates has been insufficient.

Firstly, commercial bank rates haven’t fallen to match base rates. This has been a particular problem in the Eurozone with bank rates in Spain and Greece, higher than before the crisis. See bank rates and base rates

In the aftermath of the credit crisis, liquidity shortages have meant the supply of credit has constrained lending, investment and growth. In other words reducing the cost of borrowing is insufficient to boost demand, if the supply of credit isn’t there.

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The UK economy in the 1930s

By on May 13, 2013 in economics

The 1930s economy was marked by the effects of the great depression. After experiencing a decade of economic stagnation in the 1920, the UK economy was further hit by the sharp global economic downturn in 1930-31. This lead to higher unemployment and widespread poverty. However, although the great depression caused significant levels of poverty and hardship (especially in industrial heartlands), the second half of the 1930s was a period of quiet economic recovery. In parts of the UK (especially London and the South East, there was a mini economic boom with rising living standards and prosperity.

It is worth bearing in mind that statistics don’t tell the full story. Unemployment rates in the 1930s were barely higher than unemployment rates we’ve experienced in the 1980s and 2000s. However, there is a big difference. In the 1930s, unemployment benefit was minimal – to be unemployed left workers at the real risk of absolute poverty. In the current period, unemployment benefits are relatively meagre, but they enable absolute poverty to be avoided. In that sense the depression of the 1930s created more economic poverty than the current recession.

Nevertheless, the UK was able to recover relatively quicker than many other developed economies, why was this?

1930s-economic-growth

The 1930s recession was shorter than the great recession of 2008 - see recessions compared.

The UK economy in the 1920s.

In the 1920s, the UK economy struggled with low growth, high unemployment and deflation. This was due to factors such as:

  • A decision to return to the gold standard in 1925, at a rate which many believe was 10-14% overvalued. This overvaluation of Sterling reduced demand for exports, leading to lower economic growth. Many heavy industries, such as steel and coal become less competitive in this period.
  • Deflation. The overvaluation of Sterling and relatively high real interest rates contributed to periods of falling prices. This deflation increased the burden of debt and reduced spending.
  • Tight fiscal policy. In the aftermath of the First World War, UK debt reached up to 180% of GDP. To reduce debt to GDP in a period of deflation was difficult and required high primary budget surpluses. This required strict budgets, but also because of deflation and low GDP growth, it proved very difficult to reduce debt to GDP ratios.
  • See more details at: UK economy in the 1930s

 

Stock market crash and great depression 1929-31

The stock market crash of 1929 precipitated a global recession. The US was particularly badly affected by the stock market crash because of the growth in credit in the years leading up to it. The UK was more insulated because it had experienced no real credit boom in the 1920s. In fact, the UK was already in a prolonged economic stagnation of low growth. Because the UK economy relied heavily on trade, the decline in global demand, hit the UK economy, and with lower exports, the UK economy went into recession. 1931 was particularly damaging, with real GDP falling 5%. See more on Causes of Great Depression

The 1931 Crisis

1931 was a pivotal year for the UK economy. A European financial crisis (failure of German and Austrian banks) threatened to harm the UK’s financial system. More pressingly, the economy was stuck in a deep recession, with unemployment a real problem. The UK’s membership of the gold standard also looked under threat. Many felt the UK was overvalued and so Sterling was under pressure. To keep the value of the Sterling in the gold standard, there was pressure to:

  • Reduce budget deficit through fiscal consolidation
  • Increase bank rates to attract money into UK and keep the Pound at its target rate in the gold standard.

1931 Budget

In 1931, the government was under great pressure. There was risk of a global financial crisis spilling over into London markets. The Pound was overvalued and there was a fear, the government would be unable to maintain the value of Sterling. The real economy was also in bad shape, with record levels of unemployment and growing social unrest at the extent of the recession. The Treasury put great pressure on the government to pursue fiscal austerity and reduce the budget deficit. (see: Treasury view) It was felt it was essential to balance the budget and restore confidence in the Pound.

In the 1931 budget, the chancellor Lord Snowden and Ramsay MacDonald accepted the necessity of implement budget cuts. Unemployment benefits were cut and public sector wages were also cut. This split the Labour party, and MacDonald formed a coalition of mostly Conservative MPs to pass the budget.

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When London house prices were £350 in the 1930s

By on May 13, 2013 in economics

Interesting article here about the UK economy of the 1930s  escaping from Liquidity trap and great depression of the 1930s. This involved:

  • Higher inflation target
  • Low interest rates and negative real interest rates.
  • Devaluation

The article is also interesting for another reason, a short insight into the housing market of the 1930s. Like many people in Oxford, I  live in a 1930s semi detached house. It was a golden era of home building. Supply was elastic, few planning regulations, people were not worried about congestion and overcrowding. The mini private sector housing boom was a factor in helping the UK economy recover.

85% of new houses sold for less than £750 (£45,000 in today’s money). Terraced houses in the London area could be bought for £395 in the mid-1930s when average earnings were about £165 per year. Houses were cheap because the supply of land for housing was very elastic which in turn meant that there was no incentive for developers to sit on large land banks. Underpinning the availability of land for house-building was an almost complete absence of land-use planning restrictions which applied to only about 75,000 acres in 1932 – the draconian provisions of the 1947 Town and Country Planning Act were still to come.

Monetary also played an important role, low real interest rates encouraged a rapid growth in mortgages, enabling more people to buy.

One thing is for sure, buying a terraced house in London for £395 in the mid 1930s was a very good investment!

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How does a current account surplus affect demand?

By on May 10, 2013 in trade

Readers Question: How does a current account surplus change demand in an economy?

A current account surplus means that the value of exports is greater than the value of imports (of goods and services).

Net exports is a component of Aggregate demand.  (AD) = C+I+G+(X-M).

Therefore a current account surplus means that the net exports is contributing to higher domestic demand. For example, China has had a significant current account surplus over the past few years. This high demand for exports is contributing to the high level of Chinese economic growth.

If the UK has a current account deficit, this represents a net leakage from the economy. Aggregate demand will be lower than if we had a surplus.

Evaluation

It could be the situation that a current account surplus is the result of a recession and low consumer spending. In a recession, we would expect to see a fall in consumer spending; therefore, we will see lower spending on imports. This will cause a current account surplus. In this case, the low aggregate demand is causing a current account surplus.

A current account surplus is not necessarily a good thing. For example, some criticise Germany for pursuing policies, which lead to a very large current account surplus. They argue that this is leading to lower demand in other European countries. Some economists argue, Germany should seek to boost domestic demand; this will lead to higher import spending and benefit other European countries with a large current account deficit and weak domestic demand.

On the positive side, a current account surplus is an indicator that Germany are very competitive, and this will help them to create jobs and economic growth.

Current account surplus and exchange rate

Another factor to consider is the impact of a current account on the exchange rate. In 2006, China was running a large current account surplus. However, in the past few years, the Chinese currency has steadily appreciated. This increase in value has reduced their current account surplus, and limited the growth in Chinese exports and domestic demand.

If the UK moved from a deficit to a surplus, we might expect to see an appreciation in the Pound (this is due to greater demand for Pounds as people buy more UK exports). The appreciation in the currency will tend to reduce demand (assuming relatively elastic demand)

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Over-financialisation of the economy

By on May 10, 2013 in economics

Readers Question: I am also interested in Marxist economics and they seem to say the 2007-2008 crisis was a result of over-financialisation of the the economy, and that investors/owners could not squeeze surplus out of other sectors in the economy as they once could.

Financialisation of an economy refers to the situation where the finance sector takes a bigger share of GDP and employment. The consequence of financialisation include the possibility that:

  • Financial markets have greater influence over firms and the real economy.
  • The economy is more dependent on the strength of the finance sector.
  • Widening inequality as the finance sector is often able to capture relatively higher salaries and profits.
  • Growth in financial instruments has increased the risk of unsustainable debt and lending levels.
  • The nature of the finance sector means that if it fails it is has a much wider knock on effect to other industries. If coal mines close, it doesn’t really adversely affect other industries. But, if banks get into difficulties, it has severe adverse effects for every other industry.

Epstein(2001) defines financialisation as:

“the increasing importance of financial markets, financial motives, financial institutions, and financialelites in the operation of the economy and its governing institutions, both at the national and international level” (Financialization and its consequences)

Growth of Financial sectors in developed countries

Between 1970 and 2008, most industrialised countries saw a growth in the importance of the finance industry.  The total share of finance in value added (GDP) to the economy more than doubled in 11 OECD countries. In terms of employment, economies have seen a growth in the share of financial sector employment.

finance-sector

source: Bank of England

UK Finance sector

UK finance sector growth

Source: Bank of England

UK financial sector growth – strong between 1995 and 2008, but experienced a deeper dip in the 2008 recession.

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Should the Legal Drinking Age be Increased to 21?

By on May 9, 2013 in society

Readers Question: Evaluate the case for raising the legal drinking age to 21. Will it be more effective than other methods for reducing the harmful effects of alcohol? 

There are several reasons to be concerned about the over-consumption of alcohol, especially amongst young people. In the UK, abuse of alcohol has contributed to several social, economic and health problems, including:

  • Alcohol related accidents.
  • Health problems
  • Alcohol addiction major cause of family breakdown.
  • According to a report, “Health First: An evidence-based alcohol strategy for the UK”. “The personal, social and economic cost of alcohol has been estimated to be up to £55bn per year for England and £7.5bn for Scotland,”
  • Research carried out by Sheffield University for the government shows a 45p minimum would reduce the consumption of alcohol by 4.3%, leading to 2,000 fewer deaths and 66,000 hospital admissions after 10 years. Researchers also claim the number of crimes would drop by 24,000 a year.

From an economic perspective, we say that alcohol is a demerit good.

  1. People may underestimate the personal costs of drinking alcohol to excess (especially amongst young people)
  2. There are external costs to society, e.g. costs of health care, costs of treating accidents, days lost from work. Therefore the social cost of alcohol is greater than the private cost.

These two factors give a justification for government intervention to deal with some issues related to alcohol.  Raising the legal drinking age could help reduce these personal and social costs because it is more difficult to purchase.

Arguments against raising the drinking age to 21

  • At 18, people can vote and are considered adults, so we should allow them to have a personal decision on whether to consume alcohol.
  • Alcohol in moderation isn’t necessarily harmful. Rather than a blanket ban, the government could focus on tackling binge drinking through making alcohol more expensive and tackling the drinking culture.
  • Drinking alcohol is so embedded in the culture, raising the legal age to 21, will make the majority of young people break the law.
  • It will encourage people to find ways to circumnavigate the law. Black market alcohol supplies, which may be harder to monitor.
  • Arguably, there are better ways to deal with problems of alcohol.

Will Raising the drinking age to 21 be effective?

Raising the drinking age to 21 will reduce consumption amongst young people because it will be harder to buy alcohol. Also, young people are the most likely group to misuse alcohol; e.g. drinking to excess, which causes accidents, death and health problems. If people start drinking later in life, they may be more likely to drink in moderation and not get addicted at an early age.

However, it will still be possible for young people to drink at home. People will find ways to avoid the legislation e.g. asking older people to buy alcohol for them. Nevertheless, it will be more difficult. For example, a 16 year old may not be able to get away with drinking in a pub any more. If the age is 18, it is much easier for a 16 or 17 year old to get away with drinking alcohol.

This policy doesn’t address the underlying problem of why people want to drink to excess. For that education may be a better solution; education could  help to explain the dangers of excess drinking and therefore encourage young people to drink moderation.. However, previous education policies have not seemed to be very effective. Young people don’t want to hear lectures from the government about the dangers of alcohol.
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Credit Policy

By on May 8, 2013 in economics, finance

Credit policy / financial policy is the use of the financial system to influence aggregate demand (AD). Monetary policy affects AD through the Central bank controlling interest rates and the money supply. Fiscal policy affects AD through the use of government spending and taxation.

Credit policy looks at factors such as:

  • Bank lending rates to firms and households in the economy.
  • The supply of credit and availability of loans from banks to firms and households.

In normal economic circumstances, it was felt the Central Bank could adequately control the economy through changing base rates.

When the Central Bank (e.g. ECB, Bank of England) changed interest rates, it had a strong influence on bank lending rates. When the ECB cut rates in 2001-03, bank lending rates fell, when the ECB raised rates in 2006-07, bank lending rates rose. Bank lending rates closely mirrored the Central Bank. Therefore, there was little attention paid to bank lending rates – there was no need.

However, since the credit crunch, the normal relationship between Central bank base rates has broken down. In particular, when the main base interest rate was cut, firms – especially small and medium sized firms (SME) didn’t see the actual interest rate they paid cut.

base-rates-bank-rates

See also bank and base rates in the UK

Implications of divergence between base rates and bank rates

This is very important for the effectiveness or not of monetary policy. Usually, if interest rates are cut from 5% to 0.5%, we would expect the loosening of monetary policy to boost lending, consumption and aggregate demand. But, that hasn’t been happening. Lending rates are still high, and credit tight. The base rate of 0.5% has become misleading to the actual reality of firms who face high borrowing costs.

Problems in the Eurozone

bank costs

Source: Economists – Central bank has lost control over interest rates

This problem of bank lending rates is most noticeable in the peripheral Eurozone countries. Since the crisis, small and medium sized firms have actually seen an increase in borrowing costs. Bank rates have increased, making the 0.5% ECB rate meaningless. The Economist reports

‘SMEs in Spain and Italy must pay over 6% to borrow; money is tighter there than it was in 2005, even though the ECB’s rate is far lower.’ (Woes for small business in Europe)

The problem for SME (small and medium enterprise firms) is that they are too small to sell their own bonds. They are reliant on bank lending. But, because of the credit crunch and fears over bank stability, they are finding their borrowing costs increase.

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Base rates and bank interest rates

By on May 7, 2013 in interest-rates

The Bank of England set the base rate. This is the rate at which they charge commercial banks to borrow from the Bank of England. In normal economic circumstances, this base rate will influence all the interest rates set by other banks and financial institutions.

  • If the Bank of England cut the base rate, you would expect banks to also cut their mortgage and lending rates.
  • If the Bank of England put up the base rate, you would expect banks to increase their mortgage rates.

uk-base-rate-v-bank-svr-500x336

The reason is that if commercial banks find it more expensive to borrow from the Bank of England, then they increase their lending costs to compensate. If it is cheaper to borrow from the Bank of England, they can reduce their mortgage rates and keep the same profit margin.

However, in the credit crunch, we see a greater divergence between base rates set by the Bank of England and actual bank rates that people in the real world face.

base-rates-bank-rates-mortgage-rates

interest rates at the Bank of England

This graph shows the gap between base rates and the bank rates

base-rates-bank-rates

After 2008, we see the gap between base rates and bank lending rates increases from 2% points to close to 4%. It means that mortgage holders haven’t benefited from the cut in base rates as much as you might expect.

Why gap between bank rates and base rates increased

In 2008, banks were short of liquidity, they wanted to increase their deposits and improve their balance sheets. Therefore, they were reluctant to lend and keen to attract savings. Therefore, they didn’t want to cut mortgage rates and lending rates. In effect, they were making it more profitable; they could borrow from the Bank of England at 0.5%, but they were lending out at 4%.

Interest rates are quantity of funds

Another issue is that the quantity of funds is important. After 2008, it become much difficult to get a loan. Even if interest rates were low, people couldn’t always raise a sufficient deposit to get a mortgage.

Credit policy

This suggests that traditional monetary policy (which focuses on Bank of England base rate) may be insufficient, and we need to have more focus on actual real life interest rates set by commercial banks.

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Revising for economic essays

By on May 7, 2013 in A-Level, exams

Readers Question: how to revise for a possible exam question like: discuss the likely effectiveness of ‘expansionary fiscal and monetary policies as means of closing the output gap’

Firstly write down the question on a blank piece of paper. Then try and revise in three parts.

Part One – Knowledge  define terms

  • Expansionary fiscal policy – an attempt by the government to increase AD, through increasing government spending and cutting tax, (leading to bigger budget deficit)
  • Expansionary monetary policy – When the Central Bank cuts interest rates or increases money supply, through a policy like quantitative easing.
  • Output gap. This is the difference between potential output and actual output. A negative output gap means that current real GDP is less than potential and therefore there is spare capacity / unemployment.

Part Two – Explain effect of fiscal and monetary policy on output gap

Expansionary monetary policy could involve cutting interest rates. If the Bank of England cut interest rates, this should stimulate aggregate demand. Firstly, lower interest rates reduce the cost of borrowing and therefore encourage consumers to spend on credit. Lower borrowing costs will also encourage firms to invest because it is cheaper to finance investment. Secondly lower interest rates will reduce the amount householders have to spend on mortgage interest payments and therefore they will have more disposable income; this should increase consumer spending. Overall, with higher C and I, we should see an increase in AD.
ad

This increase in AD should lead to higher real GDP and reduce the output gap. At Y1, there is a significant negative output gap, Y1 is less than potential AS. Therefore, increasing AD does reduce the output gap.

Expansionary fiscal policy

The government could decide to borrow from the private sector and use this to spend on capital investment, such as building new roads and railways. This increase in government spending will increase AD and have a similar effect in increasing GDP. Alternatively, the government could cut the rate of VAT, this lower tax will give consumers greater spending power and should hopefully increase consumption; this should also increase AD, leading to great real GDP and reduce the output gap. There may also be a multiplier effect with the initial investment causing a bigger final increase in real GDP.

Part Three evaluation

For evaluation we need to discuss

  • Will these policies actually  be successful?
  • What could determine with monetary and fiscal policy actually close the output gap?
  • What might different economists say?

Evaluation for macroeconomics could involve several factors, such as:

  • Other factors affecting AD
  • Time lags
  • It depends on the state of the economy
  • It depends on side effects of policies implemented.

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