Demand-side and Supply-side policies

1. Demand-side and Supply-side policies

2. Demand-side policies • Based on the idea that short-term fluctuations of Real GDP are due to actions of firms and consumers that affect AD, causing inflationary and recessionary gaps. • Objectives: bring the AD to the FE level of Real GDP. • D-side policies can also impact on economic growth, that is, increase potential GDP (shift LRAS curve to the right). IB exam question of this year!!

3. Fiscal Policy (FP) • Definition: manipulations by the government of its own expenditures and taxes in order to influence the level of AD. • Government receives revenues from income and business taxes, T. • Government expenditures: G • If G=T: balanced budget • If G>T: budget deficit Gov needs to borrow • If G<T: budget surplus • Public/Government Debt is the gov’s accumulation of deficits minus surpluses.

4. FP can affect AD through 3 components: • G. Direct impact on AD • C. FP, through changes in income taxes, affects the disposable income of consumers, which affects their consumption expenditures. • I. Through changes in business taxes, FP affects the after tax profits of firms, which has an impact on their level of investment expenditures.

5. Expansionary Fiscal Policy • In a recessionary gap (Y<YFE), the gov can increase AD with expansionary FP, which works to expand the level of economic activity. • Expansionary FP can consist of: • ↑ G • ↓ personal income taxes • ↓ business taxes • a combination of the three.

6. An increase in G has a direct impact on AD • A decrease in T affects AD in a 2-step process: ↓T → ↑Disposable income Yd / ↑After-tax businesses profits → ↑C / ↑I →↑ AD • The increase in real GDP will be smaller in the neoclassical model than in the Keynesian one, because of the upward sloping neoclassical AS curve. • The increase in the PL will be smaller in the Keynesian model, where the increase in AD may result in no increase in the PL at all if the AD shift occurs entirely within the horizontal segment of the Keynesian AS curve.

7. Contractionary Fiscal Policy • In a inflationary gap (Y>YFE), the gov can decrease AD with expansionary FP, which works to contract AD and the level of economic activity. • Contractionary FP can consist of: • ↓ G • ↑ personal income taxes • ↑ business taxes • a combination of the three.

8. A decrease in G has a direct impact on AD • An increase in T affects AD in a 2-step process: ↑ T → ↓Disposable income Yd / ↓After-tax businesses profits → ↓C / ↓I → ↓ AD • Figures 9.1 and 9.2.

9. Monetary Policy (MP) • Carried out by the Central Bank (CB) of each country. • The CB is a (government) financial institution whose purpose is to control the supply of money, determine the rate of interest, oversee the banking system and carry out monetary policy. • In the countries which form the European Monetary Union (EMU), monetary policy is carried out by the European Central Bank (ECB), located in Frankfurt.

10. MP impacts AD indirectly through the rate of interest. • Interest is the payment (per unit of time) for the use of borrowed money. Usually expressed as % of the principal to be paid per year. This % is called the rate of interest. • The money market is a market where the demand for money and the supply of money determine the equilibrium rate of interest. • The rate of interest is the price of money services. • The Demand for money is downward sloping.

11. Why is Dm downward sloping? (Fig. 9.3) • Money allows economic agents to carry out their buying and selling exchanges. • Money can be used as a form of saving when used to buy bonds (a certificate issued by the gov or a firm that promises to pay interest at various intervals until the date when the money is repaid to the bond holder). • So, interest is the opportunity cost of holding money, as you could have received that interest if you had saved the money instead of holding it. • The higher i, the higher the opportunity cost of holding money and the lower the quantity of money demanded.

12. The Supply of money, Sm, is fixed at a level that is decided upon by the CB. Sm does not depend on i. • Monetary policy is carried out by the CB, through changes in the money supply, which are undertaken in order to influence the rate of interest: ↑Sm→ ↓ie↓Sm→ ↑ie • In practice, the CB can target either the money supply or the interest rate. Most central banks target the interest rate: decide upon i and then adjust Sm so that the actual ie will become equal to the target i.

13. Changes in i affect two components of AD: • C, as some consumption is financed by borrowing. • I, as firms borrow money in order to finance their investment expenditures. • Therefore: ↑ i → ↓ C , ↓ I → ↓ AD and AD shifts left ↓i → ↑ C , ↑ I →↑ AD and AD shifts right

14. Expansionary (easy money) Policy • In a recessionary gap (Y<YFE), the CB increases Sm, causing the interest rate to decrease. • A lower i means a lower cost of borrowing, so consumers and firms are likely to borrow and spend more: ↓i → ↑ C and ↑ I → ↓ AD. • I is more sensitive than C to changes in i, so the increase in I will have a greater impact on AD than the increase in C.

15. Contractionay (tight money) Policy • In an inflationary gap (Y>YFE), the CB decreases Sm, causing the interest rate to increase. • A higher i means a higher cost of borrowing, so consumers and firms are likely to borrow and spend less: ↑ i → ↓ C and ↓ I → ↓ AD. • I is more sensitive than C to changes in i, so the increase in I will have a greater impact on AD than the increase in C.

16. Strengths and weaknesses of D-side policies for short-term stabilization Strengths of Fiscal Policy • The strength of FP is to pull an economy out of a deep recession, or when the economy finds itself in the horizontal segment of the AS curve. Remember Keynes and the Great Depression of the 1930s! • Combating rapid and escalating inflation.

17. Weaknesses of Fiscal Policy • Problems of timing. FP is subject to time lags: • A lag until the problem is recognized . • A lag until the appropriate policy is decided upon by the gov. • A lag until the policy takes effect in the economy. By the time the policy has taken effect the problem may have become less or more severe, so that the policy is no longer the appropriate one.

18. Problems of inadequate information. The gov relies on statistical information and forecasts for its policy decisions. Inaccuracies may then lead to inappropriate policies. • Political constraints. Gov spending and taxation are subject to numerous pressures that are unrelated to fiscal policy considerations. Spending in public and merit goods is undertaken for its own sake and cannot easily be cut. Taxes are politically unpopular and might be avoided even though they might be necessary.

19. Crowding-out effect. The increase in interest rate caused by deficit spending can lead to lower investment spending by private firms. A greater G is offset by a lower I. • In a recession, tax cuts may not be very effective in increasing AD. Part of the increase in after-tax income is saved. If this share becomes larger due to pessimistic future expectations, the impacts of tax cuts on AD will be even weaker.

20. Inability to fine tune the economy. FP can lead the economy in a general direction of smaller or larger AD, but it cannot be used to reach a precise target with respect to the level of output, employment and the price level. It is not possible to use FP to keep real GDP at or very close to its potential level. There are many factors affecting AD that the gov cannot control.

21. Strengths of Monetary Policy • Quick implementation. MP can be implemented more quickly than FP because it does not have to go through the political process. • No political constraints: • MP not subject to political pressures, does not involve changes in gov budget. • CB in many countries is independent of the governing political party.

22. No crowding-out effect. • Better suited to fine tuning of the economy in comparison with FP. Above factors make MP more accurate wrt achieving output, price level and employment objectives. However, also subject to limitations.

23. Weaknesses of Monetary Policy • Problems of timing. Although MP does not depend on the political process, it is still sunject to time lags: • A lag until the problem is recognized . • A lag until the policy takes effect in the economy. Changes in interest rates can take several months to have an impact on AD, Y and PL. This time lags becomes longer if there is pessimism in the economy. • Problems of inadequate information.

24. Possible ineffectiveness in recession. A tight money policy can effectively combat inflation. However, an easy money policy is less effective in a deep recession. In a recession, lower interest rates would encourage C and I, increasing AD. This is under the assumption that banks will be willing to ↑ their lending to households and firms and that these will be willing to ↑ their borrowing and their spending. However, in a severe recession banks may be unwilling to ↑ their lending and if firms and consumers are pessimistic about

25. the future they may avoid taking new loans and may even ↓ their I and C. This situation occurred in the 1930s and there were fears that it would occur in 2008. Weakenesses of both • If the economy is experiencing stagflation (↓Y+↑PL), neither FP or MP can bring the economy back to the macroeconomic equilibrium. These policies cannot resolve both inflation and UE at the same time.

26. Inflation requires a contractionary policy • UE requires an expansionary policy Fiscal or monetary policy? • Keynesians believe that FP is more effective in achieving stabilization. • Neoclassical economists have believed that MP is more effective. • Today economists agree in that they are most effective when used together.

27. According to most economists: • because of its greater speed and flexibility, MP is better suited to dealing with short-term stabilization, particularly when there is an inflationary gap. • FP should focus on creating a stable fiscal environment, involving avoidance of very large and persistent budget deficits or surpluses. • FP should be used to complement MP in the event of strong economic downturns to prevent a serious recession, or to pull an economy out of a serious recession (autumn 2008).

28. D-side policies and long term growth D-side policies can contribute to ↑ the level of potential GDP in two ways: • Indirectly, by providing a stable macroeconomic environment in which consumers and firms can plan and carry out their economic activities. • Firms must make decisions on investment in capital goods and whether, how and in what areas to pursue R&D and technological innovations. • Both the formation of capital goods and technological changes are important factors in increasing potential GDP.

29. In order to be able to plan over long periods of time, firms need economic stability, ie, avoidance of sharp economic upturns (inflation) and downturns (recession and UE). • Directly (Figure 9.4): • By encouraging investment through lower business taxes (FP) or lower interest rates (MP), thereby contributing to new capital formation and technological innovations that increase YP. • By directing a portion of G • to the development of infrastructure (roads, telecommunications,...) which increases the quantity of capital goods. • On R&D, which increases technology. • On training and education, that increase the quality of the labor force and can also help lower the NRU.

30. Supply-side policies • Objective: shifting the LRAS curve (not the SRAS!!), in order to achieve long-term economic growth. • Two types: • Market-oriented, favoured by neoclassical economists, who emphasize the importance of well-functioning competitive markets in bringing about shifts in the LRAS curve. • Interventionist, favoured by Keynesians. They attempt to increase LRAS by relying on gov intervention, rather than the market.

31. Market-oriented S-side policies