Pearson Edexcel IAL Economics: Fiscal and monetary policy and central banks (YEC11) – Revision Notes

Quick recall for the Pearson Edexcel International Advanced Subsidiary/Advanced Level Economics specification (Issue 2, June 2018), section 2.3.6 item 4 (demand-side policies). In the specification this is Unit 2 content, an International AS compulsory unit that also counts in the full International A Level. For explanations and fuller worked examples see the study guide, then test yourself with the practice questions. Also useful: the course hub, the checklist, the economic growth guide and the free diagnostics.

Every figure here is invented for illustration (Country B, Country C, a small town and so on). Each label names one economy only.

Definitions to know

Term	Meaning
Demand-side policy	Policy that tries to change aggregate demand (AD)
Fiscal policy	Changes to government spending and taxation
Monetary policy	Changes to the price, availability or quantity of money and credit
Reflationary	Raises AD (used with spare capacity or high unemployment)
Deflationary	Lowers AD (used when demand-pull inflation is above target)
Budget deficit	Government spending greater than tax revenue in a year
Policy rate	The interest rate the central bank sets
Quantitative easing (QE)	Central bank creates money to buy assets, mainly government bonds
Lender of last resort	Central bank lends to banks that cannot raise funds elsewhere

Map of the instruments

	Reflationary	Deflationary
Spending	Increase	Cut
Taxation	Cut	Raise
Interest rate	Cut	Raise
QE	Buy assets	Stop buying; in principle sell
Lending criteria	Loosen (higher loan-to-value)	Tighten (lower loan-to-value)
Reserve asset requirement	Lower	Higher

The first two rows are fiscal. The last four are monetary.

Transmission chains (learn these as sequences)

Interest rate cut: lower cost of borrowing, so more consumption and investment; lower payments on variable debt, so more disposable income; weaker incentive to save; possibly lower exchange rate, so higher net exports. Result: AD up, real GDP up, price level up.

Government spending rise: injection into the circular flow; multiplier raises income; more tax revenue partly offsets cost.

Tax cut: disposable income up; part is saved or spent on imports; smaller first-round injection than a spending rise of the same cost.

QE: central bank buys bonds; bond prices up, yields down; cheaper long-term borrowing; more bank reserves; sellers buy other assets, raising their prices; wealth effect on spending.

Tighter lending criteria: fewer borrowers qualify; less credit-fuelled spending, especially on housing.

Formulae and quick calculations

Item	Formula
Multiplier	1 / (mps + mpt + mpm), the reciprocal of the marginal rate of withdrawal
Change in income	Initial injection × multiplier
Real interest rate	Nominal rate − inflation rate
Inflation rate	(new index − old index) / old index × 100
Bond yield	Annual coupon / bond price × 100
Budget balance	Tax revenue − government spending (negative means deficit)
Maximum deposits from reserves	Reserves / required ratio

Method: multiplier question

1. Add up the withdrawal rates and invert.
2. Multiply the injection by the multiplier.
3. If the question concerns a tax cut, first multiply by the share of extra income spent at home.
4. If asked about the budget, subtract tax revenue gained (tax rate × change in income).

Worked reminder. Country B has mps 0.2, mpt 0.1, mpm 0.2. Multiplier = 1 / 0.5 = 2. A spending rise of 12bn raises income by 24bn. Tax revenue rises by 0.1 × 24 = 2.4bn. Net cost: 9.6bn.

Method: inflation versus target

1. Calculate the inflation rate from the index.
2. Compare with the target.
3. Say which direction policy should move, and name the instrument.

Worked reminder. Index 108.0 then 111.2: (111.2 − 108.0) / 108.0 = 2.96%, about 3.0%. Against a 2% target the central bank would consider raising the rate. Next year’s index at target: 111.2 × 1.02 = 113.42.

Central banks: four roles

1. Implement monetary policy (policy rate, QE, reserve or lending rules).
2. Work towards an inflation target.
3. Banker to the government (accounts, payments, help with issuing debt).
4. Banker to the banks and lender of last resort.

Link the roles: the lender-of-last-resort role protects confidence in the banking system, but moral hazard is the cost.

Strengths and weaknesses

Tool	Best point	Main limit
Fiscal	Direct, can be targeted, multiplier	Lags, deficit and debt, crowding out
Interest rates	Fast, reversible, central bank decides	Weak response when confidence is low; blunt; floor near zero
QE	Possible when rates are already very low	Uncertain pass-through; may mostly lift asset prices
Lending criteria	Targets credit directly	Borrowers may use other lenders
Reserve requirements	Limits lending capacity	Banks hold spare reserves; demand for loans may be weak

More worked reminders

Output gap and spending needed. Country C has potential output of 330bn and actual output of 312bn. The gap is 18bn, which is 18/330 = 5.45% of potential. With a multiplier of 2.5, the spending rise needed is 18 / 2.5 = 7.2bn.

QE and yields. A bond pays 5 a year. At a price of 80 the yield is 6.25%. If central bank buying lifts the price to 100, the yield falls to 5.0%. Say it in words: higher price, lower yield, cheaper long-term borrowing.

Lending criteria. A flat costs 150,000. A 90% limit gives a loan of 135,000 and a deposit of 15,000. At 75% the loan is 112,500 and the deposit 37,500. Tighter criteria mean a larger deposit, so fewer first-time buyers qualify.

Reserve asset requirement. New reserves of 8bn support at most 8 / 0.10 = 80bn of deposits at 10%, and 8 / 0.16 = 50bn at 16%. Raising the ratio reduces the ceiling on lending.

Fiscal versus monetary: head-to-head

Feature	Fiscal	Monetary
Decision maker	Government	Central bank (usually)
Speed of decision	Slow (budgets, legislation)	Fast (regular meetings)
Speed of impact	Spending can be slow to start	Rate changes feed through over months
Targeting	Can target groups, regions, sectors	Mostly economy-wide
Side effect	Deficit and debt	Asset prices, exchange rate
Political pressure	High	Lower if the central bank is independent

Use this table to build a judgement paragraph, not to replace one. A table row is a point. A paragraph says why that point matters in the case given.

Policy mix

Governments and central banks can pull in the same direction or in opposite ones. If both are reflationary, AD rises strongly, and the risk is overheating when there is little spare capacity. If fiscal policy is deflationary (to cut a deficit) while monetary policy is reflationary (to protect growth), the central bank may be offsetting the budget. This is why a good answer asks whether the instruments are being used together.

Evaluation prompts

• How much spare capacity is there? (Reflation raises output if yes, prices if no.)
• How large are the time lags?
• How high is existing government debt?
• Is the problem demand-side at all?
• How close are interest rates to zero?
• Who gains and loses (savers, borrowers, asset owners, taxpayers)?
• Short run or long run?

Quick self-test

1. Which two policies make up demand-side policy, and who normally sets each?
2. Name two reflationary monetary instruments.
3. A bond with a coupon of 6 a year has a price of 120. What is the yield?
4. Nominal rate 5.5%, inflation 2.0%. What is the real rate?
5. Withdrawals: mps 0.1, mpt 0.2, mpm 0.1. What is the multiplier?
6. In question 5, how much does income rise for a 5bn spending increase?
7. State one weakness of QE.
8. A bank holds 9bn of liquid assets against 60bn of deposits. The requirement rises to 20%. By how much is it short?
9. Why might a rate cut fail to raise investment?
10. State one reason moral hazard follows from a lender of last resort.

Answers

1. Fiscal (government) and monetary (central bank, usually).
2. Any two: cutting the policy rate, QE, looser lending criteria, lower reserve asset requirements.
3. 6 / 120 × 100 = 5.0%.
4. 5.5 − 2.0 = 3.5%.
5. 1 / 0.4 = 2.5.
6. 5 × 2.5 = 12.5bn.
7. Any one: unclear pass-through to lending; raises asset prices and favours asset owners; hard to reverse.
8. Required 0.20 × 60 = 12bn; shortfall 12 − 9 = 3bn.
9. Firms expect weak demand, so they do not invest even when borrowing is cheap.
10. Banks may take larger risks if they expect to be rescued.

Where marks are usually lost

• Writing “interest rates fall so AD rises” with no chain of reasoning.
• Mixing up reflationary and deflationary.
• Using the word “deflation” for deflationary policy.
• Giving one-sided answers when asked to evaluate.
• Quoting a multiplier without the withdrawal rates that make it.
• Forgetting the real versus nominal difference.
• Describing QE as printing notes.
• Ignoring the state of the economy (spare capacity, debt, how low rates already are).
• Listing the central bank’s roles without saying what each does.
• Judging the policy without a reason tied to the context.

Official syllabus

Pearson Edexcel International Advanced Subsidiary/Advanced Level in Economics specification, Issue 2, June 2018, Pearson Education Limited, section 2.3.6 item 4.