2.6.2 Demand Side Policies Flashcards
Demand side policies
- Monetary policy
- Fiscal policy
Fiscal policy
involves the government changing the levels of government spending & taxation to affect AD (strong and fast)
Monetary policy
- involves the Bank of England using interest rates and the money supply to affect AD (slow and weak)
Monetary policy instruments
- interest rates
- asset purchases to increase the money supply (quantitative easing)
Transmission mechanism involved with changes in the Bank Rate
Fiscal policy instruments:
government spending and taxation
Ways to expand the economy (fiscal)
- decrease interest rates
- use quantitative easing
- lower taxes
- increase government spending
How does decreased interest rates expand the economy?
cheaper borrowing encourages businesses to expand = more jobs and more income
How does quantitative easing expand the economy?
involves increasing the money supply and buying bonds to keep interest rates low.
- The hope is that the increase in the money supply and lower interest rates will boost investment and economic activity.
How does increased government expand the economy?
- improving infrastructure = business are better connected = more exports = increased AD
Budget (fiscal) deficit
- during a recession
- when government spending is bigger than tax revenue
- injections are high and withdrawals are low
- to encourage AD
- expansionary fiscal policy
Budget (fiscal) surplus
- during a boom
- when government spending is smaller than tax revenue
- injections are low and withdrawals are high
- austerity
Expansionary policies effect of AD
- increase AD = incentive for businesses to produce more = increase sales and profit
- also means more labour needed = decreased unemployment
Why might expansionary policies lead to inflation?
- high levels of investment and low unemployment = businessses find it hard to recruit people = compete for peoplewith scarce skills offering higher pay
Contractionary policies effect on AD
- reduces AD since prices would increase from the reduction of output = redundancies and increased unemployment
Expansionary policy
- the govt coordinates factors to increase AD and grow the economy (deacresed taxes, increase govt spending)
Contractionary policy
the govt change certain factor to slow the growth of the economy through decreasing AD (increased taxes, decreased govt spending)
AD diagram for effects of demand-side policies
AS diagram for effects of demand-side policies
How has quantitative easing been used in the UK?
- when central banks buy illiquid assets (govt bonds) from banks paying for them upfront in cash
- this increases banks liquidity and banks then use this money to lend to borrowers
Role of the Bank of England (monetary fund)
- The Bank’s monetary policy committee meet on a monthly basis to set the Bank rate and (maybe) the level of the asset purchase facility (quantitative easing)
Types of government spending in fiscal policy
- Discretionary fiscal spending
- Automatic stabilisers
Discretionary fiscal spending
choosing to spend money on something (political priorities)
Automatic stabilisers
- automatically spend money/ elss on welfare depending where you are in the business cycle ie boom = low, slump = high
Effects of demand-side policies
Strengths of demand side policy
Monetary policy evaluation
- In a liquidity trap, lower interest rates may not increase spending since ppl are trying to pay back debts
- therefore might not lead to econ growth
Monetary policy evaluation (banks not passing it off to consumers) example
in 2009, UK interest rates were cut to 0.5% but spending remained subdued.
- Banks were unwilling to lend because of liquidity shortages so though cheap to borrow, head to create credit
Monetary policy evaluation (housing bubble)
- cutting interest rates very low = distort future economic activity
- e.g can contribute to a future housing and asset bubble = destabilise econ growth
Monetary policy evaluation (housing bubble) example
- the US cut interest rates following the econ uncertainty of 9/11
- these low interest rates encouraged ppl to take on ambitious loans/mortgages = US housing bubble
Fiscal policy evaluation
it leads to an increase in govt borrowing
- to finance this extra spending = govt need to borrow from private sector
- if the economy is already growing, then higher govt borrowing = crowd out the private sector
How might fiscal policy not cause crowding out?
However, if the economy sees a rapid fall in private spending, and a rise in saving ratio, expansionary fiscal policy can help provide a boost to demand in the economy without causing crowding out.
Fiscal policies in the US
- Roosevelt’s new deal in 1933 (the Great Depression) involved increased govt spending on public infrastructure and employing people
- Smoot-Hawley tariff act in 1930 (protectionist policies)
Fiscal policies in the UK 1931
- efforts to balance the govt budget
- In 1931, Emergency Budget cut public sector wage and unemployment pay by 10%
- ths was deflationary and reduced PPP in the economy worsening the situation
Fiscal policy in the Global Financial Crisis (US)
- In 2008, the govt had the Economic Stimulus Act of $152 billion fiscal package
- followed by the American Recovery and Reinvestment act of 2009, a 4787 billion bill which involved govt spending over several years
Fiscal policy in the Global Financial Crisis (UK
- in 2008 they introduced tax cut for basic rate taxpayer, temporary 2.5% point cut in the VAT rate, £3 billion worth of investment spending from 2010
- in 2009 budget included training help for young unemployed
Monetary policy in the Global Financial Crisis (US)
- the Federal Reserve cut interest rate from 5.25% to 4.25% in 2007
- they did 3 rounds of quantitative easing to boost the money supply
Monetary policy in the Global Financial Crisis (UK)
- the MPC cut the Bank rate from 5.75% to 5.5% in 2007
- it was cut a further 5 times by the end of the year at ended at 2.0%
- it was cut even further to 0.5% in March 2009
Why might quantitative easing not work?
The fear is that increasing the money supply could cause inflation.
Example of quantitative easing working
Though evidence from 2009-12 suggests that the inflationary impact was minimal.
- Without quantitative easing, the recession was likely to be deeper, though QE alone failed to return the economy back to a normal growth projection.
Example of demand side policy causing unsustainable boom in UK
- in 1972, the UK chancellor, announced a ‘dash for growth’.
- Taxes were cut against a backdrop of rising house prices and inflation = Barber boom (rapid economic growth)
- However, it also caused a spike in inflation, and the growth proved unsustainable.
Using the classical long-run aggregate supply curve, explain what will happen in the long run to real output if aggregate demand increases.
There would be no change in real output (1)
Analysis (1):
E.g. since classical economists believe the economy will be at full employment in the long run
