2.6.2 Demand-side policies Flashcards
Demand-side policies
Demand-side policies are policies designed to increase consumer demand, so that total production in the economy increases.
Monetary vs Fiscal policy
Monetary policy is used by the government to control the money flow of the economy. This is done with interest rates and quantitative easing.
- This is conducted by the Bank of England, which is independent from the government.
Fiscal policy uses government spending and revenues from taxation to influence AD.
- This is conducted by the government.
Monetary policy instruments
1) Interest rates
2) Quantitative Easing QE: asset purchasing to increase the money supply
Interest rates: monetary policy
In the UK, the Monetary Policy Committee (MPC) alters interest rates to control the supply of money. They are independent from the government, and the nine members meet each month to discuss what the rate of interest should be. Interest rates are used to help meet the government target of price stability, since it alters the cost of borrowing and reward for saving.
The bank controls the base rate, which ultimately controls the interest rates across the economy. A reduction in the base rate will lead to a rise in AD. This happens through a number of transmission mechanisms:
• Consumption and investment increase due to lower costs of borrowing
• Higher consumption, due to lower borrowing, will mean that asset
prices increase. This will lead to a positive wealth effect.
• Saving becomes less attractive, as a lower rate of return is offered, so consumption and investment both increase. Mortgage interest repayments are lower and so therefore consumers have more income left to spend, which also increases consumption.
• Lower interest rates reduce the incentive for investors to hold their money in British banks, so demand for the pound will fall. The pound will be weaker, so exports will be cheaper and imports more expensive. Net trade will therefore increase.
Quantitative Easing QE
- Used by banks to help to stimulate the economy when standard monetary policy is no longer effective. This has inflationary effects since it increases the money supply, and it can reduce the value of the currency.
QE is usually used where inflation is low and it is not possible to lower interest rates further. - It is a method to pump money directly into the economy. It has been used by the European Central Bank to help stimulate the economy. Since the interest rates are already very low, it is not possible to lower them much more. The bank bought assets in the form of government bonds using the money they have created. This is then used to buy bonds from investors, which increases the amount of cash flowing in the financial system. This encourages more lending to firms and individuals, since it makes the cost of borrowing lower. The theory is that this encourages more investment, more spending, and hopefully higher growth. A possible effect of this is that there could be higher inflation.
If inflation gets high, the Bank of England can reduce the supply of money in the economy by selling their assets. This reduces the amount of spending in the economy.
Limitation of monetary policy
o Banks might not pass the base rate onto consumers, which means that even if the central bank changes the interest rate, it might not have the intended effect.
o Even if the cost of borrowing is low, consumers might be unable to borrow because banks are unwilling to lend. After the 2008 financial crisis, banks became more risk averse.
o Consumer confidence: Interest rates will be more effective at stimulating spending and investment when consumer and firm confidence is high. If consumers think the economy is still risky, they are less likely to spend, even if interest rates are low.
Fiscal policy instruments
Government spending and taxation
Government spending and taxation: fiscal policy
Governments can change the amount of spending and taxation to stimulate the economy. The government could influence the size of the circular flow by changing the government budget, and spending and taxes can be targeted in areas which need stimulating.
- Fiscal policy aims to stimulate economic growth and stabilise the economy.
- In the UK, the government spends most of their budget on pensions and welfare benefits, followed by health and education. Income tax is the biggest source of tax revenue in the UK.
Expansionary vs Deflationary fiscal policy
Expansionary fiscal policy: This aims to increase AD. Governments increase spending or reduce taxes to do this. It leads to a worsening of the government budget deficit, and it may mean governments have to borrow more to finance this.
Deflationary fiscal policy: This aims to decrease AD. Governments cut spending or raise taxes, which reduces consumer spending. It leads to an improvement of the government budget deficit.
Government budget (fiscal) surplus and deficit
- Deficit: A government has a budget deficit when expenditure exceeds tax receipts in a financial year.
- Surplus: A government has a budget surplus when tax receipts exceed expenditure.
Direct and Indirect taxes (fiscal policy)
- Direct taxes: are imposed on income and are paid directly to the government from the tax payer. Examples include income tax, corporation tax, NICs and inheritance tax. Consumers and firms are responsible for paying the whole tax to the government.
- Indirect taxes: are imposed on expenditure on goods and services, and they increase production costs for producers. This increases market price and demand contracts. Examples include import duties and VAT.
Limitations of fiscal policy
o Governments might have imperfect information about the economy. It could lead to inefficient spending.
o There is a significant time lag involved with employing fiscal policy. It could take months or years to have an effect.
o If the government borrows from the private sector, there are fewer funds available for the private sector, which could lead to crowding out.
o The bigger the size of the multiplier, the bigger the effect on AD and the more effective the policy.
o If interest rates are high, fiscal policy might not be effective for increasing demand.
o If the government spends too much, there could be difficulties paying back the debt, which could make it difficult to borrow in the future.
AD/AS diagrams: demand-side policies
Both diagrams show the effects of employing a supply-side policy. The LRAS curve shifts to the right, to show the increase in the productive potential of the economy. In other words, the maximum output of the economy at full employment has increased. This leads to a fall in the average price level, from P1 to P2, and an increase in national output, from Y1 to Y2.
Monetary Policy Commitee MPC
In the UK, the Monetary Policy Committee (MPC) alters interest rates to control the supply of money. They are independent from the government, and the nine members meet each month to discuss what the rate of interest should be. Interest rates are used to help meet the government target of price stability, since it alters the cost of borrowing and reward for saving.
The Great Depression: demand-side policies
The Great Depression initiated in 1929, and by 1933 real GDP had fallen by 30% and the unemployment rate increased to 25%. In the 75 years prior to this, economic declines lasted about 2 years; The Great Depression lasted over a decade.
- Keynes shifted macroeconomic thought from a focus on AS to AD. Keynesian economists emphasis the use of demand-side policies to close gaps between actual and potential output.
