Demand-Side
Policies
These are policies that aim to influence an economy’s
aggregate demand in order to stabilise the level of output and employment or to
maintain the price level. The 2 policies are fiscal and monetary.
Fiscal
Policy
Fiscal policy is the decisions made by the government on its
expenditure, taxation and borrowing.
An expansionary fiscal policy would be seen as an increase in
government spending or a reduction in taxes that shifts the aggregate demand
curve to the right. A contractionary fiscal policy involves reducing government
spending, usually to below tax revenues.
To the left is a graph showing the macroeconomic equilibrium attained by an expansionary fiscal policy. At AD1LRAS the economy is producing at below full employment level. The government increases its spending and as it is a component of AD it will cause a leftward shift of the AD curve. This creates the new equilibrium of AD2LRAS which more people are employed at, although it does cause some inflation unless we are at the elastic feature of the LRAS curve. The higher the intersect (the more inelastic the LRAS curve becomes) and hence the more inflation occurs along with little growth in employment.
In this case government expenditure is treated as an
injection into the circular flow, and will be expanded by the multiplier
effect. The higher the multiplier the more effect that government spending will
have, this is dependent on the size of withdrawals from an economy.
When undertaking fiscal policy the balance of payments needs
to be taken into account. Part of an increase in AD is likely to be withdrawn
into spending on imports whereas in the short run there isn’t likely to be an
increase in exports. Therefore in the short run there is likely to be an
increase in the current account deficit on the balance of payments.
The same applies for a contractionary fiscal policy where
there is likely to be a leftward shift of the AD curve which will cause a fall
in the increase of prices and will cause lower overall employment.
The government budget deficit or surplus (the difference
between government expenditure and revenue (taxation)) also needs to be taken
into account when deciding on a fiscal policy. By undertaking an expansionary
fiscal policy the budget surplus is likely to decrease (if expenditure
overtakes revenue) or the deficit will increase, and vice versa for a
contractionary policy. However to a certain extent, the government budget
deficit changes automatically without intervention from the government.
If the economy goes into a recession then unemployment benefit
payments will rise thus increasing government expenditure and simultaneously
tax revenues will fall as less people are paying income tax as they are out of
work. VAT recipes will also fall if people are spending less on goods and
services.
The opposite effects will be evident in a period of boom,
preventing the economy from overheating. Automatic stabilisers are initiated
during either a boom or a recession. An automatic stabiliser is an effect by
which government expenditure adjusts to offset the effects of recession and
boom without the need for active intervention. Therefore government expenditure
automatically rises during a recession and falls during a boom.
Governments may use fiscal policy in a discretionary (at
their own will) way in order to influence the path of an economy. A government
might use its discretion to increase government expenditure to prevent a
recession. Such intervention has been shown to be damaging to the long-run path
of the economy because of its effects on inflation.
Monetary
Policy
Monetary Policy is an approach used to stabilise the
macro-economy. It entails the use of monetary variables such as money supply
and interest rates to influence aggregate demand.
The prime instrument of monetary policy is the interest rate. At higher interest rates, firms undertake less investment expenditure and households consume less. Therefore inflation will fall (or won’t continue to rise). An example of this is if the economy is close to full employment. From the graph we can see that if the economy continues to grow (this will cause a rightward shift of the AD curve) the new equilibrium point will be on the 3rd feature of the LRAS curve. This is the inelastic point where the economy is at full employment and the maximum amount of overtime is being used. Therefore any further growth will cause inflation (from the inelastic point on the LRAS curve) but won’t produce any extreme output or employment.
Therefore monetary policy might be to increase the base rate
so to lower demand, and hence prevent the economy from overheating.
The responsibility of monetary policy is in the hands of the
Bank of England where a Monetary Policy Committee (MPC) has the use of the
monetary instruments to control inflation. The government set the inflation
target at 2% p/a as measured by CPI. This is within a range of ±1%, if it exceeds this or falls
below this then the Governor of the BoE has to send an open letter to the
Chancellor of the Exchequer explaining why this is the case.
The MPC sets the base rate at which they pay interest on
commercial bank reserves. The commercial banks then use this base rate to
calculate their own interest rates for domestic borrowers. Therefore if the BoE
were to change the base rate then the commercial banks would likely follow
suit.
The
Transmission Mechanism
The official rate is the base rate set by the MPC at the BoE. These affect the market rates (commercial bank interest rates), asset prices, confidence and the exchange rate.
The market rate is affected because it will always be above the base rate, the amount higher it, is dependent on the risk factor and demand and supply. If there is high demand to borrow money (lots of people need cash) and there is low supply (people don’t want to lend) then market rates will be high, and vice versa. This is shown below on a money market loan-able fund graph:
The graph above shows that it isn’t possible to control money
supply and interest rates simultaneously and independently. If the quantity of
money (supply) was to increase then interest rates would automatically fall. NB: Interest rates are market rates but the
base rate should be similar.
The base rate will affect expectations and confidence. If one
is unemployed and the base rate is about to rise one may believe that
businesses will invest less and one would remain unemployed. Therefore one’s
spending habits will change and one is more likely to save rather than spend
which will reduce AD.
People on variable loans/mortgages may have to pay more if
the base rate rises, however those on a fixed rate won’t be affected. Savers
may be happy about a rise in the base rate and so will be confident about the
future. In evaluation, the effects on AD due to confidence levels may take time
to filter through the economy.
If the base rate is increased then the exchange rate may
increase due to increased foreign investment. This means that sterling will be
strong against other currencies which may be bad for the economy as exports are
likely to fall (as they become more expensive for foreign consumers) and
imports may increase (as they become cheaper for consumers) thus affecting AD.
All of these affects affect the components of aggregate
demand and lead to inflation. If base rates fall then inflation is likely to
rise as AD should increase (this would be demand-push inflation) and conversely
if base rates rise then inflation is likely to fall as AD falls (people are
putting their money in savings and businesses aren’t investing).
Page last updated on 20/10/13
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