Responding to Economic Crisis


Assess the extent to which governmentsts are likely to encounter difficulties when attempting to respond to economic shocks that affect economies such as Germany and the UK (30)

Economic shocks are events which adversely affect the economy and the governments macro economic objectives such as growth, inflation, unemployment and the balance of payments.

Economic shocks could include a rise in the price of oil (supply side shock) or a slump in AD due to fall in consumer confidence (e.g. after terrorist attacks).

If there was a rise in the price of oil this would increase firms costs and hence AS would shift to the left causing lower output, higher unemployment and cost push inflation.

The UK govt has a target for low inflation. Therefore they may respond to this increase in inflation by raising interest rates. This will help reduce inflation but will conflict with other macro economic objectives such as lower AD and output.

Germany has less control over Monetary policy because it is a member of the Euro. Therefore the German monetary authorities cannot alter interest rates. This could be a serious problem if an economic shock affected Germany more than other EU countrie. For example, German reunification required higher interest rates to keep inflation down, but this would not be possible now.

            Alternatively, to respond to economic shocks the govt could use supply side policies, these aim to increase productivity and shift AS to the right. For example, if there was cost push inflation the govt could reduce the power of trades unions, improve education and privatise state owned companies. However, supply side policies are not always effective. For example, government intervention may cause govt failure (e.g. government has poor information). Also, supply side policies can take a long time to have effect, e.g. better education will take many years to increase productivity.

            If there was a fall in consumer confidence and hence AD, the govt could use fiscal and monetary policy to increase AD. For example, the govt could cut interest rates and taxes, this will reduce the cost of borrowing and increase consumers’ disposable income, therefore AD will increase. However, expansionary fiscal and monetary policies are not always effective. This is because if confidence is lower people may save any increase in disposable income. Also there could be significant time lag before consumers start spending again.
            Another problem that Germany faces is the EU growth and stability pact. In theory, this limits borrowing to 3% of GDP therefore in a recession they would be limited in its ability to use discretionary fiscal policy.

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