Demand-side and Supply-side Policies

Different policies used by government to achieve macroeconomic stability

Demand-side PoliciesFocus on changing AD to achieve price

stability, full employment and economic growth. These policies are put into effect to counter the short-term fluctuations in real GDP due to the actions of…….

The Animal Spirits!Behavior of consumers and businesses are responsible for the ups and downs of the business cycle.

Goals of Demand-side policiesTo bring AD to potential GDP or create economic growth by increasing potential GDP

Discretionary Fiscal PolicyFiscal Policy Monetary Policy

Stabilization PoliciesFiscal and monetary policies are designed to stabilize the

fluctuations of the business cycle. Remember, economists (but not economics) are boring and like predictability!

Government FinanceBalanced budget, Budget deficit,

Budget surplus and debt………

What’s the difference?

Fiscal PolicyFiscal policy are the decisions made by

government concerning its taxes and expenditures in order to influence the

level of AD. Fiscal policy can affect three of the four components of AD, those three

are……..

Components of AD influenced by fiscal Policy

Right you are! Fiscal policy can

influence the level of spending by

consumers, businesses and the government itself

How can fiscal policy be so powerful?The government can increase or decrease the

tax rate on consumers

The government can increase or decrease the tax rate on businesses

The government can increase or decrease its own spending levels

Suffering from a recessionary gap?

Fiscal policy remedy!Expansionary fiscal policy to the rescue…….Uhmmmm,

what’s that again?

Expansionary Fiscal PolicyIf we are experiencing a recessionary gap due to insufficient AD,

the following will help!

Increase government spending

Reduce taxes on consumers

Reduce taxes on businesses or

A combination of the above

Expansionary fiscal policy = more AD!

Different results at Different StagesIf we are in a deep recession (at the horizontal part of

the Keynesian AS curve) expansionary fiscal policy will increase GDP without increasing the average price

level

At other points of the Keynesian AS curve expansionary fiscal policy may or may not increase

GDP but will increase the average price level

Suffering from an inflationary gap?

Fiscal policy remedy!Contractionary fiscal policy to the

rescue…….Uhmmmm, what’s that again?

Contractionary Fiscal PolicyIf we are experiencing an inflationary gap due to excessive AD,

the following will help!

Decrease government spending

Increase taxes on consumers

Increase taxes on businesses or

A combination of the above

Contractionary fiscal policy = less AD!

Halftime! Time for some review questions

Questions What’s the difference between budget deficit and government debt?

What are the objectives of fiscal policy?

What’s the difference between expansionary and contractionary fiscal policy?

What will fix an inflationary gap?

What will fix a recessionary gap?

Monetary PolicyMonetary policy is carried out by the

central bank of each country. Central banks also control the money supply, determine interest rates and oversee the banking system

Interest RatesSo what’s the relationship between interest

rates and the demand for money?

When interest rates are high, people hold less cash, when interest rates are low, people hold more cash.

Comprende? Or is it Entiende?

Changes to the money supplySo what happens to interest rates if the central bank increase the money supply? Interest rates increase, decrease or stay the

same?

And if the central bank decreases the money supply? Interest rates increase, decrease or stay the same?

Interest Rates and AD

Why change the money supply?As you have already seen, when the

central bank increases the money supply, interest rates fall, and when interest rates

fall, what happens to AD?

Easy Money!

Expansionary Monetary PolicyWhen the central bank increases the money supply, interest rates fall, and consumers and

businesses are more likely to borrow. Increased borrowing means increased spending, which

means increased AD which is the perfect medicine to fight a recessionary gap!

Tight Money!

Contractionary Monetary PolicyWhen the central bank decreases the money

supply, interest rates rise, and consumers and businesses are less likely to borrow. Decreased borrowing means decreased spending, which

means decreased AD which is the perfect medicine to fight an inflationary gap!

So to summarize…..During a deflationary gap, to increase AD the government

may choose to increase spending or cut taxes (fiscal policy) or increase the money supply/lower interest rates

(monetary policy)

During inflationary gap, to decrease AD the government may choose to decrease spending or raise taxes (fiscal

policy) or decrease the money supply/raise interest rates (monetary policy)

So which is better? Fiscal or Monetary?

Strengths of fiscal policy

In case of emergency…Fiscal policy can be extremely effective

during times of economic emergency, whether that is during a deep

recessionary gap (see 1930s) or times of escalating inflation

Fiscal Policy and long-term economic growth

Expansionary fiscal policy leads to investment and gains in research and development/new technology as

well as infrastructure improvement and training/education. All of these can have the effect of shifting the AS curve to the right and create economic

growth in the future.

The many weaknesses of fiscal policy

TimingFiscal policy comes with delays. Delays in

recognizing the problem, delays in making the appropriate decision and delays until the policy has taken effect. By the time these “lags” are

overcome, the problem could be worse, maybe been solved already…..

The many weaknesses of fiscal policy

InformationFiscal policy decisions are based on

statistical information compiled by government workers. Can these workers be trusted? Your teacher used to be one,

so what do you think?

The many weaknesses of fiscal policy

PoliticsTaxes are unpopular. Government might want to raise

taxes to slow AD, but that is not going to be a popular move with voters

Government might want to cut spending, but many programs are protected by law, so this may not be

easy to do either

The many weaknesses of fiscal policy

Crowding Out?If the government begins to borrow more

money, what will happen to interest rates? What effect will that have on private investment? Might that be a

problem?

The many weaknesses of fiscal policy

Tax cuts don’t always lead to increased ADGovernment may think reducing taxes will

lead to increased spending, but if consumer confidence is low, people may

just take that money and put it in the bank, rather than spend it…..government

spending is more effective…

The many weaknesses of fiscal policy

Inability to “fine-tune” the economyFiscal policy can guide the economy to a certain point, but it is not very effective in

reaching precise targets in terms of output, employment, or price levels.

Strengths of Monetary Policy

Strengths of Monetary PolicyQuick implementationNo political constraintsNo crowding out effect

Better able to fine-tune the economy

Weaknesses of Monetary PolicyLags can exist due to problem recognition, and time for policy

to take effect

Reliance on statistics compiled by government bureaucrats

May not be effective during severe recession (banks may not want to lend money, consumers and businesses may not want

to take loans)

What about stagflation?Fiscal and monetary policy can correct

economic problems that arise from a problem with AD, but what about a negative supply shock? Fiscal policy is unable to deal with

instability arising from a leftward shift of the aggregate supply curve

Pick one!!!Keynesians believe most strongly in fiscal policy

while other economists are wishy-washy and prefer a combination of fiscal and monetary policy. Utilizing the strengths of each policy

together is probably the wisest strategy.

Opponents of Fiscal and Monetary PolicyMonetarists argue that demand-side policies only

make matters worse. They believe government should focus on social priorities and change the money supply

to match the rate at which economic growth is occurring. They also argue for policies that increase

wage and price flexibility to allow the markets to more easily adapt to changing conditions.