2.6 - Demand side policies Flashcards
Macroeconomic policies and objectives
Demand side policies
Demand side policies are policies designed to manipulate consumer demand
Two categories of demand-side policies
- Fiscal policy
- monetary policy
Expansionary policy
Aimed at increasing AD to bring about economic growth
Deflationary
policy
Aims to decrease AD to control inflation
Monetary policy
Where the central bank or regulatory authority attempts to control the
level of AD by altering base interest rates or the money supply in the economy.
Who is responsible for setting monetary policy in the UK?
The Bank of England
(The Bank’s Monetary Policy Committee)
> they are independent of the government
Fiscal policy
involves the use of government spending and taxation to manipulate the
level of aggregate demand and improve macroeconomic performance in an economy.
The UK Government presents their fiscal policies to the country each year when it delivers the government budget
> What is the government budget?
A document that presents the governments revenue and expenditure plans for the fiscal year ahead
Two main instruments of monetary policy
- interest rates
- asset purchases to increase the money supply (quantitative easing)
Official rate
The base rate of interest set by the Bank of England’s monetary policy committee.
Explain how the Bank of England’s monetary policy committee can influence commercial bank interest rates
- Monetary policy committee can lower its official (base) rate
> this is the rate that the Bank of England will
charge for short-term loans to other banks or financial institutions - This influences commercial banks to also lower their interest rates to maintain their profit margins
> (banks make profits by lending money to consumers at higher rates than what they pay on their deposits or borrow from the central bank). while encouraging more borrowing and economic activity
A rise in interest rates causes a fall in AD through…
● The rise in interest rates will increase the cost of borrowing for firms and
consumers.
> This will lead to a fall in investment and consumption, reducing AD.
> Two particular areas of consumption that will decrease are consumer durables and houses.
> Higher interest rates require higher rates of return for investment.
> they also makes savings more attractive, as the interest earnt on them will be higher
● Since less people are borrowing and more are saving, there is a fall in demand for assets such as stocks, shares and government bonds.
> This leads to a fall in prices for these assets .
> Therefore, consumers will experience a negative wealth effect since the value of their assets fall, which will lead to a fall in consumption.
> Moreover, investment is less attractive since firms are likely to see lower returns on their investments as the quantity demanded for their goods and services is likely to be lower as a result of a decrease in consumption in a decrease in consumption
> also they may be receiving less profit due to a decrease in revenue (decrease sales and possibly prices) - less financially equipped to invest
> AD falls because of the fall in consumption and investment.
● People will also become less confident about borrowing and spending if interest rates rise.
> On top of this, other loans, such as mortgages, will become more expensive to repay and so consumers have to dedicate more of their
income to paying back these debts.
> This means they have less disposable income to spend on goods and services, so consumption will fall, causing AD to fall.
- AD shifts left, Real GDP/economic output decreases - lowers inflationary pressures - lowers demand pull inflation
● Higher interest rates will increase the incentive for foreigners to hold their money in British banks as they can see a higher rate of return on their savings > As a result, there will be increased demand for pounds and the value of the pound will rise/appreciate .
>This means that imports
will be cheaper, and exports will be more expensive.
> This decreases net trade and therefore AD
Problems with altering base rates to manipulate interest rates
- Exchange rate may be affected so much that exports fall significantly and imports rise significantly, causing a balance of trade deficit.
> Time-lag, changes in interest rates take up to 2 years to have their full effect and small changes in interest rates may not affect people’s decisions.
> There are a range of different interest rates and not all of them are affected by the Bank of England base rate. - commercial banks are not obliged to match the base rate
> A lack of confidence in the economy may mean that, no matter how low interest rates are, consumers and businesses do not want to borrow or banks do not want to lend to them.
> High interest rates over a long period of time will discourage investment leading to a lack of innovation and R&D
can decrease the quanity and quality of the factors of production
and decrease LRAS.
Quantitative easing
- The Bank of England electronically creates new money to try to boost
the economy by using it to buy large amounts of financial assets (such as government bonds) in order to increase the
money supply and get money moving around the economy, encouraging spending.
What can quantitative easing prevent
It can prevent the liquidity trap, where even low interest rates cannot
stimulate AD.
What does quantitative easing do?
Quantitative easing has the effect of increasing consumption and investment, which
increases AD and can help the country meets its inflation target
how does quantitative easing boost AD
- Since The Bank Of England is buying assets, there is a rise in demand for these assets causing asset prices to rise .
- This causes a positive wealth effect since shares, houses etc. are worth more so people will increase their consumption.
- Moreover, the cost of borrowing/interest rates will decrease as higher asset prices mean lower yields (return on assets) making it cheaper for households and businesses to finance spending.
- Also because the money supply increases, Private sector companies receive more money which they can spend on goods and services or other financial assets, which may increase investment or consumption and therefore increase AD.
- It may also push asset prices up further.
- Banks have higher reserves, meaning they can increase their lending to households and businesses so both consumption and investment increase as people can buy on credit.
- Commercial banks may lower their interest rates as they are receiving more money from the Bank of England and so can offer very low interest deals to their customers.
- The increased money supply will mean that the price of money falls;
interest rates are the price of money. - This will encourage borrowing, and therefore
increase investment and consumption so increase AD. - If many banks decide to lower their interest rates, the same mechanisms will apply as those following a reduction in
the base rate.
Problems with quantitative easing
- if not controlled properly, could cause high inflation and even
hyperinflation. - There is no guarantee that higher asset prices lead into higher consumption
through the wealth effect, especially if confidence remains low.
-
Which country has experienced hyperinflation as a result of printing money?
Venezuela
The role of the bank of england
- The Bank of England’s Monetary Policy Committee (MPC) consists of nine members
- They meet 8 times a year to set the monetary policy
- At this meeting they set the Base Rate and discuss if quantitative easing is required (or should continue)
- Policy is decided by majority vote
- It can take up to two years for the full effects of decisions to be seen in the economy
- The single most important consideration in their deliberations is the inflation target of 2% CPI
Some of the Factors That Influence the Decision Made by The Monetary policy committee
- Without further intervention, the likely state of the economy a few months ahead
- Rate of real GDP growth
(output gaps?) - Current level of CPI Inflation
- Interest rate elasticity
(low confidence = inelastic response) - State of the property market
(Overheating?) - Unemployment figures
- Business and consumer confidence
- Global outlook
- The exchange rates
Interest rate elasticity
The responsiveness of the components of aggregate demand to a change in interest rates
Fiscal policy instruments
government spending and taxation
What does an increase in tax (income and corporation tax) do?
- A rise in income tax will cause a fall in disposable income.
- This will lead to a
reduction in consumption and thus decrease AD. - A rise in corporation
tax will decrease a firm’s post-tax profits. - This will lead to a reduction in investment
and thus decrease AD
A rise in government spending…
Will lead to an increase in aggregate demand
Government budgets
The government’s fiscal (spending, borrowing and taxation) plans are outlined in the budget.
A government budget deficit
government revenue < government expenditure
A government budget surplus
government revenue > government expenditure
How is a government budget deficit financed?
A budget deficit has to be financed through public sector borrowing
This borrowing gets added to the public debt
Public debt
The cumulative total of pas government borrowing which has to be repaid with interest
Direct taxes
- Taxes imposed on an individual and/or organisation’s income or profits
- They are paid directly to the government by the individual or firm
Indirect taxes
- Taxes imposed on the spending of goods and services
- The supplier is responsible for sending payment to the government
- Depending on the PED and PES producers are able to pass on a proportion of the indirect tax to the consumer
Expansionary policies include
- Reducing taxes
- Decreasing interest rates
- Increasing government spending
- Increasing quantitative easing
Contractionary policies include
- Increasing taxes
- Increasing interest rates
- Decreasing government spending
- Decreasing/stopping quantitative easing
There are problems which need to be considered when evaluating fiscal policy:
- Government spending also impacts LRAS. For example, by cutting government spending to reduce AD, the government may be reducing the quality of education or spending on research and technology.
- Taxes and spending have an impact on inequality, so some decisions aimed to reduce/increase demand may increase income inequality. They also have an impact
on incentives, for example high taxes may reduce incentives to work - The government also has to worry about political issues, for example they may be
unwilling to raise taxes in order to reduce demand as this may lead to them being voted out in the next general election - The impact of fiscal policy depends on the multiplier : the bigger the multiplier, the
bigger the impact on AD.
> Classical economists argue that the multiplier is almost zero
whilst Keynesian economists argue that it can be large if targeted correctly.
Evaluation of demand-side policies
- On a Keynesian LRAS, the impact of changes in AD depend on where the
economy is operating : if the economy is at full employment then a rise in AD will only lead to higher prices. However, if unemployment is very high, then a rise in AD
will only lead to higher output. - Both policies see significant time lags between their introduction and their full effect.
- The biggest issue of demand-side policies is that, in most cases, an expansionary policy is inflationary whilst a deflationary policy brings unemployment.
- So through demand
management, the government cannot bring about both low and stable inflation and high economic growth/low unemployment.
Monetary vs fiscal policy
● Monetary policy is useful as the government is able to increase demand without having to increase their spending, which would result in a larger fiscal deficit.
● Fiscal policy can have significant impacts on the supply side of the economy, for
example increases in spending on education to increase AD will also increase LRAS.
Moreover, it is more effective at targeting specific groups and reduce poverty, for
example by increasing benefits it can increase AD and reduce inequality.
Great Depression
- The Great Depression started in the USA in October 1929 and continued until the late 1930’s
- By 1932 the USA unemployment rate was around 25%
- More than 9,000 banks closed during this decade
- The flow of money in the economy was weak (poor liquidity)
- The Great Depression created a global slump
- In the UK, unemployment doubled and exports halved leading to a major recession
Great Depression
Policy Responses USA
> Fiscal Policy
- Roosevelt’s New Deal (1933-1939) provided large government spending on infrastructure and conservation projects (Keynesian approach which increases AD)
- The government employed many people. Construction projects included The Edgar Hoover Dam and The Golden Gate Bridge
- Protectionism increased to increase domestic production and consumption (the Smoot–Hawley Tariff Act in 1930)
Great Depression
Policy Responses USA
> monetary policy
- In February 1930 the Federal Reserve Bank cut the Bank Rate from 6% to 4%
- In late 1930 they raised the rate again to help strengthen the exchange rate as investors were selling dollars to buy gold
- Raising the rate was a contractionary policy that further weakened the flow of money
Great Depression
Policy Responses UK
> Fiscal policy
- The Government prioritised a balanced budget with contractionary policies as they wanted to avoid crowding out
- In 1931, they cut public sector wages and unemployment benefits by 10% - which further reduced consumption and confidence in the economy
- In 1931 they raised income tax from 22.5% to 25% which decreased disposable income and consumption
- In 1932, they introduced a 10% tariff on all imports (except from British Colonies) so as to increase production and consumption within the UK
Crowding out
Occurs when increased government spending (usually financed by borrowing) leads to lower private sector spending
Great Depression
Policy Responses UK
> monetary policy
- In 1931 the, the UK stopped using the gold standard which had appreciated the currency significantly since 1919
- The Pound (£) depreciated by nearly 25%; exports immediately increased and so did AD
- The Bank Rate was lowered from 6% to 2% in late 1931 and this helped AD increase
The 2008 Global Financial Crisis started in the USA in September 2008 with the collapse of the investment bank, Lehman Brothers
- The crisis was inextricably linked to interest rates and risky lending in the property market
- In total, about 10 million households lost their homes (roughly 1 in every 20 homes)
- Unemployment doubled from around 5% to 10%
- 489 Banks failed in the five-year period following the crisis - most were bailed out by central governments
- The 2008 Global Financial Crisis created a global slump
- UK unemployment rose from 5.2% to 7.8%
2008 Financial Crisis
Policy Responses UK & USA
● Both governments were forced to nationalise banks and building societies and
guarantee savers their money in order to prevent the chaos of a collapsed banking system. For example, the British government bought Northern Rock and most of Royal Bank of Scotland and Lloyds Bank.
● They used expansionary monetary policies with record low interest rates and quantitative easing. The Bank of England said the QE led to lower unemployment
and higher growth than would otherwise have been the case.
2008 Financial Crisis
Policy Responses UK
> Fiscal
Keynesian approach involving significant government spending and expansionary fiscal policy from 2008 to 2010
The banks were not allowed to fail and were supported by the Government
Policies included income tax cuts, VAT reduction of 2.5%, £20bn. small business loan guarantee scheme, a car scrappage scheme to support the car industry
A major injection by the government was £3bn. investment spending on infrastructure and defence
The new Conservative Government switched from expansionary fiscal policy to Austerity
Cutting government spending and raising taxes delayed the recovery
2008 Financial Crisis
Policy Responses UK
> monetary
The Bank of England cut the Bank Rate nine times between December 2007 and March 2009 dropping from 5.75% to 0.5%
Several rounds of quantitative easing worth £375bn. took place between March 2009 and July 2012
2008 Financial Crisis
Policy Responses USA
> fiscal
Keynesian approach involving significant government spending and expansionary fiscal policy from 2008 to 2012
The banks were not allowed to fail and were supported by the Government
The Economic Stimulus Act of 2008 injected $152bn. in fiscal stimulus
The American Recovery and Reinvestment Act of 2009 injected another $787bn. over the next few years
Both of these increased AD and helped the economy to quickly recover
2008 Financial Crisis
Policy Responses USA
> monetary
The Federal Reserve cut Bank Rates eight times between October 2007 and the end of 2008 from 5.25% to 0.25%
Three rounds of quantitative easing known as QE1, QE2 and QE3 injected over $3tn. into the money supply.
Automatic stabilisers
When the economy goes into a recession, government spending will rise automatically. This is because public spending will go up because unemployment benefits increase (tax revenue will fall)
4 ways quantitative easing can boost AD
- boosts assets prices
= positive wealth effect - injects cash into banks which encourages lending
- lowers long-term real interest rates through higher bond prices
- increases inflationary expectations, which encourages households to spend today and not save.
