Policies for Dealing with Economic Shocks

Q) UNDERTAKE AN EVALUATION OF THE CAUSES OF ECONOMIC INSTABILITY AND THE ROLE, IF ANY, THAT THE GOVERNMENT CAN PLAY IN REDUCING ECONOMIC INSTABILITY BY CONSTRAINING THEIR DISCRETION IN POLICY MAKING

Basically, what can the government do to reduce economic instability?

Dealing With Demand Side Shocks

1. Monetary Policy.

Changing interest rates can affect AD. For example, in a recession the government can cut interest rates to boost demand and increase growth. However, there are many limitations of this

1. Monetary policy is usually operated by an independent Central Bank. Their target is low inflation not economic growth.

Cuts in interest rates don’t necessarily increase spending. If confidence is very low, lower interest rates may not stimulate demand.

More detail here: What determines effectiveness of Monetary policy? 

Are UK recessions caused by Monetary policy? 

Unconventional Monetary Policy

In times of a severe recession, cutting interest rates may be insufficient to restore economic growth. In this case it may be necessary to pursue unconventional monetary policies such as quantitative easing. This involves electronically creating money and using it to buy government bonds. This can be necessary in a balance sheet recession where spending falls considerably.

2. Expansionary Fiscal Policy

Expansionary fiscal policy involves increasing AD, through increasing government spending and cutting taxes. It will lead to a budget deficit. In times of a recession it can help the economy come out of a recession. It can help create a multiplier effect and get unused resources being used economically efficient.

However, expansionary fiscal policy has many criticisms.

For more detail see here: Criticisms of fiscal policy 

Basically, it is argued fiscal policy may lead to crowding out. – This means the increase in government spending leads to less private sector spending. Also, when expansionary fiscal policy is really needed, government borrowing may become too high, leading to higher interest rates on government bonds and a fiscal crisis.

Other policies might include:

  • Exchange Rate policy – has relatively limited impact and is harder to manipulate
  • Supply side policies – take a long time, but, may increase productivity.

Also maybe of some help

  • Difficulties of controlling inflation
  • i.e. if there is an increase in the price of oil, this can cause lower growth and higher inflation. It is then very difficult to reduce both inflation and increase economic growth. Fiscal and monetary policy generally can only deal with one problem at a time.
  • Also worth noting. IF a member of EURO, a country has even less capacity to change economic management. – Interest rates are set by ECB
By on November 12th, 2007

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