Answers to Pause-for-Thought Questions
Part K: Macroeconomic Policy
Chapter 30
If the government is running a budget deficit, does this mean that GDP will increase?
GDP will rise if aggregate expenditure exceeds GDP (see Figure 29.2). This will occur if injections exceed
withdrawals. A budget deficit means that government expenditure (an injection) exceeds taxation (a
withdrawal). Whether total injections exceed total withdrawals, however, depends on the size of the other two
injections (I and X) and the other two withdrawals (S and M). A budget deficit will cause national income to
rise, therefore, provided its expansionary effect is not negated by the other two withdrawals exceeding the
other two injections: i.e. so long as (G – T) > [(S + M) – (I + X)].
Why will the multiplier effect of government transfer payments, such as child benefit, pensions and social
security be less than the full multiplier effect from government expenditure on goods and services?
The ‘transfer payments multiplier’ will be smaller than the government expenditure multiplier, because part of
transfer payments is not spent on domestic goods: some is saved, some goes in taxes and some is spent on
imports.
Gives some other examples of ‘random shocks’ that could undermine the government’s fiscal policy.
Four examples are:

A stock market collapse.

A major industrial dispute.

A general election.

A prolonged drought.
Explain how open-market operations could be used to increase the money supply.
The central bank could buy back bonds from the banking system before they reached maturity. The banks’
balances in the central bank would be credited, allowing the banks to create more credit.
Assume that the central bank announces a rise in interest rates and backs this up with open-market
operations. What determines the size of the resulting fall in aggregate demand?
The responsiveness of aggregate demand to a rise in interest rates depends on a number of factors. These
include:

Confidence and expectations. If businesses believe that the rise in interest rates will dampen the
economy, then they are likely to reduce investment and aggregate demand may fall significantly.
Similarly if potential house purchasers think that a rise in interest rates will stop house prices rising (or
even cause them to fall), then there will be a slowdown in house purchase and a reduction in demand for
various items such as furniture that accompany house purchase.

If there are high levels of consumer debt, then an interest rate rise is likely to be more effective in
curtailing aggregate demand than in a situation where consumer debt is low.

The size of the multiplier will determine the subsequent effects of any initial fall in aggregate demand.

Any random shocks that occur after the rise in interest rates.
Answers to pause-for-thought questions in Economics for Business (3rd edition), John Sloman and Mark Sutcliffe
Do you agree that ‘ever more rapid financial flows across the world that are unpredictable and uncertain’
make Keynesian discretionary fiscal (and monetary) policy less suitable? Explain.
Discretionary fiscal policy can be undermined by international financial flows. For example, if government
expenditure is raised in order to stimulate the economy, the resulting increase in demand for money will drive
up the rate of interest. This will lead to an inflow of finance from abroad and an appreciation of the rate of
exchange. This will reduce the demand for exports (an injection) and increase the demand for imports (a
withdrawal). The effect will therefore be to dampen the rise in aggregate demand. Also, the unpredictability of
international financial flows makes the effects of fiscal (and monetary policy) changes less predictable.
Note that if there had been a policy of maintaining interest rates at the original level, and thus increasing
money supply in line with the extra demand for money, then the above effects would not have occurred. What
this means is that if fiscal policy is to be effective, it must be backed up by monetary policy.
Chapter 31
Why might a recovering economy (and hence a fall in government expenditure on social security benefits)
make the government feel even more concerned to make discretionary cuts in government expenditure?
To prevent money supply and the economy from expanding too rapidly. The automatic stabilising effects of the
cuts in social security benefits and the rise in tax revenues may be insufficient.
If taxes as a proportion of national income have risen since 1979, does this mean that there can have been
no positive incentive effects of the various tax measures taken by first the Conservative and then the Labour
governments?
It depends on the type of tax change. A rise in the average rate of tax but a reduction in the marginal rate of tax
could encourage people to work more because they keep more of any rise in income. This effect could be
achieved by reducing the marginal rate of income tax but removing various personal allowances (such as the
married man's allowance). Both Conservative and Labour governments adopted such policies.
It also depends on how people perceive tax changes. If people are given an income tax cut, this might
act as an incentive, even if VAT has gone up so as to keep the amount they can purchase the same as before.
They may believe that they are better off because their take home pay has gone up in money terms, even
though in real terms there is no change in their income.
1.
2.
Think of some other ‘pro-market’ solutions to the regional problem.
Do people in the less prosperous areas benefit from pro-market solutions?
1.
Two examples are:

Reductions in planning restrictions in the less prosperous areas.

Adjusting unemployment and social security benefits to an area’s cost of living. Thus if the cost of
living were lower in the less prosperous regions, there would be a reduction in unemployment and
social security benefits in those regions.
2.
Those currently in work lose from lower wages. Those out of work lose if their benefits are reduced.
There are gains, however, for those who now find a job, especially if capital is relatively mobile into the
area and therefore there has not been a need to have a significant cut in wage rates.
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Answers to pause-for-thought questions in Economics for Business (3rd edition), John Sloman and Mark Sutcliffe
If you were the government, how would you set about deciding the rate of subsidy to pay a firm thinking of
moving to a less prosperous area?
If the purpose were to provide jobs, then the government should estimate the costs of providing additional jobs,
and raise the subsidy to such a level where the marginal cost of providing one more job was felt to be worth the
benefit of so doing. The problem, of course, is in estimating the number of jobs that will result, both directly
and indirectly through multiplier effects, and also the difficulty in estimating the marginal social benefit of
providing extra jobs. This will involve value judgements about the personal benefits to the workers involved.
There is also the problem of ensuring that the subsidies are used as efficiently as possible, and not simply used
to subsidise capital-intensive industries that provide few jobs.
How can the UK’s low level of investment relative to national income be explained?
The UK’s low level of investment relative to national income has been a feature of the UK economy for
many years. Some of the reasons advanced to explain this situation are the short-termism of UK financial
markets and the difficulty UK business has in raising long-term investment finance. Volatility in the UK
economy and in UK interest rates in particular have also created an uncertain environment for business,
reducing its willingness to invest long term. Business profitability has also been generally low; this forms
the basis of most investment finance.
Give some criticisms of these arguments.
Although a market-orientated supply-side policy may improve the general efficiency of the economy and the
supply side in particular, it does involve the government effectively giving up managing economic affairs
and ensuring the economy meets objectives other than efficiency, such as fairness and equity through a
fairer distribution of wages. Even the objective of efficiency will not necessarily be achieved through a
market-orientated supply-side policy, given various market failures such as monopoly power and
externalities (see Chapter 20).
Chapter 32
Assume that the US economy expands. What will determine the size of the multiplier effect on other
countries?



The size of US marginal propensity to import. The bigger it is, the bigger the rise in imports for any
given expansion in US income and hence the bigger the rise in other countries' exports to the USA and
the larger the rise in their aggregate demand.
The size of the multiplier in other countries. The bigger it is, the bigger will be the rise in their income
as a result of a rise in exports to the USA.
For any one country, the effect will be bigger, the larger the proportion of the increased US imports
that come from that country.
Referring to Table 32.1, is there any evidence that there was any greater convergence between the G7
countries in 2001 than in 1991?
There were still wide differences between the countries, although not quite as wide as in 1991. Divergences in
interest rates and rates of economic growth had narrowed somewhat and there had been a general fall in
inflation and in government borrowing requirements and a greater convergence in their levels. Also, despite
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Answers to pause-for-thought questions in Economics for Business (3rd edition), John Sloman and Mark Sutcliffe
some differences between the size of output gaps, their narrowing suggested that countries’ business cycles
were coming more into line. On most measures, however, Japan was considerably out of line with the other six
countries.
Under what circumstances may a currency bloc like the ERM (a) help to prevent speculation; (b) aggravate
the problem of speculation?
(a) By its persuading speculators that the combined strength of the countries’ reserves and their combined
monetary policies would guarantee that rates of exchange could be maintained within their bands. Under
these circumstances speculation would be pointless.
(b) If exchange rates were being maintained at clearly disequilibrium levels. The longer devaluation or
revaluation were put off, and the more inevitable speculators believed the devaluation or revaluation
would eventually be, the more would speculation take place.
Is greater factor mobility likely to increase or decrease the problem of cumulative causation associated
with regional multipliers?
Labour mobility would increase it. As workers were attracted to areas of the Union where wages were high and
jobs were plentiful, so the areas they left would become depressed regions and would suffer a multiplied
decline in income and a resulting further rise in unemployment.
Capital mobility could help to reduce the problem. As the text argues, capital might be attracted to areas
where labour costs are low: i.e. the depressed regions. On the other hand, with the demand for capital likely to
be high in the more prosperous regions, capital is likely to be attracted to these areas, further widening the
divide between the richer and poorer parts of the Union.
Before you read on, see if you can identify (a) the ways exchange transactions might be controlled; (b) the
difficulties in using such policy?
Exchange transactions might be controlled in a number of ways. For example governments might restrict the
amount of foreign exchange dealing that could be conducted within a given period of time. These
restrictions could apply to companies, individuals or dealers. For example, in the 1960s the UK government
imposed a £50 limit on the amount of foreign exchange holiday makers could take abroad. The difficulties
in administering exchange controls and their anti-market bias has tended to mean that this approach to
currency management now receives little use around the world.
An alternative to controlling exchange transactions is to tax them. The Tobin Tax, as explained in the
text, is one such proposal. It involves a small tax on all foreign exchange transactions, thereby reducing
(rather than preventing) the most speculative movements of money, which are often conducted with only the
expectation of small profit margins. The weakness with the Tobin Tax concerns the difficulty in
administering it and the likelihood that speculators would find ways of avoiding paying it.
Non-interest-bearing deposits, whereby a government insists that a given percentage of any capital
inflow is deposited with the central bank for a period of time, is another means of regulating foreign
exchange. The weakness with this system is the likely disincentive to inward investment.
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