Demand-side Policies Flashcards
What are demand side policies
Policies designed to increase consumer demand, so that total production in the economy increases.
Monetary and 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 government.
Monetary policy instruments-interest rates
In UK, the monetary policy committee (MPC) alters interest rates to control the supply of money. They are independent from the government, and the bunch 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 interest 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.
Asset purchases to increase the money supply :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 isn’t possible to lower interest rates further.
QE 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 low, it isn’t 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 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.
Limitations of monetary policy
-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.
-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.
-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
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 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.
The government budget (fiscal) surplus and deficit
-A government has a budget deficit when expenditure exceeds tax receipts in a financial year.
-A government has a budget surplus when tax receipts exceed expenditure.
Direct and indirect taxes
-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.
Limitations of fiscal policy
-Governments might have imperfect information about the economy. It could lead to inefficient spending.
-There is a significant time lag involved with employing fiscal policy. It could take months or years to have an effect.
-If the government borrows from the private sector, there are fewer funds available for the private sector, which could lead to crowding out.
-The bigger size of the multiplier, the bigger the effect on AD and the more effective the policy.
-If interest rates are high, fiscal policy might not be effective for increasing demand.
-If the government spends to much, there could be difficulties paying back the debt, which could make it difficult to borrow in the future.
Demand-side policies in the Great Depression
-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 though from a focus on AS to AD. Keynesian economists emphasis the use of demand-side policies to close gaps between actual and potential output.
Cause of the Great Depression
-It was set off by the Wall Street crash of 1929.
-This led to a huge loss in consumer and business confidence, decreasing consumption and investment.
-The 1920s had been a period of unsustainable boom and the banking system was unstable; the government allowed the banks to crash.
-The USA had introduced protectionism whilst the UK was committed to the gold standard, where its currency was fixed to gold and was overvalued.
Responses in Uk to Depression
-The government thought balancing the budget was essential so they cut public sector wages and unemployment benefits and raised income tax.
-Interest rates were high to help maintain the pound, which came under attack from speculators.
-Eventually, they left the gold standard and cut interest rates.
Responses in USA to Depression
-Roosevelt’s new deal used public sector investment, work schemes for the unemployed and fiscal stimulus to increase AD and bring about a recovery.
-Some argue that not enough spending was undertaken for it to be effective; it was the war which eventually ended the depression.
-They also tried to increase the money supply, but it is unclear how effective this was.
