Demand Side Policies Flashcards
What a demand side policy?
Any deliberate action taken by governments or monetary authorities to shift the AD curve
What is monetary and fiscal policy?
Monetary policy- manipulation of monetary variables in order to influence the level of AD
Fiscal policy- manipulation of government spending and taxation in order to influence the level of AD
What are monetary policy instruments used? ( INTEREST RATES)
Interest rates- cost of borrowing money or the reward for saving
Interest rates can be used to affect components of AD. FOR EXAMPLE
Consumption- A fall in interest rates would mean that people would get less return on their savings and that it would be cheaper for people to borrow. Reduced incentive to save, combined with increased incentive to borrow, would likely increase spending on goods and services meaning that consumption would rise
INVESTMENT- that is assumed is that lower interest rates mean that it will be cheaper for firms to borrow money for investment, resulting in investment increasing
NET EXPORTS- decrease in interest rates will likely lead to a fall in the exchange rate (chapter 6.2). This would make exports cheaper and imports more expensive, likely leading to higher export revenue and lower import expenditure, resulting in net exports increasing
What are monetary policy instruments used? ( QUANTITATIVE EASING)
Quantitative easing- when a central bank purchases financial assets such as government bonds in order to increase the money supply and lower market interest rates.
WHY QE MAY BE USED?
After 2008 monetary authorities found that interest rates alone could not stimulate AD. So may use QW when decreasing the interest rates may not work. Could be due to the commercial banks have low cash reserves with which to lend. Or due to low business and consumer confidene people simply dont want to borrow money.
What is expansionary monetary policy and what is contractionary monetary policy?
Expansionary monetary policy anything that increases aggregate demand
Contractionary- anything that reduces AD
How does QE work?
- The central bank creates money electronically
- This electronic money is used to buy up financial assets ( mainly government bonds) from financial institutions ( mostly banks)
- This means demand for government bonds will rise, causing their price to rise. Relationship between bond prices and their interest rates is inverse so rise in price of government bonds will lead to lower interest rates on them.
- For banks that had government bonds replaced with cash, they may be more willing to lend to consumers and firms and at lower interest rates. OR banks may invest in riskier corporate bonds.
- Increase in purchasing of corporate bonds leads to increase in their price and thus a decrease in the interest rate for all corporate bonds.
- Banks that had corporate bonds replaced with cash, Banks now may be more willing to lend to consumers and firms at lower interest rates. More importantly banks will find it easier to raise finance. Banks can issue their own corporate bonds as a means of borrowing money off of other individuals. As interest rate on bonds has fallen, this means the interest they will have to pay back to the lender is now lower. Means banks can build up their cash reserves and start making profits.
- As a result banks should be more willing and able to lend to firms and consumers.
- Consumption and investment should rise due to lower market interest rate which will then lead to AD increasing, and thus inflation increasing
Evaluation of monetary policy effectiveness?
Depends on initial level of economic activity- if an economy is operating with a large amount of spare capacity, there will be virtually no effects on inflation but large effects on growth. Additionally if monetary policy results in increase of LRAS and the level of AD is too low to take advantage of this this change in LRAS can be of little use. Also if economy is operating at full capacity a increase in aggregate demand doesn’t necessarily mean an increase in growth or reducing unemployment Because economy is already close to utilising all factors of production so all that will happen is an increase in inflation due to pressures on factors of production
DEPENDS ON SIZE OF INTEREST CHANGE- if they only go down by small amount this means effectiveness of monetary policy will be limited. Because AD will not rise by much so inflation or growth wouldn’t change by much.
Time lag- when bank rate is initially changed must go through process called monetary transmission mechanism. Takes time for commercial banks to respond to change in policy and thus take a very long time before this is reflected in market interest rate. Also once interest rate has changed its gonna take time for consumers and firms to fully take action in the desired manner and solve whatever the initial problem was. This takes up to 2 years which reduces the effectiveness of monetary policy.
LOW BUSINESS AND CONSUMER CONFIDENCE- if business and consumer confidence are extremely low, this can nullify the ability of the central bank to affect the economy via monetary policy. This would be because if consumers and firms simply dont want to borrow money but instead want to save then they will do that even if market interest rates fall. This means a change in interest rates may have no effect on consumption and thus no effect on AD, inflation or growth
What are discretionary fiscal policy measures?
Discretionary fiscal policy- deliberate changes in government spending and taxation designed to influence AD.
Government spending- government spending on education and training, health or infrastructure. Spending on education and training can increase the human capital of those in the labour force. Improved health services mean people should be be off of work sick for so long and peoples general health may improve resulting in an increase in productivity of a large number of workers. Infrastructure projects can improve transport conditions, making it cheaper and more efficient for firms to use supplier vehicles, and also for people to travel to schools and hospitals which can further increase productivity. This leads to an increase in AD and LRAS.
Corporation tax- a decrease in corporation tax would increase amount of profits that firms can retain and use for investment so would likely increase investment. Higher investment increases both AD and LRAS.
Income tax- decrease in income tax, leads to an increase in disposable income which leads to an increased in spending on goods and services and thus higher consumption and thus higher AD.
What is the difference between government budget (fiscal) deficit and surplus
If government spends more than it receives in taxation this is known as fiscal or budget deficit. Leads to increase in AD
If government spends less than it receives in taxation this is known as fiscal or budget surplus. This leads to a decrease in AD.
What is a direct and indirect tax?
Direct tax- tax which is levied on the income or profits of a person / firm e.g. income tax, corporation tax (called capital gains tax in the UK) etc..
Indirect tax- A tax levied on spending on goods or services e.g. expenditure tax (VAT in the UK)
What is inflation targeting and what is its effect?
Inflation targeting- An approach to macroeconomic policy whereby the central bank is charged with meeting a target annual inflation rate that must be made known to the public
Effect on central bank- An inflation target makes the conduct of monetary policy clear, as it represents a firm commitment of price stability (by the central bank) to both firms and households. Central banks can further enhance this when they publish reasons for the decisions they make
Effects on firms and households-
Expectations- If the ability of the central bank to achieve the inflation target is credible, this can directly affect the expectations of inflation. If people are expecting the inflation target to be met, they may build this into their behaviour and this will do much to bring about the inflation target (i.e. expectations of inflation can become self-fulfilling) e.g. if workers expect inflation to be high in the future, they are likely to ask for higher wage rises, increasing the likelihood of cost-push inflation
Evaluation of fiscal policy?
Depends on the Initial Level of Economic Activity – If an economy is operating with a large amount of spare capacity, there will be virtually no effects on the price level but large effects on growth. Additionally, if the fiscal policy resulted in an increase of LRAS, and the level of AD is too low to take advantage of this, then the change in LRAS will be of little use (which could contrast with the effects of the graph you showed in your analysis in an essay). Furthermore, if the economy is operating at full capacity, the effects will be more concentrated on the price level whilst there may be no change in growth (or a somewhat small one if LRAS changes)
Depends on the Extent of the Discretionary Fiscal Policy – If tax rates only go down by a small amount (or were already very low to begin with) or government spending only increases by a very small amount, for example, this will mean that the effectiveness of the fiscal policy will be limited. This would be because AD would not rise by that much, and neither would LRAS
Business and Consumer Confidence – If business and consumer confidence are very low, for example, then tax cuts may not be enough to incentivise consumption and investment as people are pessimistic about future economic prospects. Additionally, in the case of higher government spending, its multiplier effect may be heavily reduced due to an increase in savings.
What are the strengths and weaknesses of demand side policies?
Strengths- if there is spare capacity, the economy can grow quickly.
If multiplier is large they can have a significant impact on growth.
If used to control demand pull inflation they can solve the problem.
Weaknesses is just opposite.
