12: Demand-side and supply-side policies

Question 1

Define demand side policies:

Answer 1

Demand side policies focus on changing aggregate demand, or shifting the aggregate demand curve to achieve the goals of price stability, full employment and economic growth.

Question 2

What is discretionary policy?

What are the two types of discretionary demand-side policy?

Answer 2

Policy at the discretion of the government.

1. Fiscal policy
2. Monetary policy

Question 3

What are stabilisation policies?

Answer 3

Fiscal and monetary policies that work to reduce the size of economic fluctuations.

Question 4

What are the sources of government revenue?

Answer 4

1. Taxed of all types
2. The sale of goods and services such as transportation, electricity, water, postal service. These goods may be subsidised but not free of charge.
3. The sale of government owned enterprises or property - privatisation. E.g. privatisation of the British postal service.

Question 5

Types of government expenditure:

Answer 5

1. Current expenditure - spending on day to day items that are recurring, e.g. wages.
2. Capital expenditures - public investments or the production of physical capital.
3. Transfer payments - payments by the government to vulnerable groups.

Question 6

Distinguish between a budget deficit, a budget surplus and a balanced budget:

Answer 6

If tax revenues are equal to government expenditure, the government is said t o have a balanced budget. If expenditure is larger than revenues, there is a budget deficit and if expenditure is less than revenues there is a budget surplus.

Question 7

What is public/government debt?

Answer 7

Deficits - surplus

Question 8

Why are the sale of goods and services not included in the calculation of surplus?

Answer 8

Because there are one off payments. The government has a limited amount of capital that it can sell, so deficits cannot indefinitely be paid off by this. Government enterprises can be sold to pay off accumulated public debt however. This is advantageous because it reduces interest payments and the money saved on this can be spent elsewhere.

Question 9

What is fiscal policy?

Answer 9

Manipulations by the government of its own expenditures and taxes to influence the level of aggregate demand.

Question 10

How can fiscal policy effect the four components of GDP?

Answer 10

C: personal income taxes can be manipulated. Higher taxes means less spending, lower taxes means more spending, as this affects disposable income.

G: The government can increase or decrease its own spending.

I: Investment spending can be changes by changing corporate taxes.

(X-M): the government can’t change these through fiscal policy.

Question 11

How can expansionary fiscal policy help an economy close a deflationary gap?

How does this differ with neoclassical/Keynesian?

Answer 11

Define fiscal policy.
Define deflationary gap.
If a deflationary gap is caused by insufficient aggregate demand (AD) the government can increase its own spending and lower corporate and income taxes to increase spending. Doing these things simultaneously could lead to a budget deficit.
Show on both graphs: neoclassical and Keynesian.
AD1 is at Yrec and Pl1, it moves to the right to Yp. on the neoclassical Yp is where the vertical LRAS is. On the Keynesian Yp is where the AS starts to go up.
PL rises to Pl2.

In the neoclassical model a rightward shift of the AD curve always leads to an increase in price level and an increase in output. The increase in output with the Keynesian model will be larger, due to the horizontal section of the AS curve. In addition, in this model a rightwards shift of the AD curve may not lead to an increase in PL, if AD2 remains on the horizontal stretch.

Question 12

How can contractionary fiscal policy help to close an inflationary gap?

Answer 12

Define (contractionary) fiscal policy.
Define inflationary gap.

If the economy is facing an inflationary gap caused by excessive aggregate demand, the government can decrease government spending and/or increase business and income taxes. This works to decrease disposable income and investments so spending is less and AD is less.
Show on both graphs, AD1 is to the right of Yp. AD2 is at Yp.

With the Keynesian model, if AD were to decrease on the horizontal part of the AS curve, the Pl will not decrease and the GDP would decrease more than with the neoclassical.

Question 13

What is the ratchet effect? Explain using a diagram:

Answer 13

With the Keynesian model price levels do not easily fall when there is a decrease in aggregate demand. This can be shown on a graph as AD increases, but the Pl does not decrease, even on the curve. Draw a line from Pl1 (the original price level) and AD should move until it intersects where that Pl is at Yp.

Question 14

What are automatic stabilisers?

Answer 14

Factors that automatically, without any action by the government, work towards stabilising the economy by reducing short term fluctuations of the business cycle.

Question 15

What are the two important automatic stabilisers?

Answer 15

1. Progressive income taxes

2. Unemployment benefits

Question 16

How are progressive income taxes automatic stabilisers?

Answer 16

In an inflationary gap as real GDP increases government tax revenues also increase, meaning disposable income decreases. This leads to a lower economic growth than would otherwise occur.
In a deflationary gap the opposite occurs. As GDP is lowered, incomes fall and the government tax revenues decrease, increasing disposable income and lessening the negative economic growth.
The more progressive the income tax the greater the stabilising effect on economic activity.

Question 17

How are unemployment benefits taxes automatic stabilisers?

Answer 17

In a recession real GDP decreases and unemployment increases so unemployment benefits rise. If there were no unemployment benefits the recession would be far worse as spending would dramatically decrease since the unemployed would have no source of income. However the unemployment benefits work to some extent to maintain consumption.
In an expansion unemployment benefits are reduced as unemployment falls, therefore consumption increases less than it would in the absence of unemployment benefits. If unemployment fell without unemployment benefits, people will go from 0 income to a source of income so spending will rise more.

Question 18

How does the multiplier effect the effectiveness of fiscal policy?

Answer 18

The larger the multiplier, the stronger the impact of fiscal policy on real GDP. Also, an increase in government spending has a larger impact on aggregate demand than the equivalent decrease in taxes. This is because government spending enters the spending stream in its entirety where as how much of the new disposable income after taxes enters the spending stream depends on MPC. Whatever does enter the stream is then effected by the multiplier.

Question 19

How do automatic stabilisers work in terms of the multiplier?

Answer 19

Automatic stabilisers work by reducing the value of the multiplier as they lower the size of MPC.

Question 20

How does fiscal policy have indirect effects on potential output?

Answer 20

Fiscal policy creates a stable macroeconomic environment that encourages activities impacting long term economic growth. This gives producer and consumer confidence.

Question 21

How does fiscal policy have direct effects on potential output?

Answer 21

1. They allocate a portion of government spending to the development of physical capital - roads, airports.
2. They allocate a portion of government spending to the development of human capital - education.
3. They provide incentives to encourage investment by firms through lower business taxes.

Question 22

Evaluate fiscal policy (strengths):

Answer 22

Strengths:

1. Can pull an economy out of a deep recession. - this occurred after the Great Depression with the New Deal where the government increased spending.
2. Dealing with rapid and escalating inflation.
3. Ability to target specific sections of the economy as government can increase spending depending on their priorities. For example they can focus on education or healthcare.
4. Direct impact of government spending on AD. Tax cuts are less direct as during a recession it is likely MPS is high and MPC low.
5. Ability to affect potential output - indirectly as creates a stable environment and directly through investments in human and physical capital.

Question 23

Evaluate fiscal policy (weaknesses):

Answer 23

Weaknesses:

1. Problems of time lags. There is a lag when:
   a) it takes time to recognise the problem.
   b) it takes time to agree upon the appropriate policy
   c) it takes time for the policy to take effect
2. Political constraints - the government cannot reduce spending on merit goods such as healthcare and education. This occurred in 2010 with the liberal democrats pledged to keep education costs down but in fact they raised them and as a result they became very unpopular. In addition if they raise taxes they will be unpopular.
3. Crowding out - with expansionary fiscal policy the government is forced to borrow. This leads to a higher rate of interest which leads to lower investment and the expansionary fiscal policy is weakened. However Keynesian economists believe that investment will increase in spite of higher interest due to improved business expectations as a result of increased spendings.
4. Inability to deal with supply-side causes of instability - it cannot combat stagflation as contractionary policy could combat the problem of inflation but would make the inflation worse and an expansionary policy could combat the recession but would make inflation worse.
5. Tax cuts may not increase AD in a recession as people save more since they do not trust the economy.
6. It cannot ‘fine-tune’ the economy. Fiscal policy can lead the economy in a general direction of larger or smaller AD it cannot be used to reach a precise target with respect to the level of output, employment and price level.

Question 24

What is the difference between the central bank and commercial banks?

Answer 24

The central bank is a government financial institution whereas commercial banks are financial institutions whose main functions are to hold deposits for their customers, make loans to their consumers and transfer funds by cheque and electronically from one bank to another and to buy government bonds.

Question 25

What are the responsibilities of the central bank?

Answer 25

1. The central bank acts as a banker to the government - it sells bonds to commercial banks and the public and acts as an adviser to the government on financial and banking matters.
2. It acts as a banker to commercial banks
3. It regulates commercial banks
4. It conducts monetary policy

Question 26

How is the rate of interest determined?

Answer 26

It depends on a number of factors including:

1. The level of risk of the loan (+)
2. The length of the period of time over which the loan must be paid (+)
3. The size of the loan (-)
4. The degree of monopoly power of the lender (+)

Question 27

Define money:

Answer 27

Money is anything that is widely acceptable as payment for goods and services. Money consists of currency and cheque accounts.

Question 28

Describe the rate of interest curve:

Answer 28

rate of interest on y, quantity of money on x
Money supply is vertical at Qe, this fixed level is decided by the central bank.
Dm is the money demand curve. It is downwards sloping since when interest rate is low demand for money is very high and when interest rate is low demand for money is low.
The central bank can determine money supply by changing rate of interest. The Sm curve then shifts to a vertical line where Dm meets the i. It can also increase money supply which in turn will decrease interest rate but this is less common.
The federal reserve (the central bank in the US) determines the federal funds rate.

Question 29

How do changes in the interest rate effect AD?

Answer 29

Interest rate changes effect C and I.
C: some consumer spending is paid for out of borrowing so changing the interest rates can effect consumer expenditure.
I: This effects the amount of borrowing by businesses to finance their investments,

Question 30

Describe the mechanism through which expansionary monetary policy can help an economy through a recessionary gap:

Answer 30

Define expansionary monetary policy.
Define recessionary gap.

During a recessionary gap the central bank decides to increase money supply which decreases the interest rate. There is a lower cost of borrowing so consumers and firms borrow more and consumer spending and investment spending increase. AD increases and the AD curve shifts to the right and the recessionary gap closes. The PL increases and real GDP increases to potential level and the unemployment rate returns to full employment.

The Pl increase depends on whether you use the Keynesian or neoclassical model and which stage on the Keynesian AS curve the AD was originally at.

Draw both graphs.

Question 31

Describe the mechanism through which contractionary monetary policy can help an economy through an inflationary gap:

Answer 31

Define contractionary monetary policy.
Define recessionary gap.

During an inflationary gap the central bank may decide to decrease money supply by increasing interest rates. The cost of borrowing increases for consumers and firms and so consumer and firm spending decreases. AD decreases and the AD curve shifts to the left, and the inflationary gap closes. The PL decreases and real GDP decreases to potential level and the unemployment rate returns to full employment.

Question 32

What is inflation targeting?

Answer 32

Rather than using monetary policy to maintain full employment as well as a low and stable rate of inflation, the central bank focuses on an explicit or implicit target rate of inflation.
If the inflation rate is higher than the target, with a tolerance margin of .1, the central bank will use contractionary monetary policy and vice versa.

Question 33

Advantages of inflation targeting?

Answer 33

1. A lower rate of inflation
2. A more stable rate of inflation
3. Improved ability of economic decision makers to anticipate the future rate of inflation - this reduces uncertainty
4. Greater coordination between monetary and fiscal policy
5. Greater central bank transparency and accountability

Question 34

Disadvantages of inflation targeting?

Answer 34

1. Reduced ability of the central bank to pursue other macroeconomic objectives
2. Reduced ability to respond to supply side shocks - response to supply side shocks may cause higher than targeted inflation.
3. Reduced ability to deal with unexpected events such as a financial crisis - such events may also require expansionary monetary policy which may lead to a rate that is higher than targets.
4. Finding an appropriate inflation target is difficult.
5. Implementation is difficult.

Question 35

Strengths of monetary policy:

Answer 35

1. Relatively quick implementation, less lags than fiscal/
2. Central bank independence so they can make decisions with long term interest in the economy and are not swayed by politics.
3. No political restraint as it does not effect the supply of merit goods and there is less uproar than changes in taxes.
4. No crowding out - it leads to lower interest rates not higher ones as with expansionary monetary policy as the government have to borrow (Dm shifts right and causes i to increase).
5. The interest rate can be increased in small steps so it can fine tune the economy more than fiscal policy.

Question 36

Weaknesses of monetary policy:

Answer 36

1. Time lags - less than fiscal but the problem must be recognised and the policy takes time to come into effect. Interest rates can take several months to come into effect and by then economic conditions may have changed.
2. Possible ineffectiveness during recession. In severe recession banks may be unwilling to increase their lending because they may fear borrowers will not be able to repay their loans. In addition if consumers are pessimistic about future economic conditions they may avoid taking out new loans.
3. Conflict with government objectives as it might effect exchange rates.
4. Inability to deal with stagflation. It also only effects demand.

Question 37

What are supply side policies?

Answer 37

Supply side policies focus on the production and supply side of the economy, and specifically on factors aimed at shifting the LRAS or Keynesian AS curves to the right to increase potential output and achieve long term economic growth.

Question 38

What are the two types of supply side policies? Which is favoured by whom?

Answer 38

1. Interventionist - favoured by Keynesian economists.

2. Market based - favoured by neoclassical economists.

Question 39

Name interventionist supply side policies:

Answer 39

1. Investment in human capital: education and wealth
2. Investment in new technology
3. Investment in infrastructure
4. Industrial policies

Question 40

How will investment in human capital affect the supply side?

Answer 40

This is a type of industrial policy. 1. Training and education: more and better training and education lead to an improvement in the quality of labour resources, increasing the productivity of labour. These can assist workers to become more employable, reducing the natural rate of unemployment. E.g. specific technology training programmes to decrease structural unemployment or grants or low interest student loans to encourage education, establishing government projects in depressed areas such as the london docklands in 2000, which went derelict in the 70s as it could no longer support large shipping containers.
2. Improved access to health care services - a healthier work force is a more productive work force.

This increases AD in the short run and shift the LRAS and Keynesian AS curves in the long run, increasing potential output (Yp).

Question 41

How do investments in new technology affect the supply side?

Answer 41

This is a type of industrial policy. Governments can provide tax incentives or patents to firms that take part in research and development (R & D). This leads to an increase in AD in the short run and increases the potential output (Yp) over the long term, shifting the LRAS or Keynesian AS curves to the right.

Question 42

How do investments in infrastructure affect the supply side?

Answer 42

This is a type of industrial policy. Infrastructure is a type of physical capital including power, telecommunications, roads, airports and transport systems. Many types of infrastructure are merit goods or public goods, justifying government intervention. Good infrastructure leads to more efficient production at lower costs. For example good road, railway and other transport systems saves time and effort spent transporting goods and services. Investments in infrastructure therefore increase AD in the short run and shift the LRAS and Keynesian AS curves in the long run, increasing potential output (Yp).

Question 43

How do industrial policies affect the supply side?

Answer 43

Industrial policies are government policies designed to support the growth of the industrial sector. Other examples include:

1. Support for small and medium size enterprises (SMEs). This may take the form of tax exemptions, grants, low-interest rate loans and business guidance.
2. Support for ‘infant industries’. these are newly emerging industries in developing countries.

Question 44

What are the three types of market based policies?

Answer 44

1. Encourage competition
2. Labour market reforms
3. Incentive related policies

Question 45

What are the methods of increasing competition?

Answer 45

1. Privatisation
2. Deregulation
3. Private financing of public sector projects
4. Outsourcing
5. Restricting monopoly power
6. Trade liberalisation

Question 46

How does privatisation increase competition?

Answer 46

Privatisation involves the transfer of ownership of a firm from the public to private sector, which can increase efficiency due to improved management and operation of the privatised firm. The government do not have incentives to lower costs so they are less efficient.

Question 47

How does deregulation increase competition?

Answer 47

Deregulation increases efficiency. There are two main types of regulation: economic and social.
Economic regulation involves government control of prices, output and other activities of firms, offering them protection against competition. A main form of deregulation has been to allow new, private firms to enter into monopolistic or oligopolistic industries, thus forcing existing firms to face competition - in 1999 for example congress repealed the glass seagall act.
Social regulation involves protecting consumers against undesirable effect of private sector activities, usually negative externalities. Social regulation can be inefficient however, such as if health and safety rules are too strict and reduce inefficiency due to unnecessary paperwork and government interference.

Question 48

How does private financing of public sector projects increase competition?

Answer 48

In recent years private sector firms have begun financing public projects and the government buys the service from the firm, rather than coordinating the initiative themselves. This increases competition as several firms will compete to be selected by the government to take on the project. They will lower costs and increase efficiency in order to compete.

Question 49

How does outsourcing increase competition?

Answer 49

Public services are provided by firms on contractual agreement between the government and private service provider. Firms will compete with each other to acquire contracts.

Question 50

How does restricting monopoly power increase competition?

Answer 50

Enforcing anti-monopoly legislation (not allowing mergers, not allowing agreements to raise prices between monopolies) and breaking up firms that engage in monopolistic practices into smaller units that will behave more competitively. This will result in increased efficiency, lower costs and improved quality.

Question 51

How does trade liberalisation increase competition?

Answer 51

International trade between countries has become freer in recent decades dye to reductions in trade barriers. Freer trade increases competition domestically and globally, resulting in greater efficiency in production and an improved allocation of resources.

Question 52

What are labour market reforms?

Answer 52

These forms are intended to reduce labour market rigidities by making labour markets more competitive. This will lower the natural rate of unemployment. Lower wages result in lower costs of production which leads to increased profits which in turn leads to more investment and research and development and capital goods production. All of this shifts the AS curves to the right and increases real GDP.

Question 53

Examples of labour market reforms:

Answer 53

1. Abolishing minimum wage legislation
2. Weakening the power of labour unions
3. Reducing unemployment benefits
4. Reducing job security

Question 54

How will abolishing minimum wage legislation help the supply side?

Answer 54

Wage flexibility leads to greater employment as firms can hire more people for the same amount. This increases the productivity of the firm and investments go up, leading to more research and development and more economic growth as a whole.
You can draw a price floor graph to show that minimum wage legislation results in oversupply of labour.

Question 55

How will weakening the power of labour unions help the supply side?

Answer 55

If the power of labour unions is reduced then there is less wage price stickiness and wages can respond to the forces of supply and demand, leading to increased output and less unemployment as the supply of labour can meet the demand for labour.
You can draw a price floor graph to show that labour unions result in oversupply of labour.

Question 56

How will reducing unemployment benefits help the supply side?

Answer 56

Reducing unemployment benefits will increase incentive to find a job, which could decrease the natural rate of unemployment. In addition it may lead to an increase in investment in human capital as the job market is competitive so unemployed people may go back to school or learn new skills which would decrease structural unemployment and improve the efficiency of the work force in general, increasing real GDP.

Question 57

How will reducing job security help the supply side?

Answer 57

Reducing job security means that it is less costly for firms to fire workers so costs of production decrease shifting AS to the right. It also incentivises workers to work harder as they feel less safe in their position.

Question 58

What incentive-related policies are there?

Answer 58

1. Lowering personal income taxes
2. Lowering taxes on capital gains and interest income
3. Lowering business tax

Question 59

Explain how lowering tax effects the supply side?

Answer 59

Lowering tax is a method of demand side fiscal policy, but some economists argue that it effects AS even more so. Cuts in taxes incentivise people to work more, as it increases their disposable income more than it did before. People work for longer hours a week. In addition lowering tax could mean a lower pension so retiring later makes more sense. This could hugely improve the efficiency of the work force, increasing supply.
Lower tax on capital goods mean that people are incentivised to save and saving means more money available for investment later.
Lowering business taxes means firms have more money for research and development.

Question 60

Evaluate supply side policies in terms of time lags:

Answer 60

Market based and interventionist have significant time laps. However, interventionist also works on the demand side in the short run which is beneficial in a recession but could contribute to inflation.

Question 61

Evaluate supply side policies in terms of economic growth:

Answer 61

Interventionist: increases investment, R&D, education where the market is unlikely to provide them on its own. Asian Tigers did well with interventionist.

Market based policies: Government interference is likely to lead to resource misallocation where as market based policies can achieve long term growth without this. There are unintended consequences of government intervention, particularly because of political pressures which is not efficient. In addition, interventionist policies involve a lot of government spending which has opportunity costs. This requires a great amount of revenue, which requires tax which works as a disincentive to work, creating inefficiency.

Question 62

The debate over incentive-related policies:

Answer 62

Tax cuts may not increase supply side. People may choose to consume rather than save so they do not have money for investment. In the US for example despite consistent tax cuts saving is at its lowest point in 80 years. It is hard to pinpoint the effect of one policy as often in real life several demand and supply side policies are introduced together.

Question 63

Evaluate supply side policies in terms of ability to reduce unemployment:

Answer 63

Interventionist can decrease unemployment by investing in human capital, which will reduce structural unemployment particularly. However, if the government focuses significantly on improvements in technology this could work to decrease employment as machines tend to be more efficient so they could potentially replace need for some human jobs.
Market based policies involving labour market reform is likely to reduce unemployment, though the wages will be low so it may not be beneficial to the work force as a whole. Market based policies that encourage competition may work to reduce employment however as to increase efficiency firms may fire workers, particularly if job security is reduced by other market based policies.

Question 64

Evaluate supply side policies in terms of ability to reduce inflationary pressure:

Answer 64

They both do it by moving the LRAS or Keynesian AS curve to the right.

Question 65

Evaluate supply side policies in terms of impact on government budget:

Answer 65

Interventionist policies and incentive-related marked based policies have a negative effect on the government budget. These can create a budget deficit.

Question 66

Evaluate supply side policies in terms of effects on equity:

Answer 66

Interventionist policies work towards equity as a more educated, healthy workforce means income should be spread more equally as it is providing incomes to previously unemployed people.
Market based policies are generally inequitable. Increased competition may lead to unemployment as firms fire people to increase efficiency. In addition, labour market reforms lead to increased unemployment. Wage legislations were put in place in order to protect workers, particularly low income workers to removal of these laws could damage them.
In addition incentive related policies can lead to worse distribution of income. Cutting taxes will mainly benefit high income earners, as progressive tax schemes are partly in place to reduce income inequality. Thus they will receive a higher percentage of their already higher wage.
In addition privatised goods may be more expensive, which will effect low income earners more than high income earners.

Question 67

Evaluate supply side policies in terms of effects on the environment:

Answer 67

Market based policies to increase competition may have negative effects on the environment as it promotes activities that have negative externalities.