Cambridge International as and a level Economics Ebook

SELF-ASSESSMENT TASK 
5.9
1
Explain how an expansionary fi scal policy measure 
may encourage households and fi rms to spend more.
2
Assess the infl uence that expectations may play in 
breaking a vicious cycle of defl ation.
3
Assess what impact a lower exchange rate may have 
on the domestic price level.
From the early 1990s Japan experienced periods of 
defl ation and stagnant economic growth. A vicious 
cycle was created with consumers delaying purchases, 
fi rms cutting wages and employment, and consumer 
expenditure falling further.
In 2012, the new prime minister Shinzo Abe 
introduced ‘Abeconomics’. Th
is was a policy 
combination of expansionary fi scal and monetary 
policies designed to encourage households and 
fi rms to spend more and so end defl ation and 
stimulate economic growth. Th
e government was 
increasing its spending, increasing the money 
supply and encouraging a fall in the foreign 
exchange rate in a bid to achieve an infl ation rate 
of 2%. It was also urging fi rms to increase the wages 
they pay.
126
Cambridge International AS Level Economics

---

In this chapter it has been shown that:
■ 
The instruments of fiscal policy are government 
spending and taxation and the instruments of 
monetary policy are interest rates, the money supply 
and the exchange rate.
■ 
Among supply side policy measures are cuts in tax 
rates, reductions in welfare payments, increased 
spending on education and training, trade union 
reform, privatisation, deregulation and government 
subsidies.
■ 
Governments may use expenditure dampening or 
expenditure switching measures to reduce a current 
account deficit. Expenditure dampening measures 
seek to reduce demand for domestically and foreign 
produced products, while expenditure switching 
measures try to encourage households and firms to 
buy more domestically produced products and less 
foreign-produced products.
■ 
Fiscal and monetary policy measures may only 
improve the current account position in the short 
term and may have adverse side eff ects on the 
government’s other macroeconomic objectives.
■ 
Supply side policy measures may provide longer-term 
solutions to a current account deficit and a financial 
account deficit but the eff ects of the measures 
are uncertain and some may take time to have 
an eff ect.
■ 
Deflationary fiscal and monetary policies are used 
to correct demand-pull inflation and supply side 
policy measures are used to prevent it occurring 
in the long term.
■ 
There is no guarantee that higher tax rates and 
higher interest rates will discourage consumer 
expenditure.
■ 
Among the measures a government may use to 
reduce cost-push inflation are a rise in the country’s 
foreign exchange rate, increased government 
spending on training and cuts in corporation tax.
■ 
Foreign firms selling products to the country do not 
have to allow the price of their products to fall in line 
with a revaluation of the country’s currency, a more 
skilled labour force may not reduce costs if wages rise 
by more than output and government subsidies may 
not always reduce inflationary pressure.
■ 
Reflationary fiscal and monetary policy measures are 
used to correct deflation but their eff ectiveness may 
be limited if households and firms are worried about 
the country’s future economic prospects.