Demand Side Policies - A-Level Economics

Fiscal Policy

Demand-­‐side   policies  involve  the  government  manipulating  AD  in  order  to  achieve macroeconomic objectives.
Fiscal policy is the government manipulation of tax rates, government spending and government borrowing to influence AD and the performance of the economy.

How it Works

The government spend tax revenue on several things, including:

• Financing the provision of public and merit goods.
• Redistributing incomes
• Controlling externalities (e.g. subsidies)
• Financing government debt

However, tax revenue does not have to equal expenditure in the short run, and the government can therefore use this to boost or slow down the economy.

A contractionary fiscal position is when tax rates are increased and/or government spending is reduced. This decreases AD and reduces the rate of inflation
An expansionary fiscal position is when tax rates are decreased and/or government spending is increased. This increases AD and increases the rate of inflation

Budget Deficit

When the economy is growing slowly, the government can run an expansionary  fiscal policy to boost AD: The government can reduce taxes and increase government spending  to pump spending power into the economy.

Income  Tax: A reduction in income tax increases disposable income, which leads to a rise  in consumption and hence AD

Corporation Tax: A reduction in corporation tax increases firms’ retained profits, which leads to a rise in investment and hence AD.

Government Spending: Increasing government spending increases AD directly because G is a component of AD).
Multiplier: Government spending creates more jobs (e.g. for builders). The incomes earned  by  these  workers  will  be  re-­‐spent  in  the  economy,  creating  new  incomes-­‐  the multiplier effect.

Therefore, AD increases and the AD curve shifts to the right. If the economy is below full capacity, there is a rise in price and output. If the economy is at full capacity, there is a rise in price only.

However, the government need to limit the extent of the deficit to prevent inflation reaching too high a point.

Example: Budget Deficit

For example, if the government builds a new hospital and does not pay for it all through current taxation, but instead borrows to finance the scheme, there will be an increase in AD. When the government pays for the workers and building materials for the hospital, the incomes will be re-­‐spent in the economy-­‐ the multiplier effect.

Budget Surplus

When inflation is prevalent in the economy, the government can increase taxes and reduce government spending to reduce the amount of money in the economy.

However, they need to limit this because over doing this can lead to a sluggish economy with high unemployment.

National Debt

If the government budget does not balance over 5 years, and continuous budget deficits build up, the government can face national debt. If the government continues to overspend, future generations will face huge costs.

Evaluation: How effective is Fiscal Policy?

Magnitude

The effect of the fiscal position depends on the size of changes in G and T.

Time Lag

In the UK, Fiscal Policy can only be implemented in the annual budget, so there is a time  lag. It is often the case that the policy comes into effect when the economy has started to turn around in the normal course of the economic cycle, so the policy can do more harm than good.

Implementation Lag

Tax changes cannot begin until the start of the new fiscal year, so the effect is delayed   even further.

Multiplier

The magnitude of the effect depends on the size of the multiplier. The larger the MPS, the smaller the multiplier, and hence the smaller the effect on AD.

Response of Workers

When the government sets out to expand its spending, people try to cash in on this by increasing their pay demands, so the effect will be increased wages and costs rather than expanded output.

Effect on Private Sector

Government spending reduces the scope for private firms to supply the same service. For example, if the government built a hospital, there is less scope for a private hospital in the area to provide the same service.

Inflationary or Deflationary Effects

• A fiscal deficit aimed at boosting the economy can cause high inflation rates if it is not managed well.
• A fiscal surplus aimed at reducing inflation can cause higher unemployment if it is not managed well.

Spare Capacity

If the economy is at maximum efficiency (at the point where the LRAS curve is vertical), a change in AD will have no effect on output and will only affect the price. Therefore the effect of the fiscal intervention is only inflationary for a budget deficit or deflationary for a budget surplus. Hence, the elasticity of the AS curve at where the AD curve shifts determines the effect of the fiscal position

Effect on Balance of Payments

If AD increases, income increases, which leads to an increase in imports. But there is no immediate reason for exports to change, so in the short run there is likely to be an increase in the current account deficit.

Other Factors

The effect on AD is not certain because other factors affect AD as well.

Out-­‐Dated Information

It takes a long time to collect data about economic performance, so once the government have information with which to decide their Fiscal position, the information will be out of date-­‐ the economy will have changed.

Economic Growth

The shift in AD leads to actual growth, but does not lead to potential growth-­‐ this would require the AS curve to shift to the right (see below).

Budget Deficit

Although expansionary fiscal policy helps boost the economy in the near future, it can lead to inflation and it also inhibit future governments by contributing to the budget deficit.

Crowding Out Effects

Government borrow money to fund the additional spending. Therefore there will be an increase in demand for borrowing, so the interest rates will rise, which will limit investment by private firms in the economy. This has the opposite effect of the intention of the policy.

Effect of Fiscal Policy on Aggregate Supply

Fiscal policy can also be used to increase aggregate supply:

• A fall in income tax improves incentive to work, so supply of labour increases
• A fall in corporation tax increases investment in capital stock
• An increase in government spending on education improves quality and quantity of labour
• A fall in government spending on unemployment benefits increases the supply of labour.

Monetary Policy

The Monetary Policy Committee (MPC) has the sole purpose of controlling inflation by deciding upon the interest rate.

The MPC make the decision independently of the government: the MPC are only  concerned about the inflation rate.
The MPC have a target for CPI inflation of between 2%, plus or minus 1%.

Causes of Inflation

In terms of AD/AS analysis, inflation is caused by an increase in AD (shift to the right) or a decrease in AS (shift to the left).

• A  shift  to  the  right  in  AD  is  called  demand-­‐pull  inflation.  Common  reasons  for  an increase in AD are reductions in unemployment, an increase in consumer and business confidence and a rise in house prices.

• A  shift  to  the  left  in  AS  is  called  cost-­‐push  inflation.  It  occurs  when  the  cost  of production increases in an economy, for example due to an rise in commodity prices, a fall in the exchange rate or a a rise in corporation tax.

Benefits and Costs of Inflation

Monetary policy is used to control inflation, whether too high or low. A stable inflation rate helps minimise the costs of high inflation, but is still high enough to allow the economy to bear the benefits of inflation.

Costs of Inflation

Loss of International Competitiveness

Inflation increases the price of UK goods on the global market (assuming a fixed exchange rate), which will reduce demand for exports. Imports will also be relatively cheaper, so the trade deficit of the Balance of Payments will worsen.

Evaluation: However, the exchange rate should fall because the pound depreciates in value. This would counteract the rise in imports and fall in exports mentioned. Also, the effect depends on the inflation rate relative to the inflation rate of other countries

Redistribution of Income

• Workers on fixed-­‐incomes will find that incomes fall in real terms. These workers tend to be those with lower bargaining power in lower paid jobs.
• Workers on inflation-­‐linked incomes will not lose out. These workers tend to be those with higher bargaining power in high paid jobs.
• Inflation redistributes incomes from savers to borrowers.

Increased uncertainty

Inflation can disrupt business planning. Budgeting becomes difficult because of uncertainty over rise in both prices and costs. Moreover, they are likely to predict and fear increases in interest rates, so they might reduce investment.

Fall in Direct Foreign Investment (FDI)

Foreign investors are less likely to invest in a currency that is falling in value.

Benefits of Inflation Reduction in real interest rate

If the interest rate is not changed by the MPC, the cost of borrowing falls, so large debts such as mortgages are less costly.

Reduction in Inequality

The real value of savings decreases, so the gap between the poor (who will have less savings) and the middle-­‐class (who will have more savings) decreases, and hence the level of inequality decreases.

Higher Revenues and Profits

Low, stable allows businesses to raise their prices, revenues and profits, whilst at the same time workers can expect to see an increase in their wages. This can give psychological  boost and might lead to rising investment and productivity.

Reduced Production Costs

Inflation allows firms to reduce their costs by not rising wages in line with inflation, reducing real production costs. Also, this might mean that they can reduce the number of workers they make redundant.

How it Works

• When inflation is too high, the MPC can increase interest rates to reduce AD (contractionary monetary policy)

• When inflation is too low, the MPC can decrease interest rates to increase AD (expansionary monetary policy)

To understand how this works, consider option 2: increasing interest rates to reduce AD. The rise in interest rates has several effects:

Reduction in House Prices

Higher interest rates increase the cost of mortgage interest repayments, so mortgages are less affordable. This, coupled with the increase in cost of borrowing, will lead to a fall demand for housing, so house prices will fall and consumption and AD will fall (negative wealth effect)

More Saving, Less Borrowing

The opportunity cost of borrowing rises, so consumers make fewer large purchases on credit, so consumption falls. This applies to firms too, who reduce investment, which reduces AD. This fall in investment also helps reduce any potential outward shift of the AS curve which could increase prices.

Increase in DFI

Foreign investors are attracted by high interest rates, so there might be an influx of ‘hot money’. This increases the exchange rate, which makes imports cheaper and exports dearer-­‐ AD decreases further.

All of these changes shift the AD curve to the left with multiplier effects.

Evaluation of Contractionary Monetary Policy

Time Lag

Interest rates can take nearly 2 years to have their full impact

Fixed-­‐Rate Mortgages

Many mortgage holders have fixed-­‐rate policies, so the impact on their spending will be limited.

Income Distribution

A rise in interest rates worsens income distribution because it hurts borrowers (e.g. people paying off a mortgage), and helps savers. Savers are more likely to be the wealthier people in the economy, who have a higher marginal propensity to save (MPS), so they will benefit. Therefore,  there  is  a  re-­‐distribution  of  income  from  borrowers  to  savers,  and  from  the middle  class  to  the  wealthy-­‐  income  distribution  worsens.  Hence,  some  argue  that monetary policy does more harm than good.

Rise in Production Costs

Higher interest rates increases production costs. However, the cause of inflation might have been due to increased production costs (cost-­‐push inflation), so the rise in interest rates might cause firms to increase prices further, which will increase inflation and have the opposite effect!

Economic Growth and Balance of Payments

High interest rates reduce AD and therefore hinder economic growth. Moreover, as explained above, they lead to a reduction in exports and an increase in imports, so they worsen the Balance of Payments trade balance.

Spare Capacity

If there is high spare capacity in the economy, and the economy is at the horizontal section of the AS curve, a change AD will not affect price, so the effects on inflation will be limited.

What factors does the MPC consider when making decisions?

• Output Gap & Unemployment

• Consumer Spending

• Consumer Confidence

• Fiscal Position

• (X-­‐M) & Exchange Rate

• House Prices

• Borrowing

• Business Investment

• Business Confidence

• Average Wages & Earnings

• Commodity Prices

• Inflation Trends

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