7- Demand side policies Flashcards
Aim of demand side policies
To manipulate consumer demand
Aim of expansionary policy
- Increase AD
- Increase growth
- Redistribute income
- Increase inflation
Aim of deflationary policy
- Decrease AD
- Control inflation
- Reduce budget deficit
- Reduce current account deficit
2 types of demand side policies
- Monetary policy
- Fiscal policy
2 types of monetary policy
- Interest rates
- Money supply (QE)
Interest rate
The price of money.
How interest rates can manipulate AD
- Higher interest rate- higher cost of borrowing- less investment (higher rates of return needed)- less consumption (more attractive to save)
- High interest rates- less borrowing- less demand for stocks- price falls for stocks- negative wealth effect
- Lower confidence
- Mortgage repayments more expensive
- Higher interest rates- higher demand for the pound- higher value- cheaper imports.
Issues with using the interest rate to manage demand
- Time lag- interest rate takes 2 years to have an effect
- Trade imbalance
- When interest rates are low, a further cut won’t stimulate demand
- A lack of confidence may mean consumers and firms don’t borrow not the low interest rates.
- Long term high interest rates- decrease LRAS- less investment
How QE works?
1) Central banks create money electronically
2) They use that money to buy financial assets from financial institution (gov bonds in the UK)
3) This will increase demand for gov bonds and increase the price but will decrease the yield (the rate of return).
4) This makes it cheaper for the issuer of the bond to raise finance and it reduces the incentive for investors
5) Financial institution either loan this money out or reinvest into other assets.
6) This increases price of cooperate bonds (positive wealth effect) so it makes it easier for commercial banks to raise finance.
7) Banks issue more bonds - more finance for loans
8) Access to credit improve, market interest rates down, improved willingness to lend at lower interest rates.
Problems with QE
- If not controlled properly- inflation or hyperinflation
- Confidence is likely to be very low so it may not stimulate consumption
Evaluation of fiscal policy
- It may have supply side effects- cutting gov spending- may reduce LRAS with worse education and infrastructure
- High tax may reduce incentives
- Low tax may lead to inequality
- Bigger the multiplier, bigger the impact on AD
- Political issues- with raising taxes
- Potential crowding out
- Could increase budget deficit
Other evaluation
- Increase in AD when economy is at full capacity will lead to inflation.
Types of taxes
- Direct - income tax
- Indirect- VAT, coperation
- Tax allowance
- Progressive vs regressive
Types of gov spending
- Education
- Infrastructure
- Health care
- Public sector wages
Liquidity trap
Keynes wrote about the liquidity trap-
A situation where even low nominal interest rates have a very little effect on AD due to low business and consumer confidence and a fragile banking system.
