Demand-side and Demand-side and Supply-side Supply-side

policiespolicies

Demand-side policiesDemand-side policies

Based on the idea that short-term Based on the idea that short-term fluctuations of Real GDP are due to fluctuations of Real GDP are due to actions of firms and consumers that actions of firms and consumers that affect AD, causing inflationary and affect AD, causing inflationary and recessionary gaps.recessionary gaps.

Objectives: bring the AD to the FE Objectives: bring the AD to the FE level of Real GDP.level of Real GDP.

D-side policies can also impact on D-side policies can also impact on economic growth, that is, increase economic growth, that is, increase potential GDP (shift LRAS curve to the potential GDP (shift LRAS curve to the right). right). IB exam question of this year!!IB exam question of this year!!

Fiscal Policy (FP)Fiscal Policy (FP) Definition: manipulations by the Definition: manipulations by the

government of its own expenditures and government of its own expenditures and taxes in order to influence the level of taxes in order to influence the level of AD.AD.

Government receives revenues from Government receives revenues from income and business taxes, T.income and business taxes, T.

Government expenditures: GGovernment expenditures: G If G=T: balanced budgetIf G=T: balanced budget If G>T: budget deficit Gov needs to borrowIf G>T: budget deficit Gov needs to borrow If G<T: budget surplusIf G<T: budget surplus

Public/Government Debt is the gov’s Public/Government Debt is the gov’s accumulation of deficits minus surpluses.accumulation of deficits minus surpluses.

FP can affect AD through 3 FP can affect AD through 3 components: components: G. Direct impact on ADG. Direct impact on AD C. FP, through changes in income taxes, C. FP, through changes in income taxes,

affects the disposable income of affects the disposable income of consumers, which affects their consumers, which affects their consumption expenditures. consumption expenditures.

I. Through changes in business taxes, I. Through changes in business taxes, FP affects the after tax profits of firms, FP affects the after tax profits of firms, which has an impact on their level of which has an impact on their level of investment expenditures.investment expenditures.

Expansionary Fiscal PolicyExpansionary Fiscal Policy In a recessionary gap (Y<YIn a recessionary gap (Y<YFEFE), the ), the

gov can increase AD with gov can increase AD with expansionary FP, which works to expansionary FP, which works to expand the level of economic expand the level of economic activity.activity.

Expansionary FP can consist of:Expansionary FP can consist of:1.1. ↑ ↑ GG

2.2. ↓ ↓ personal income taxespersonal income taxes

3.3. ↓ ↓ business taxesbusiness taxes

4.4. a combination of the three. a combination of the three.

An increase in G has a direct impact on ADAn increase in G has a direct impact on AD A decrease in T affects AD in a 2-step A decrease in T affects AD in a 2-step

process:process:↓↓T T → ↑→ ↑Disposable income Yd / Disposable income Yd / ↑↑After-tax businesses After-tax businesses

profits profits → ↑→ ↑C / C / ↑↑I I →→ ↑↑ AD 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.

Contractionary Fiscal PolicyContractionary Fiscal Policy In an inflationary gap (Y>YIn an inflationary gap (Y>YFEFE), the gov ), the gov

can decrease AD with expansionary can decrease AD with expansionary FP, which works to contract AD and FP, which works to contract AD and the level of economic activity.the level of economic activity.

Contractionary FP can consist of:Contractionary FP can consist of:1.1. ↓ ↓ GG

2.2. ↑↑ personal income taxespersonal income taxes

3.3. ↑↑ business taxesbusiness taxes

4.4. a combination of the three. a combination of the three.

A decrease in G has a direct impact A decrease in G has a direct impact on ADon AD

An increase in T affects AD in a 2-An increase in T affects AD in a 2-step process:step process:↑↑ T T → → ↓↓ Disposable income Yd / ↓Disposable income Yd / ↓ After-After-

tax businesses profits tax businesses profits → → ↓↓ C / ↓C / ↓ I I →→ ↓ ↓ ADAD

Figures 9.1 and 9.2.Figures 9.1 and 9.2.

Monetary Policy (MP)Monetary Policy (MP) Carried out by the Central Bank (CB) Carried out by the Central Bank (CB)

of each country.of each country. The CB is a (government) financial The CB is a (government) financial

institution whose purpose is to control institution whose purpose is to control the supply of money, determine the the supply of money, determine the rate of interest, oversee the banking rate of interest, oversee the banking system and carry out monetary policy.system and carry out monetary policy.

In the countries which form the In the countries which form the European Monetary Union (EMU), European Monetary Union (EMU), monetary policy is carried out by the monetary policy is carried out by the European Central Bank (ECB), located European Central Bank (ECB), located in Frankfurt.in Frankfurt.

MP impacts AD indirectly through the MP impacts AD indirectly through the rate of interest.rate of interest.

InterestInterest is the payment (per unit of time) is the payment (per unit of time) for the use of borrowed money. Usually for the use of borrowed money. Usually expressed as % of the principal to be paid expressed as % of the principal to be paid per year. This % is called the per year. This % is called the rate of rate of interestinterest..

The The money marketmoney market is a market where is a market where the demand for money and the supply of the demand for money and the supply of money determine the equilibrium rate of money determine the equilibrium rate of interest.interest. The rate of interest is the price of money The rate of interest is the price of money

services.services. The Demand for money is downward sloping.The Demand for money is downward sloping.

Why is DWhy is Dmm downward sloping? (Fig. 9.3) downward sloping? (Fig. 9.3) Money allows economic agents to carry out Money allows economic agents to carry out

their buying and selling exchanges.their buying and selling exchanges. Money can be used as a form of saving Money can be used as a form of saving

when used to buy bonds (a certificate when used to buy bonds (a certificate issued by the gov or a firm that promises to issued by the gov or a firm that promises to pay interest at various intervals until the pay interest at various intervals until the date when the money is repaid to the bond date when the money is repaid to the bond holder).holder).

So, interest is the opportunity cost of So, interest is the opportunity cost of holding money, as you could have received holding money, as you could have received that interest if you had saved the money that interest if you had saved the money instead of holding it.instead of holding it.

The higher The higher ii, the higher the opportunity , the higher the opportunity cost of holding money and the lower the cost of holding money and the lower the quantity of money demanded.quantity of money demanded.

The Supply of money, SThe Supply of money, Smm, is fixed at a level , is fixed at a level that is decided upon by the CB. Sthat is decided upon by the CB. Smm does not does not depend on depend on ii..

Monetary policy is carried out by the CB, Monetary policy is carried out by the CB, through changes in the money supply, through changes in the money supply, which are undertaken in order to influence which are undertaken in order to influence the rate of interest: the rate of interest: ↑↑SSmm → → ↓↓iiee ↓S↓Smm → ↑→ ↑iiee

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 SSmm so that the actual iiee will become equal to the target i.

Changes in Changes in ii affect two components affect two components of AD:of AD: C, as some consumption is financed by C, as some consumption is financed by

borrowing.borrowing. I, as firms borrow money in order to I, as firms borrow money in order to

finance their investment expenditures.finance their investment expenditures. Therefore:Therefore:

↑ ↑ ii → → ↓ C , ↓ I ↓ C , ↓ I →→ ↓ AD and AD shifts left ↓ AD and AD shifts left

↓↓ ii → ↑ → ↑ C , C , ↑↑ I I →→ ↑↑ AD and AD shifts right AD and AD shifts right

Expansionary (easy money) PolicyExpansionary (easy money) Policy In a recessionary gap (Y<YIn a recessionary gap (Y<YFEFE), the CB ), the CB

increases Sincreases Smm, causing the interest rate , causing the interest rate to decrease. to decrease.

A lower A lower ii means a lower cost of means a lower cost of borrowing, so consumers and firms are borrowing, so consumers and firms are likely to borrow and spend more: ↓likely to borrow and spend more: ↓ ii → → ↑ ↑ C and C and ↑↑ I I →→ ↓ AD. ↓ AD.

I is more sensitive than C to changes in I is more sensitive than C to changes in ii, so the increase in I will have a greater , so the increase in I will have a greater impact on AD than the increase in C.impact on AD than the increase in C.

Contractionay (tight money) PolicyContractionay (tight money) Policy In an inflationary gap (Y>YIn an inflationary gap (Y>YFEFE), the CB ), the CB

decreases Sdecreases Smm, causing the interest rate to , causing the interest rate to increase. increase.

A higher A higher ii means a higher cost of means a higher cost of borrowing, so consumers and firms are borrowing, so consumers and firms are likely to borrow and spend less: likely to borrow and spend less: ↑ ↑ ii → → ↓ C ↓ C and ↓ I and ↓ I →→ ↓ AD. ↓ AD.

I is more sensitive than C to changes in I is more sensitive than C to changes in ii, , so the increase in I will have a greater so the increase in I will have a greater impact on AD than the increase in C.impact on AD than the increase in C.

Strengths and weaknesses Strengths and weaknesses of D-side policies for short-of D-side policies for short-

term stabilizationterm stabilizationStrengths of Fiscal PolicyStrengths of Fiscal Policy1.1. The strength of FP is to pull an economy The strength of FP is to pull an economy

out of a deep recession, or when the out of a deep recession, or when the economy finds itself in the horizontal economy finds itself in the horizontal segment of the AS curve. Remember segment of the AS curve. Remember Keynes and the Great Depression of the Keynes and the Great Depression of the 1930s!1930s!

2.2. Combating rapid and escalating inflation.Combating rapid and escalating inflation.

Weaknesses of Fiscal PolicyWeaknesses of Fiscal Policy1.1. Problems of timingProblems of timing. FP is subject to . FP is subject to

time lags:time lags: A lag until the problem is recognized .A lag until the problem is recognized . A lag until the appropriate policy is A lag until the appropriate policy is

decided upon by the gov.decided upon by the gov. A lag until the policy takes effect in the A lag until the policy takes effect in the

economy.economy.

By the time the policy has taken effect the By the time the policy has taken effect the problem may have become less or problem may have become less or more severe, so that the policy is no more severe, so that the policy is no longer the appropriate one.longer the appropriate one.

2.2. Problems of inadequate informationProblems of inadequate information. The . The gov relies on statistical information and gov relies on statistical information and forecasts for its policy decisions. forecasts for its policy decisions. Inaccuracies may then lead to Inaccuracies may then lead to inappropriate policies.inappropriate policies.

3.3. Political constraintsPolitical constraints. Gov spending and . Gov spending and taxation are subject to numerous taxation are subject to numerous pressures that are unrelated to fiscal pressures that are unrelated to fiscal policy considerations. Spending in public policy considerations. Spending in public and merit goods is undertaken for its and merit goods is undertaken for its own sake and cannot easily be cut. Taxes own sake and cannot easily be cut. Taxes are politically unpopular and might be are politically unpopular and might be avoided even though they might be avoided even though they might be necessary.necessary.

4.4. Crowding-out effectCrowding-out effect. The increase in . The increase in interest rate caused by interest rate caused by deficit deficit spendingspending can lead to lower investment can lead to lower investment spending by private firms. A greater G spending by private firms. A greater G is offset by a lower I.is offset by a lower I.

5.5. In a recession, In a recession, tax cutstax cuts may not be may not be very effective in increasing AD. Part of very effective in increasing AD. Part of the increase in after-tax income is the increase in after-tax income is saved. If this share becomes larger due saved. If this share becomes larger due to pessimistic future expectations, the to pessimistic future expectations, the impacts of tax cuts on AD will be even impacts of tax cuts on AD will be even weaker. weaker.

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

Strengths of Monetary PolicyStrengths of Monetary Policy1.1. Quick implementationQuick implementation. MP can be . MP can be

implemented more quickly than FP implemented more quickly than FP because it does not have to go because it does not have to go through the political process.through the political process.

2.2. No political constraints:No political constraints: MP not subject to political pressures, MP not subject to political pressures,

does not involve changes in gov does not involve changes in gov budget.budget.

CB in many countries is independent CB in many countries is independent of the governing political party.of the governing political party.

3.3. No No crowding-outcrowding-out effect. effect.

4.4. Better suited to Better suited to fine tuningfine tuning of the of the economy in comparison with FP. economy in comparison with FP. Above factors make MP more Above factors make MP more accurate wrt achieving output, accurate wrt achieving output, price level and employment price level and employment objectives. However, also subject to objectives. However, also subject to limitations.limitations.

Weaknesses of Monetary PolicyWeaknesses of Monetary Policy1.1. Problems of Problems of timingtiming. Although MP . Although MP

does not depend on the political does not depend on the political process, it is still sunject to time process, it is still sunject to time lags:lags:

A lag until the problem is recognized .A lag until the problem is recognized . A lag until the policy takes effect in the A lag until the policy takes effect in the

economy. Changes in interest rates can economy. Changes in interest rates can take several months to have an impact take several months to have an impact on AD, Y and Pon AD, Y and PLL. This time lags becomes . This time lags becomes longer if there is pessimism in the longer if there is pessimism in the economy.economy.

2.2. Problems of Problems of inadequate informationinadequate information..

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

the future they may avoid taking new the future they may avoid taking new loans and may even ↓ their I and C. This loans and may even ↓ their I and C. This situation occurred in the 1930s and situation occurred in the 1930s and there were fears that it would occur in there were fears that it would occur in 2008.2008.

Weakenesses of bothWeakenesses of both If the economy is experiencing If the economy is experiencing

stagflation (↓Y+stagflation (↓Y+↑↑PPLL), neither FP or MP ), neither FP or MP can bring the economy back to the can bring the economy back to the macroeconomic equilibrium. These macroeconomic equilibrium. These policies cannot resolve both inflation and policies cannot resolve both inflation and UE at the same time.UE at the same time.

Inflation requires a contractionary policyInflation requires a contractionary policy UE requires an expansionary policyUE requires an expansionary policy

Fiscal or monetary policy?Fiscal or monetary policy? Keynesians believe that FP is more Keynesians believe that FP is more

effective in achieving stabilization.effective in achieving stabilization. Neoclassical economists have believed Neoclassical economists have believed

that MP is more effective.that MP is more effective. Today economists agree in that they Today economists agree in that they

are most effective when used together. are most effective when used together.

According to most economists:According to most economists: because of its greater speed and flexibility, because of its greater speed and flexibility,

MPMP is better suited to dealing with short- is better suited to dealing with short-term stabilization, particularly when there is term stabilization, particularly when there is an an inflationaryinflationary gap. gap.

FP should focus on creating a stable fiscal FP should focus on creating a stable fiscal environment, involving avoidance of very environment, involving avoidance of very large and persistent budget deficits or large and persistent budget deficits or surpluses.surpluses.

FP should be used to complement MP in the FP should be used to complement MP in the event of strong economic downturns to event of strong economic downturns to prevent a serious recession, or to pull an prevent a serious recession, or to pull an economy out of a serious recession (autumn economy out of a serious recession (autumn 2008).2008).

D-side policies and long term D-side policies and long term growthgrowth

D-side policies can contribute to D-side policies can contribute to ↑↑ the the level of potential GDP in two ways:level of potential GDP in two ways:

1.1. Indirectly, by providing a stable Indirectly, by providing a stable macroeconomic environmentmacroeconomic environment in which in which consumers and firms can plan and consumers and firms can plan and carry out their economic activities.carry out their economic activities.

Firms must make decisions on investment Firms must make decisions on investment in capital goods and whether, how and in in capital goods and whether, how and in what areas to pursue R&D and what areas to pursue R&D and technological innovations.technological innovations.

Both the formation of capital goods and Both the formation of capital goods and technological changes are important technological changes are important factors in increasing potential GDP.factors in increasing potential GDP.

In order to be able to plan over long periods In order to be able to plan over long periods of time, firms need economic stability, ie, of time, firms need economic stability, ie, avoidance of sharp economic upturns avoidance of sharp economic upturns (inflation) and downturns (recession and (inflation) and downturns (recession and UE).UE).

2.2. DirectlyDirectly (Figure 9.4): (Figure 9.4): By encouraging investment through lower By encouraging investment through lower

business taxes (FP) or lower interest rates business taxes (FP) or lower interest rates (MP), thereby contributing to new capital (MP), thereby contributing to new capital formation and technological innovations that formation and technological innovations that increase Yincrease YPP..

By directing a portion of GBy directing a portion of Ga.a. to the development of infrastructure (roads, to the development of infrastructure (roads,

telecommunications,...) which increases the telecommunications,...) which increases the quantity of capital goods.quantity of capital goods.

b.b. On R&D, which increases technology.On R&D, which increases technology.c.c. On training and education, that increase the On training and education, that increase the

quality of the labor force and can also help lower quality of the labor force and can also help lower the NRU.the NRU.

Supply-side policiesSupply-side policies ObjectiveObjective: shifting the : shifting the LRAS curveLRAS curve

(not the SRAS!!), in order to achieve (not the SRAS!!), in order to achieve long-term economic growth.long-term economic growth.

Two types:Two types:1.1. Market-orientedMarket-oriented, favoured by , favoured by

neoclassical economists, who emphasize neoclassical economists, who emphasize the importance of well-functioning the importance of well-functioning competitive markets in bringing about competitive markets in bringing about shifts in the LRAS curve.shifts in the LRAS curve.

2.2. InterventionistInterventionist, favoured by Keynesians. , favoured by Keynesians. They attempt to increase LRAS by relying They attempt to increase LRAS by relying on gov intervention, rather than the on gov intervention, rather than the market.market.

Market-oriented S-side Market-oriented S-side policiespolicies Early 1980s, some neoclassical economists Early 1980s, some neoclassical economists

in the UK and the US emphasize the in the UK and the US emphasize the importance of the supply-side of the importance of the supply-side of the economy in the growth of real GDP. economy in the growth of real GDP. Margaret Thatcher and Ronald Reagan Margaret Thatcher and Ronald Reagan adopted this view.adopted this view.

Since real GDP tends automatically Since real GDP tends automatically (according to the neoclassicals) towards (according to the neoclassicals) towards long-run FE equilibrium, the focus of gov long-run FE equilibrium, the focus of gov policies should be less on stabilization and policies should be less on stabilization and more on achieving increases in potential more on achieving increases in potential output (shifts of LRAS). output (shifts of LRAS).

Theoretical justificationTheoretical justification An economy pursuing S-side policies will be An economy pursuing S-side policies will be

able to achieve able to achieve rapid growthrapid growth, , price price stabilitystability and and FEFE at the same time. The at the same time. The reason is that a stable price level and FE reason is that a stable price level and FE are expected to follow as a consequence of are expected to follow as a consequence of policies that promote growth (ie, increasing policies that promote growth (ie, increasing AS).AS).

In the neoclassical view, inflationary and In the neoclassical view, inflationary and recessionary gaps are automatically recessionary gaps are automatically eliminated. Therefore, as long as the eliminated. Therefore, as long as the economy can move from one long-run economy can move from one long-run equilibirum to another, there will be no UE.equilibirum to another, there will be no UE.

If increases in AS match increases in AD If increases in AS match increases in AD (Fig. 9.4) the price level does not need to (Fig. 9.4) the price level does not need to increase. Therefore economic policy increase. Therefore economic policy should focus on increasing AS (shifting should focus on increasing AS (shifting both LRAS ans SRAS) so that this will at both LRAS ans SRAS) so that this will at least match increases in AD.least match increases in AD.

Increases in AS may address the problem Increases in AS may address the problem of stagflation, which D-side policies cannot of stagflation, which D-side policies cannot correct. (Page 262, Fig. 9.5).correct. (Page 262, Fig. 9.5).

S-side policies may aim at:S-side policies may aim at:1.1. Reducing the size of the gov sector and Reducing the size of the gov sector and

increase competition.increase competition.2.2. Improving incentives by lowering taxes.Improving incentives by lowering taxes.3.3. Making labour mkt more responsive to S and D.Making labour mkt more responsive to S and D.4.4. Liberalizing international trade and capital Liberalizing international trade and capital

flows.flows.

1. Reducing the size of the gov 1. Reducing the size of the gov sector and increasing competitionsector and increasing competition Rationale: a large gov sector may be Rationale: a large gov sector may be

inefficient (admin costs, unproductive inefficient (admin costs, unproductive workers, burocracy), as govs do not workers, burocracy), as govs do not face incentives to maximize profits.face incentives to maximize profits.

A.A. Privatization. Privatization. Leads to increased Leads to increased efficiency.efficiency.

B.B. Private financing of public sector Private financing of public sector projects. A private firm undertakes to projects. A private firm undertakes to build, finance and operate public build, finance and operate public services and the gov buys the services services and the gov buys the services from the private firms. from the private firms. Increases Increases competition, efficiency and quality.competition, efficiency and quality.

C.C. Contracting out to the private sector Contracting out to the private sector (outsourcing). (outsourcing). Increased competition, Increased competition, improved efficiency, lower costs and improved efficiency, lower costs and improved qualityimproved quality..

D.D. Deregulation. Elimination or reduction of Deregulation. Elimination or reduction of gov regulation of private sector activities.gov regulation of private sector activities.

Economic regulation: government control of Economic regulation: government control of prices and output, which offers firms prices and output, which offers firms protection against competition. Ex: transport, protection against competition. Ex: transport, airlines, tv broadcasting, electricity,...airlines, tv broadcasting, electricity,...

Social regulation: protection of consumers Social regulation: protection of consumers against undesirable impacts of private sector against undesirable impacts of private sector activities in areas like food, pharmaceuticals, activities in areas like food, pharmaceuticals, worker protection agains injuries and worker protection agains injuries and pollution control. Some economists argue pollution control. Some economists argue that social regulation is excessive.that social regulation is excessive.

E.E. Restricting monopoly power can result Restricting monopoly power can result in increased competition, greater scope in increased competition, greater scope for the forces of S and D, increased for the forces of S and D, increased efficiency, lower costs and improved efficiency, lower costs and improved quality. Ways of restricting monopoly quality. Ways of restricting monopoly power:power:

By enforcing anti-monopoly legislation,By enforcing anti-monopoly legislation, By breaking up large firms wngaging in By breaking up large firms wngaging in

monopolistic practices into smaller units,monopolistic practices into smaller units, By preventing mergers between firms By preventing mergers between firms

that might result in excessive monopoly that might result in excessive monopoly power.power.

Strengths of these policiesStrengths of these policies. Reduction . Reduction of gov control of economic activities and of gov control of economic activities and the transfer to the private sector can the transfer to the private sector can give rise to more competition, greater give rise to more competition, greater efficiency and lower costs of production, efficiency and lower costs of production, with possibly increased quality of goods with possibly increased quality of goods and services.and services.

WeakenessesWeakenesses Privatization. A public monopoly may become Privatization. A public monopoly may become

a private monopoly. Private firms are likely a private monopoly. Private firms are likely to to ↑↑ prices, which may damage lower income prices, which may damage lower income groups. There may also be negative effects groups. There may also be negative effects on employment if private firms lay off on employment if private firms lay off workers when trying to cut costs.workers when trying to cut costs.

Private financing activities. Private financing activities. Prices might be higher than when the Prices might be higher than when the

government is the provider.government is the provider. Loss of gov control over the project and Loss of gov control over the project and

reduced project flexibility.reduced project flexibility. The concern that firms may not pay sufficient The concern that firms may not pay sufficient

attention to population safety needs and that attention to population safety needs and that these may be sacrificed as a consequence of these may be sacrificed as a consequence of trying to keep costs low.trying to keep costs low.

Outsourcing.Outsourcing. Loss of flexibility to respond to changing Loss of flexibility to respond to changing

market conditions.market conditions. When outside firms are involved: loss of When outside firms are involved: loss of

internal talent that could have been used, gov internal talent that could have been used, gov job losses and job losses for the country as a job losses and job losses for the country as a whole.whole.

Deregulation.Deregulation. Sometimes leads to higher prices and lower Sometimes leads to higher prices and lower

quality services.quality services. Frequently led to increased UE, due to Frequently led to increased UE, due to

increased competitive pressure.increased competitive pressure. The financial crisis led to broad recognition The financial crisis led to broad recognition

of the need to increase the regulation of of the need to increase the regulation of financial services, as well as to a partial financial services, as well as to a partial nationalization of some financial services nationalization of some financial services institutions.institutions.

Social deregulation is unlikely to be in the Social deregulation is unlikely to be in the public interest.public interest.

1.1. Lowering personal income taxes. The Lowering personal income taxes. The gov can gov can ↑↑ or ↓ personal income taxes or ↓ personal income taxes as part of fiscal policy, thereby ↓ or as part of fiscal policy, thereby ↓ or ↑↑ AD. S-side economists argue that AD. S-side economists argue that changes in income taxes have an even changes in income taxes have an even greater impact on AS. They claim that greater impact on AS. They claim that tax cuts will give rise to higher after-tax cuts will give rise to higher after-tax incomes, and this is an incentive tax incomes, and this is an incentive for people to provide more work. This for people to provide more work. This can happen throughcan happen through

2. Improving incentives by 2. Improving incentives by lowering taxeslowering taxes

↑ ↑ number of hours workednumber of hours worked ↑ ↑ number of people interested in finding number of people interested in finding

workwork ↑↑ number of years worked.number of years worked. ↓ ↓ in UE, as unemployed workers choose to in UE, as unemployed workers choose to

shorten the duration of their UE.shorten the duration of their UE.

All these factors may work to shift the All these factors may work to shift the LRAS curve to the right.LRAS curve to the right.

2.2. Lowering taxes on interest income Lowering taxes on interest income (taxes paid on income received from (taxes paid on income received from interest on savings deposits). This will interest on savings deposits). This will increase incentives to save, increasing increase incentives to save, increasing the funds available for I, which will the funds available for I, which will increase the production of capital, increase the production of capital, which increases potential output.which increases potential output.

3.3. Lowering business taxes increases Lowering business taxes increases AD by increasing I. S-side AD by increasing I. S-side economists argue that this is a S-economists argue that this is a S-side measure, since the increase in side measure, since the increase in after-tax profits increases the after-tax profits increases the financial resources of firms to financial resources of firms to produce new and improved capital produce new and improved capital goods and pursue technological goods and pursue technological innovations. Both these effects innovations. Both these effects increase potential output.increase potential output.

Strengths of these policiesStrengths of these policies. If they . If they work as intended, tax cuts would give work as intended, tax cuts would give rise to:rise to: increases in the quantity of labour and increases in the quantity of labour and

capital resources,capital resources, a reduction in UE,a reduction in UE, increased saving,increased saving, increased I andincreased I and more R&D and technological innovations,more R&D and technological innovations,

All of which contribute to increasing YAll of which contribute to increasing YPP..

Weaknesses of these policiesWeaknesses of these policies.. Some economists argue that tax policies may have a Some economists argue that tax policies may have a

larger impact on AD than AS. Income tax cuts may larger impact on AD than AS. Income tax cuts may result in people supplying less work if they decide to result in people supplying less work if they decide to use their extra after-tax income to increase their use their extra after-tax income to increase their leisure time. Also, consumers may decide to use their leisure time. Also, consumers may decide to use their higher disposable income to consume more rather higher disposable income to consume more rather than to save, which will have an impact on AD.than to save, which will have an impact on AD.

Tax cuts may give rise to increasing inflation. If the Tax cuts may give rise to increasing inflation. If the impacts of tax cuts are greater on AD than on AS, impacts of tax cuts are greater on AD than on AS, then they may create inflation.then they may create inflation.

They may worsen income distribution, as it is the They may worsen income distribution, as it is the wealthy who earn most of the interest income and wealthy who earn most of the interest income and business profits, and therefore these tax cuts will business profits, and therefore these tax cuts will affect wealthy people by increasing their after-tax affect wealthy people by increasing their after-tax incomes more then they will affect the other incomes more then they will affect the other population groups.population groups.

Tax cuts are likely to increase gov’s budget Tax cuts are likely to increase gov’s budget deficit unless they are accompanied by deficit unless they are accompanied by decreases in gov spending. But decreases in decreases in gov spending. But decreases in G (contractionary FP) may not be G (contractionary FP) may not be appropriate if the economy is contracting appropriate if the economy is contracting (downward phase of the business cycle).(downward phase of the business cycle).

Tax cuts were implemented in the 1980s in Tax cuts were implemented in the 1980s in the Uk and in the US, but economists the Uk and in the US, but economists disagree on whether or not these have disagree on whether or not these have worked to increase Yworked to increase YPP. The reason is that . The reason is that whatever growth has occurred has been the whatever growth has occurred has been the result of both D-side and S-side effects of D-result of both D-side and S-side effects of D-side and S-side policies, being very diffciult side and S-side policies, being very diffciult to isolate the effect of a particular policy.to isolate the effect of a particular policy.

3. Increasing labour market 3. Increasing labour market flexibilityflexibility1.1. Abolishing minimum wage legislation, so Abolishing minimum wage legislation, so

that wages become more flexible in the that wages become more flexible in the downward direction. The effects will be downward direction. The effects will be lower UE, greater firms profits (labour costs lower UE, greater firms profits (labour costs are lower) and increased capital goods are lower) and increased capital goods production and economic growth due to production and economic growth due to increased firm profits. increased firm profits.

2.2. Weakening the power of labour trade unions, Weakening the power of labour trade unions, so that wages will be more responsive to S so that wages will be more responsive to S and D. Same benefits as above.and D. Same benefits as above.

3.3. Reducing UE benefits, which are argued to Reducing UE benefits, which are argued to have the effect of lowering the incentive to have the effect of lowering the incentive to search for a new job. The effect would be search for a new job. The effect would be lower UE.lower UE.

4.4. Reducing job security (laws that protect Reducing job security (laws that protect workers against being fired making it workers against being fired making it costly for firms to fire workers). It is costly for firms to fire workers). It is argued that firms would be more likely argued that firms would be more likely to hire new workers if they know they to hire new workers if they know they can fire them easily and without cost can fire them easily and without cost when they are no longer needed. Also, when they are no longer needed. Also, reducing job security would decrease reducing job security would decrease firm’s labour costs, increasing profits.firm’s labour costs, increasing profits.

Strengths of these policies. Strengths of these policies. If wages can fall when there is UE, this will If wages can fall when there is UE, this will

reduce firms’ costs of production and give reduce firms’ costs of production and give rise to increased profits, higher employment rise to increased profits, higher employment and profits.and profits.

Weaknesses of these policies.Weaknesses of these policies. Some economists argue that paying workers Some economists argue that paying workers

a higher than equilibrium wage encourages a higher than equilibrium wage encourages them to work harder, increasing their them to work harder, increasing their productivity, which increases demand for productivity, which increases demand for labour (↓ UE).labour (↓ UE).

These policies involve changes in legislation These policies involve changes in legislation that provide protection for workers with very that provide protection for workers with very low incomes. Reducing protection results in low incomes. Reducing protection results in lower wages and job insecurity, increasing lower wages and job insecurity, increasing income inequalities.income inequalities.

UE benefits can play an important role UE benefits can play an important role in a recession, as they compensate for in a recession, as they compensate for the loss of income of the unemployed, the loss of income of the unemployed, helping maintaining the level of helping maintaining the level of consumption spendingconsumption spending

4. Liberalizing international 4. Liberalizing international trade & capital flowstrade & capital flowsFreer trade and freer capital Freer trade and freer capital

movements between countries movements between countries increase global competition, increase global competition, improving the allocation of improving the allocation of resources within countries and resources within countries and globally.globally.

Interventionist S-side Interventionist S-side policiespolicies They presuppose that the free market They presuppose that the free market

economy cannot by itself achieve the economy cannot by itself achieve the desired results in terms of increasing desired results in terms of increasing potential output. Therefore, gov potential output. Therefore, gov intervention is necessary in some areas:intervention is necessary in some areas:

1.1. Public Public training and educationtraining and education programmes can provide skills to programmes can provide skills to workers, which may become more workers, which may become more employable and more productive. This employable and more productive. This also improves the quality of labour also improves the quality of labour resources, increasing production resources, increasing production possibilities. possibilities.

2.2. Improved Improved health carehealth care services and services and access to these, which leads to access to these, which leads to improvements in the quality of labour improvements in the quality of labour services.services.

3.3. R&DR&D makes technological advances makes technological advances possible, and these are a very important possible, and these are a very important factor behind increases in potential factor behind increases in potential output and economic growth. Gov in output and economic growth. Gov in many countries are involved in R&D many countries are involved in R&D and, in addition, they provide incentives and, in addition, they provide incentives to the private sector to engage in R&D to the private sector to engage in R&D (tax incentives, granting of patents).(tax incentives, granting of patents).

4.4. Provision of Provision of job informationjob information (employment agencies), which (employment agencies), which decreases the time the unemployed decreases the time the unemployed spend trying to locate jobs, helping spend trying to locate jobs, helping lower the level of UE.lower the level of UE.

5.5. Support for small and medium-sized Support for small and medium-sized enterprises (enterprises (SMEsSMEs), in the form of tax ), in the form of tax exemptions, grants, low interest loans exemptions, grants, low interest loans and business guidance. This promotes and business guidance. This promotes efficiency, more capital formation, efficiency, more capital formation, more employment possibilities and more employment possibilities and therefore increases in potential therefore increases in potential output.output.

6.6. Support for ‘Support for ‘infant industriesinfant industries’. These ’. These are newly emerging industries (in are newly emerging industries (in developing countries) which sometimes developing countries) which sometimes receive gov support (grants, subsidies, receive gov support (grants, subsidies, tax exemptions, export protection). This tax exemptions, export protection). This also provides support for growth of the also provides support for growth of the private sector.private sector.

7.7. Improvements in infrastructure, which Improvements in infrastructure, which decrease production costs. decrease production costs. InfrastructureInfrastructure is a type of physical is a type of physical capital and includes power, capital and includes power, telecommunications, roads, dams, urban telecommunications, roads, dams, urban transport, airports and ports. transport, airports and ports.

Strengths of industrial policiesStrengths of industrial policies. . ((DefinitionDefinition: policies designed to support : policies designed to support the growth of the industrial sector of an the growth of the industrial sector of an economy, shifting the LRAS curve or economy, shifting the LRAS curve or the K-AS curve to the right)the K-AS curve to the right)

1.1. They offer opportunities for gov support in They offer opportunities for gov support in particular areas that would not materialize particular areas that would not materialize as needed if left to the market.as needed if left to the market.

2.2. Industrial policies allow the gov to support Industrial policies allow the gov to support particular industries that are believed to particular industries that are believed to offer the greatest possibilities for growth in offer the greatest possibilities for growth in the future.the future.

3.3. A number of policies can be useful in A number of policies can be useful in lowering certain kinds of UE.lowering certain kinds of UE.

Weakenesses of interventionist Weakenesses of interventionist policies.policies.

1.1. Gov interference may lead to inefficiencies Gov interference may lead to inefficiencies and resource misallocation, whereas reliance and resource misallocation, whereas reliance on the market through market-oriented S-on the market through market-oriented S-side policies will achieve the desired impacts side policies will achieve the desired impacts on long-term growth while avoiding these on long-term growth while avoiding these disadvantages. disadvantages.

2.2. The use of tax revenues for the support of The use of tax revenues for the support of interventionist activities uses resources that interventionist activities uses resources that might have better alternative uses elsewhere. might have better alternative uses elsewhere. Supporters of market solutions argue that Supporters of market solutions argue that large amounts of tax revenues are needed in large amounts of tax revenues are needed in order to provide all the support services. This order to provide all the support services. This implies high taxes (disincentive to work) and implies high taxes (disincentive to work) and large gov sector (promotes inefficiencies).large gov sector (promotes inefficiencies).

Interactions between D-side and S-Interactions between D-side and S-side policiesside policies

S-side policies have also D-side effects, for S-side policies have also D-side effects, for example, lower income taxes may provide example, lower income taxes may provide incentives to work harder and longer, but incentives to work harder and longer, but also, increase consumption spending.also, increase consumption spending.

In the real world, given the complex In the real world, given the complex interactions between the different polices, it interactions between the different polices, it is difficult to identify what particular policy is is difficult to identify what particular policy is responsible for what effect.responsible for what effect.

Economists generally agree that S-side Economists generally agree that S-side policies play a very important role in policies play a very important role in increasing potential output.increasing potential output.

They disagree on:They disagree on:1.1. Whether market-oriented or interventionist Whether market-oriented or interventionist

policies are more effective.policies are more effective.

2.2. The importance of S-side effects of D-side The importance of S-side effects of D-side policies in causing growth. Some economists policies in causing growth. Some economists (Keynesians) argue that these can be very (Keynesians) argue that these can be very important, while others (neoclassicals) argue important, while others (neoclassicals) argue that they are less so. that they are less so.

Growth in real GDP involves increases in Growth in real GDP involves increases in both AD and AS.both AD and AS.