What this lesson teaches
I can explain fiscal, monetary and supply-side policy and judge how well each works.
Syllabus 8843, 3.2.3(b). Macroeconomic Policies: Policy measures and their effectiveness in achieving macroeconomic objectives:; Fiscal policy - How discretionary fiscal policy can influence the level of economic activities and living standards through government spending and taxation; Supply-side policies - How supply-side policies can improve quantity, quality and mobility of factors of production to increase the productive capacity of an economy and hence affect living standards; Monetary policy - How monetary policy can influence the level of economic activities and living standards through the management of exchange rates (case of Singapore) and interest rates
Make a guess
Interest rates are cut in a deep recession. Firms have idle machines and expect weak sales. Will investment rise much?
- No. Lower rates make banks stop lending to firms.
- Probably not. Cheap loans do not create orders.
- Yes. Lower rates cut the cost of borrowing, so firms invest more.
Show the answer
Probably not. Cheap loans do not create orders.
Firms invest when they expect new machines to pay off. With spare capacity and weak sales, there is no reason to borrow.
Cheaper borrowing does little when firms expect weak sales or banks will not lend.
Interest rate cuts may not work in a deep downturn. If firms expect weak sales and have idle machines, cheaper loans will not persuade them to invest.
If households are worried about their jobs, they may save more and pay off debts instead of spending.
If banks tighten lending standards, lower rates may not reach borrowers. Many existing loans also have fixed rates.
Monetary policy takes time, often a year or more, to have its full effect, and it cannot fix supply problems such as skill shortages.
- Limits
- Low confidence, bank lending, fixed-rate loans, time lags.
Worked example: Cheaper credit, few customers
A central bank cuts rates. A firm has idle machines and expects fewer orders. Its bank also tightens lending rules, and households fear job losses.
- The firm has no reason to invest, however cheap the loan.
- The bank's tighter rules block some borrowers anyway.
- Worried households save instead of spending.
- The rate cut has little effect on AD.
Watch out for this
Lower interest rates always increase spending.
If confidence is low or banks will not lend, spending may barely change.
Check your understanding
A central bank raises rates to cool inflation, but most home loans are fixed for five years. Why might the policy work slowly?
- Many borrowers' repayments stay the same until their fixed terms end.
- Fixed-rate borrowers save more when rates rise, so spending falls at once.
- A rate rise cannot affect inflation until the government also cuts spending.
Show the answer
Many borrowers' repayments stay the same until their fixed terms end.
Right. The higher rate reaches these households only when they refinance, so spending falls with a long lag.