A not so
perfect pdf of
Economics
By Saad Athar
Analysis And Application of Diagrams
Analysis:
The concave to the origin PPC has rising opportunity cost because when we
increase the production of one good results in loss on other perspective goods. In figure
1.1, when the Economy was at point A, it produced 50 goods Y and 15 Goods X. When
it moved from point A to point B, the economy started producing 40 Goods Y and 25
Goods X thus there was an increase of 10 Goods X, but the economy gave up 10 Goods
Y. However, when economy moved from B to C, they gained only 5 Goods X and gave
up 10 Goods Y in return despite there are more resources devoted on Good X.
Key takeaways:
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Whenever you draw a diagram, make sure you label the correct concepts and
values on the axes and it should be in accordance with the economic principles.
Mentioned the diagram or the figure number i.e Figure 1.1.
Elaborating the diagram in detail by explaining the effects of movement from one
point to another
Using the names of mentioned goods that was assigned to them in the diagram
itself i.e Good X and Good Y
Identifying the PPC curve is concave to origin
The details written in Paragraphs are in accordance with the points drawn on the
diagram e.g Point A has 50 Goods Y and 15 Goods X
When discussing the production level of goods, the right point is referred so saying
50 Goods of Y and 15 Goods of X produced at point B is absurd and reflects lack
of understanding.
Application of concept of why concave PPC has a decreasing opportunity
cost:
The asymmetry we observe in opportunity cost trend while moving from point A
to C is because the resources of Economy are not perfect substitute of each other. That
being said, there are resources that are more efficient at producing Good Y than Good X.
Meanwhile, there are resources that are more productive at productive Good X than Y.
Therefore, despite devoting more resources to Good X at point C, the economy gained
only a few goods X and lost double of Good X of Good Y, the opportunity cost changed
from 1 Good X for 1 Good Y to 1 Good X for 2 Good Y because the recent switched
resources were perhaps more suitable for Good Y resulting in a rising opportunity cost.
Key takeaways:
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Remember, a good application is the one which isn’t understandable without
reading the diagram that you drew before because applications are essentially
analysis done in context of diagrams and the way you can’t understand
something without knowing it’s context, similarly, your applications should have
such vital information from diagrams.
Elaborated how Economy doesn’t have perfect substitutes by highlighting the
imbalances in production between different points.
Calculation of opportunity cost.
Proved increasing opportunity cost by taking production levels of two different
points.
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Referring to points mentioned in diagram to demonstrate the relevancy of
diagram.
Analysis and application of other concepts on the same diagram:
In figure 1.1, the point H which is within the curve demonstrates a scenario
when an economy despite possessing the resources and potential to produce more
than 50 Goods Y and 30 Good X, it is producing less good at point H meaning the
economy isn't employing all its resources, therefore, point H manifests unemployment of
resources in the economy. Moreover, the point F in figure 1.1 illustrates the concept of
scarcity because the economy can’t attain point F due to the fact that economy is
constrained by resources, hence, reflecting the idea of limited resources because if
resources weren't scarce, the economy would never have to trade off production of one
good to get more of another.
Analysis and application of what causes PPC curve to shift outwards:
Whenever there is an increase in the quantity of resources or quality of
resources, the PPC curve shifts outward reflecting the economy has now more potential
to produce the goods. For instance, an economy experienced an immigration of labour
that resulted in an increase in the overall size of the labour force of the economy, as a
consequence, the economy has now more labour available for its production and since
labour is a factor of production (resource), an increase in a resource in Economics
results in PPC curve to shift outward, therefore, this immigration will cause PPC curve
to shift from black to blue demonstrating the economy now have more resources. In
contrast, a decrease in resources is shown by an inward shift of PPC.
Key takeaways:
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An example of how you should illustrate a concept if the question requires you to
illustrate any concept or difference with the help of an example.
The example should not be relevant only but also applied on the diagram as well
to reflect the application of concept on the diagram as well.
A tip that you might found useful in your life. The word ‘immigration’ starts from
letter ‘i’ and imports also starts from ‘i’, the word import means when something
foreign enters your country so if someone says ‘immigration’ then use the letter ‘i’
to link it with the word ‘imports’ and derive the conclusion that foreign people are
entering your country.
In contrast, the word ‘emigration’ starts from ‘e’ and exports also starts from ‘e’,
the word export means when something from your country is given to a foreign
country so use ‘e’ of ‘emigration’ to link it with ‘exports’ to conclude the fact that
people left your country for a foreign country.
Analysis and application of concept what causes movement in within curve:
As a thumb rule of economics, whenever an economy starts employing its unused
existing resources, the PPC observes a movement closer to the curve. A point on the
PPC curve such as point A in the diagram reflects that there are no idle resources. It
can be understood from an example that an economy is already aware of oil existing in
their lands that they discovered before, however, due to lack of finance, the economy
was unable to extract the oil lying underneath their lands. Luckily, an international
agency agreed to assist them in this regard by providing the finance to extract this oil.
Such an event will cause the economy in the above diagram to shift from point A to
point D reflecting the economy is making use of existing resources and now idle
resources are being employed in the economy.
Note:
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The example used over here has a sentence ‘is already aware of oil existing in
their lands’ the reason why such a sentence was used because if the economy
would have discovered oil in this example, then there would have been a right
outward shift of PPC curve because discovering resources is essentially increase
in quantity of resources that’s why this sentence was used here to reflect the
resources didn’t increase, instead, they were unemployed due to a financial
hindrance.
Tips on Evaluation
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The formula of Salt in Chemistry is NaCl, and it is the same across the globe. Be
it America or China, the formula of Salt remains the same regardless of wherever
you are. However, this isn’t the case with Economics. The policies we study in
Economics are not black and white like the formula of Salt, instead, each policy
has different outcomes in the given circumstances. For instance, an inflation may
not be as problematic for America the way it is catastrophic for Pakistan and
other third world countries. That being said, you should apprehend the fact that
the reason Cambridge makes you write evaluation is because they want you to
realize that there are always some limitations and assumptions of different
theories and due to these assumptions, we observe several outcomes of a same
policy so in short, evaluation is your arena where you have to wrestle with the
examiner explaining how the policy he mentioned in question won’t always give
the desired outcome.
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As the nature of Economics suggest, your evaluations should be based on
normative statements. What it essentially means that you should not openly
denounce a policy saying that it is always harmful or favour a policy saying that it
is always correct. Your statement should acknowledge the fact that policies are
dependent on what circumstances they are being executed in. For instance,
imposing import duties is beneficial if it is for short-term but the same policy
becomes harmful if it is for long-term.
Nevertheless, you should provide a conclusion in the end that demonstrates what
do you think is better is most cases.
Use real-time examples of countries to support your case, especially when you
are attempting an essay on Macroeconomics.
A good conclusion line should be written in end that wonderfully encompasses or
summarizes whatever you wrote above.
Evaluation is essentially criticizing whatever you wrote above so for example, if
the examiner made you to write benefits of planned and market economic system
in the above paragraphs, your evaluation is basically raising objections on these
two systems and calmly driving to a conclusion that manifests your bias towards
an approach, gently.
2 of evaluations are being written here to give you a slight idea of what an
evaluation looks. You will be able to read further at the end of this PDF where
there are some solved answers waiting for you.
Evaluation on whether free market economic system or planned economic
system provides maximum benefit to consumers:
It may be true that the free market economic system brings competition with it and be it
a potential or actual competition, the prices will decrease in both cases. However,
there's no surety that there will always be competition because it is quite possible that a
big firm dominates other small firms by taking over them which will result in a monopoly
in markets that perhaps will result in the exercise of price fixing and others, as a
consequence, the choice of consumers will be limited and they may be forced to pay a
higher price for a product. Moreover, there are several things that consumers perceive
beneficial for them which actually aren't such as cigarettes and unhealthy chocolates so
due to information failure, the consumers may end up purchasing products that are not
beneficial for them, such a case will not maximise the benefit for consumers. Similarly,
there's likely to be the overconsumption of demerit goods in the market economic
system and consumption of demerit goods may have trivial benefits for someone who's
consuming it but it will put the people surrounding in danger resulting in an adverse
impact on society because of failure to take into account the external costs. Also, there's
a possibility that there is a product with higher demand from consumers but the
producers may fail to provide the product to the consumer despite the consumer being
sovereign in a free market economic system. This happens because of the immobility of
resources, for instance, the supplier of that product requires a special category of labour
to effectively produce it but since that particular labour is geographically immobile, the
suppliers won't be able to provide the good to consumers. Furthermore, public goods
such as defence will not be provided by market forces because of the incentive to free;
if a good is non-excludable and non-rival in nature, the individual's cheapest option is to
wait for someone else to pay for the good. Nevertheless, it is also not certain that the
planned economic system will always be doing what maximises the benefits for the
consumer. For instance, the government may politicise their decision, a good example
of it could be that the government may refuse to increase or impose a tax on petrol
despite the fact that petrol consumption results in pollution in the environment just
because the elections are near and the government can't risk their political capital.
Similarly, the directives of the government may devote resources to specific sectors
where there's low demand out of bias and this perhaps will result in inefficient resource
allocation. Also, the government practising maximum and minimum prices to intervene
in markets may result in unofficial markets and loss of consumer welfare. For example,
a maximum price set to make wheat cheaper may result in hoarding and a minimum
price being imposed on a certain product will encourage people to engage in black
markets.
Well, it's true that each system has its pros and cons but if we consider the economic
model adopted by developed countries, we reach a conclusion that developed
economics practises the economic model that has a major share of market forces.
Nevertheless, there should be a government as an authority to deal with monetary,
fiscal and foreign policies and free rider problems. Also, to regulate markets a little to
ensure there's no unfairness but that intervention should be minimal. In short, a mixed
economic system sounds like a good economic model such as hong-kong.
Key takeaways:
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A balanced criticism was made on both economic models but with a conclusion
that showed the inclination of writer towards market economic system.
The evaluation didn’t immediately reject one economic model and favoured
another but kept a balanced approach.
Relevant examples were provided to support the case.
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Don’t consider this as an ideal evaluation thinking you should write this much
content as well. This is an attempt to show you what points an evaluation can
consider and how they are to be illustrated.
However, evaluation should be detailed and the content should be similar.
Evaluation of Question whether Inflation is more harmful or bad
deflation is harmful:
After examining the harmful aspects of both inflation and deflation,
asserting whether deflation is a bigger problem than inflation or not highly depends on
the performance and macroeconomic aims of an economy. For third-world countries like
Pakistan, inflation is a bigger problem than deflation because such countries have taken
foreign loans from IMF and other countries, so inflation makes it harder for them to
repay their loans as inflation makes their exporting goods expensive thus causing
contraction in exports which deteriorates their current account and results in
depreciation of their currency. Further, hyperinflation could be one of the worst things to
happen to an economy, so for any country like Venezuela, hyperinflation is the bigger
problem because it also ceases the country's money to carry out its functions.
Nonetheless, the rate of inflation should also be considered so if the rate is not in
double-digits and is in accordance with the macroeconomic aims of the country, then it
is not to be branded as a problem. For instance, New Zealand doesn't have any
problem with the inflation rate from 0-3% because it is in line with their macroeconomic
aim. Talking about deflation, it does bring benefits for some economic groups. People
on a fixed income like pensions and creditors will benefit. Moreover, if exports are price
elastic, the value of a country's exports will rise hence improving the current account.
However, deflation can also become a bigger problem than inflation if it is a bad
deflation. Sometimes it gets hard to figure out the policy to combat bad deflation,
particularly if it is a deflationary spiral. A good example could be Japan's deflation which
has made the policymakers of Japan to introduce negative interest rates for the first
time in history. And yet failed to solve the deflation problem. In 2015, when
Switzerland's central bank introduced negative interest rates with the expectation of
recession to tackle their deflation, things didn't turn out to be well instead their economy
observed growth contrary to their expectation.
Conclusion: Therefore, the depressing effect on demand of deflation is the fundamental
reason why policymakers suggest that the ideal rate of inflation should be a positive 12% because such a rate demonstrates sustained economic growth and leading
prosperity.
Key takeaway:
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Real-world examples were used to substantiate points.
Not an ideal but might be helpful
how you should write your answer
Considering you have to write an essay as your answer in the exam, the first thing you
should keep in mind is that your essay should be written in such a manner that even
someone who has no clue about economics could grasp the concept you are trying to
illustrate in your essay. What this means is that you should define the fundamental
concepts if it says at the beginning of each answer. For example, if the question asks
you to write an account on public and private goods, start your answer by defining what
they actually are and explaining technical terms like 'rivalry' and 'excludability' in normal
language. Now for a moment, let's look from the perspective of a seeker of knowledge,
the only thing a learner desires after a description is relevant examples because
examples are like a sweet dish, everybody wants it after the main course.
Therefore, once you're done with the description, the next thing you should do is to give
a few practical relevant examples (relevant means that examples should be pertinent to
the examiner's condition if there is any, for instance, modern economy/century) and
draw and analyse diagrams (a must if the examiner asked you to do) to support and
enhance your answer as it reflects that how skilfully you can apply the concepts. An
example of private good could be a cup of coffee, and an example of public good could
be a streetlight, whereas, examples of quasi-public good could be Netflix and grazing
fields. Don't forget to analyse your example, so if you used Netflix as an example of
quasi-public good, analyse how it fits its definition by being non-rival in nature as it is
available for everyone and one's consumption doesn't affect the other's consumption.
Nevertheless, it holds the characteristic of being a rival because one needs to subscribe
to their subscription annually or monthly.
Note: when we analyse something, we go into depth which is not the case in explaining
something
Once you are done with all of this, you have addressed a considerable portion of the
question. Now address the other part of the question, usually, examiner mentions the
other part of the question evidently by giving a scenario/problem/opinion, for example,
why public goods cannot be supplied in a free-market economy or what are the other
types that are considered as 'near money' or how PPC (production possibility curve)
shows opportunity cost.
If you concentrate on the past paper pattern of questions, you will apprehend that the
examiner first expects you to briefly elaborate a concept, and then asks you to explain
the technicalities of that concept or address a problem of that concept by questioning
why/how. There is no such hard and fast rule in this part of the question, all you have to
do is be well-grounded with the syllabus. You should know the reason behind credit
cards or cheques not being considered as money, how PPC shows the opportunity cost
by having a negative slope and the concept of scarcity by putting a line that manifests
the points beyond are unattainable or why people in a free-market economy give up on
producing public goods because of no incentive and the free-rider problem.
If I try to briefly summarize the answer structure
-Start your answer by defining the concept
-Explain the technical terms
-Provide relevant examples and draw diagrams (Don't forget analyse them since they
are the best way to enhance your answer)
Note: Diagrams are supposed to be analysed, stating decrease/increase in price etc is
not sufficient for analysis. You are expected to examine it properly
-Address to the main part of the question (for example, functions of money/price
mechanism)
-Address the 2nd part of the question
Note: in diagrams, usually, it is to analyse what concepts are shown by that particular
model.
-Write a good conclusive line to close your essay
Note: Read the question carefully, if there is any condition or scenario mentioned by the
examiner don't ignore it. Your content should be in relevance with the question asked.
(Refer to Next Page)
Some answers that I wrote
Q. Explain what is meant by 'protectionism' and describe two ways in which the
steel industry could be protected (8)
Ans: Protectionism fundamentally means protecting domestic producers from foreign
competition.
Different economies intervene in international trade and adopt different measures to
protect their domestic producers, likewise, the steel industry can be protected from
some of those measures.
The most popular method of protectionism used by the countries is to impose tariffs on
imported goods. A tariff essentially is an indirect tax that is levied on foreign goods
which ultimately makes the imported product expensive, therefore, the people will find
the imported goods expensive, and they will reduce the quantity demanded. On the
other hand, considering the imported good is characteristically a substitute for the
domestic good, an increase in the price of the substitute good will encourage people to
purchase the domestically produced steel as it's cheaper and can be used in the place
of foreign-produced steel.
An alternative policy that a country may adopt is to limit the imports of steel to a given
volume. For example, the country sets a quantitative limit of 500 tons on the sale of
foreign steel into the country that initially had the demand of 1000 tons of steel. In this
framework, the supply of foreign steel will diminish, as a result, there will be a shortage
in the market that will lead to an increase in the price of foreign steel which will make it
expensive for local people to purchase the foreign steel. Therefore, they will switch to
locally produced steel to fulfil their demand.
There are other methods as well that can be executed to protect the steel industry such
as embargo, Voluntary export restraints and many more. What should be executed
depends on the given circumstances and context.
Q) Explain the characteristics that money needs to have in order to perform its
functions effectively. (8)
Money is anything that is generally accepted as payments for goods and services, or in
payments of debt.
Any type of money should fulfil and serve these 4 primary functions in the modern
economy. Primarily, it should perform the medium of exchange which means that sellers
should be willing to accept from the buyers in exchange for their purchases, hence,
eliminating the requirement of finding the coincidence of wants. The second one is unit
of account, the money should provide a common measure of the value of goods and
services. In easy words, the prices could be expressed in terms of it. Third on the list is
the store of value, the economic agents should have the ability to transfer the wealth
over a period of time either by holding cash or storing it with a financial institution. In
other words, it shouldn't perish or be too big to save. The last one is that it should
enable people to borrow money and pay it back at a later date, this function is known as
the standard of deferred payment.
Any money that aims to serve these aforementioned functions should have the following
characteristics.
It should be generally accepted because this supports the function of the medium of
exchange. This means the essential quality of money is that it must act as an item being
acceptable to all, without having any hesitation in the exchange for goods and services.
Moreover, it should be limited in supply because anything being unlimited in supply
makes it worthless, the constraints on the amount of money in the monetary circulation
ensure that values remain constant for the currency. Further, it should be durable, this is
crucial for money because not being durable would make it pretty poor for store of
value, therefore, it should withstand all the hardships and be able to maintain
undamaged after long usage. Fourth, the money should be portable which means that it
could be movable from place to place to be used for monetary transactions.
Furthermore, the money should be divided into small units because being divisible
would make it easier to be used for the purchase of goods with different values. Last, it
should have uniformity, with that being said, all $10 notes must look the same and so on
because it establishes when a note is genuine and prevent counterfeiting which means
duplication of money.
In conclusion, anything that aims to be money should be acceptable to all, limited in
supply, durable, portable, divisible and uniform in order to perform the fundamental 4
functions defined by the economists.
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The next answer is an example to tell evaluation isn’t to be necessarily in
the last paragraph. You can do it along with the core paragraphs because
evaluation often is essentially drawback/disadvantage of a policy.
B) Discuss whether monetary policy measures are always effective in correcting
a high rate of inflation. [12]
Monetary policy measures include changes in the interest rates, changes in money
supply and changes in the value of exchange rates.
A rise in the interest rates means that the cost of borrowing rises which reduces the
demand for loans. This means that large-scale purchases such as purchase of cars and
purchase of houses are discouraged. Also, the return on savings is increased which
increases the opportunity cost of spending. This means that households' consumption is
likely to fall which reduces the aggregate demand of the country. Hence, a rise in
interest rate can be used to control demand-pull inflation.
However, a rise in the interest rates might not guarantee a fall in the households'
consumption. This is because the commercial banks may not increase the interest rates
offered to the customers. Also, the households may not respond to the rise in interest
rates by increasing the savings. This is because the households' are optimistic about
the future or may be a majority of the households are target savers. Also, the rise in
interest rates increases the income of the lenders which might have an offsetting effect
on the household consumption expenditure.
Also, a high rate of interest rates attracts hot money flows which may increase the
external value of the currency which makes the exports less price competitive. This
means that there will be a pressure on domestic prices. This reduces demand pull
inflation. Coupled with that imports of raw materials will be less expensive which also
reduces cost push inflation.
However, hot money flows might not appreciate the currency if the central bank is
observing a fixed exchange rate regime.
Also, if the central bank is able to reduce the growth of money supply then the price
level of the economy can be controlled. As the monetarists argue that the only cause of
inflation is the rise in the growth of money supply faster than the growth in the real
output of the country.
A rise in interest rates may have an adverse effect on investment. This is because it will
increase the cost of borrowing funds to invest and will increase the opportunity cost of
using profits to invest. If investment falls below depreciation, the capital stock will
decline. The resulting decrease in aggregate supply can push up the price level. It might
cause cost push inflation.
On balance, it seems that monetary policy measures are able to control inflation in the
short term but in the long term a country might not be able to control inflation through
monetary policy measures only. For a monetary policy to be effective it should be well
coordinated with the fiscal policy measures. The government should be prudent enough
to raise revenue through taxes so that it may not have to resort to the central bank for
budget deficit monetization which increases the money supply in the market.
One important thing to note for monetary policy measures is the time lag effect of these
measures. There is a time lag between changing interest rates and the full effect being
transmitted to the macroeconomy. Therefore, monetary policy measures are not always
effective in correcting a high rate of inflation.
Q. Discuss the advantages and disadvantages of protecting an industry such as
steel and consider whether the protection will be an overall benefit to this
economy (12)
The possible arguments that are provided in favour of protectionism that is also
considered as its advantages are the following.
The first and foremost is the infant industry argument that the new firms that have
recently entered the steel market and have the potential to grow may be eliminated from
the foreign competition due to lower prices and not being able to qualify for the
economies of scale, so with the help of protection, such industries get the time to
establish themselves and get their potential nurtured and get an opportunity to unleash
their potential of comparative advantage or absolute advantage if they have any. If the
economy is developing and has a resource curse in the sector of steel, then the
protectionist measures will help in solving this curse as firms will be reluctant to invest
with high competition.
Moreover. if the foreign countries are selling their steel in large quantities at prices
deliberately below those charged by domestic firms, often even below the cost of
production as china is alleged for doing this in the market of steel, then in such a
scenario, protectionist measures help in saving domestic firms from the unfair
competition which is known as dumping. Furthermore, steel is an important good in an
economy and is used in the majority of construction work so in that sense if the
economy becomes dependent on any other country, then there is a risk that if they run
into political conflict the economy's production will be highly affected, therefore, such
strategic measures are taken to prevent the economy from being dependent on vital
goods.
The other arguments include saving people from getting unemployed, the domestic
firms will close down due to cheaper foreign steel which will result in people getting
unemployed. Also, besides saving competition the protectionist measures can also be a
source of government revenue. Another important advantage is that it is the source of
correction of the balance of payment which will reduce the current account deficit if
there is any, which will perhaps make other imported raw materials for steel makers
cheaper due to the appreciation of the currency.
However, the government intervention will distort the market signals of steel and this
can lead to the misallocation of resources. For instance, the local steel is poorer in
quality compared to foreign steel which will affect the production in the economy.
Moreover, Protection can lead to increased costs of production due to a lack of
competition that might contribute to inflation in the economy and force the households to
purchase poorer quality goods for a higher price. This will deteriorate the standard of
living. Additionally, the local producers won't be much motivated to be efficient or
innovative. Also, the protectionist measures will limit the choice for the consumers of
steel and the trading countries might retaliate stronger by imposing their own trade
barriers that will affect the exports of local goods.
To assess whether the protection will benefit the economy overall depends on given
circumstances. The infant industry argument does help in supporting infant industries
but it might promote protectionism dependency in the economy thus they might not
make efforts to reduce their cost of production to the extent they can. If the other
country retaliates with a stronger trade barrier then it will affect the exports of the
country, as a consequence, the exporters will fire the employees which will still increase
the unemployment in the economy. Moreover, that retaliation might also widen the
current account deficit leading to deprecation. Furthermore, the argument of dumping
can't be easily executed because to assert that there is actually dumping from other
countries is extremely complicated and difficult based on facts and figures.
Nevertheless, protectionism might be harmful in the short-run but in the long term, it
may contribute to economic growth by increasing the exports of the country will increase
the net exports leading to an increase in Aggregate demand. More firms being settled
up means they will pay taxes to the government that will finance the government
expenditure. The introduction of protectionist measures will also increase the producer
surplus of local producers.
Although these things are uncertain, the government should ensure that the benefits of
protectionist measures must always outweigh the cost of trade barriers.
Q. Analyse how fiscal policy and monetary policy can be used to solve the
problem of deflation. Assess which policy is likely to be more effective (12)
Fiscal policy fundamentally is the use of taxation and government expenditure and
Monetary policy is the manipulation of interest rates, exchange rates and the money
supply strategies to influence the level of economic activity and macroeconomic
objectives.
Deflation is defined as a persistent fall in the average level of prices in the economy. If
the deflation is due to the improved supply-side policy and productivity, it is not bad.
However, if it is due to the falling demand of the economy then it is termed as bad
(Draw AD and AS diagram to demonstrate the fall in demand). To solve bad deflation
we have the following measures.
Expansionary fiscal policy is one of the tools that can be used to overcome bad
deflation. One aspect of expansionary fiscal policy is government spending. Since
government spending is a component of Aggregate demand(AD), therefore, an increase
in government spending will simultaneously increase the aggregate demand curve to
the shift resulting in increased demand in the economy. The other aspect of
Expansionary fiscal policy is to reduce the direct and indirect taxes in the economy.
Such as a decrease in income tax will increase the disposable income, hence,
households will have more money to spend more leading to an increase in consumption
which will shift the AD to right. Similarly, a decrease in corporate tax will increase a
firm's incentive to expand which will cause an increase in investment leading to an
increase in Aggregate demand.
The second measure is the expansionary monetary policy. A fall in interest rates will
reduce the cost of borrowing which will decrease the opportunity cost of spending, as a
result, people will spend more leading to higher consumption resulting in a shift in an
increase in AD. Moreover, a decrease in interest rate will discourage foreign investors to
invest whilst the domestic investor will move his money to a foreign country where he
can enjoy higher interest, as a consequence, there will be an outflow of money leading
to an increase in the supply of local currency that will cause depreciation, that being so,
our export prices will be more competitive leading to increase in net exports that will
cause AD to shift right.
To assess which policy will be effective depends on several factors. Both policies have
their own complication. A rise in public sector spending might drive down or even
eliminate private sector spending. One limitation that is present in both policies is the
time lag. A cut in income tax, for example, will take time to have a significant impact on
the spending habits of households and there is a time delay between recognising the
need and implementing it. Nevertheless, The fiscal policy sounds better in the sense
that an increase in government spending will help to reduce the consumer confidence
that was lost due to deflation. Moreover, Fiscal policy is relatively quick and influences
the economic activity level more. Whereas, economic activity is not totally dependent on
interest rates. The global financial crisis of 2008 proved that despite interest rates being
close to, or 0% in countries didn't help them in solving the recession. Even Japan
introduced a negative interest rate but still yet failed to solve its deflation problem. If the
exchange rate is fixed then a decrease in interest rate won't cause depreciation, as a
result, the export prices won't become competitive.
Though, whatever the policy is. It should be highly kept in mind that the deflation should
not be temporary or due to negative shock, rather it should be core deflation because in
that case, both expansionary policies won't turn out to be a good plan