2.6.2 Demand-side Policies

• Demand-side policies aim to shift aggregate demand (AD) in an economy
• There are two categories of demand-side policies
  • Fiscal policy and monetary policy
    
    
• Fiscal policy involves the use of government spending and taxation to influence AD
  • The government is responsible for setting fiscal policy
  • The UK Government presents their fiscal policies to the country each year when it delivers the Government budget
    
    
• Monetary policy involves adjusting interest rates and the money supply so as to influence AD
  • The Bank of England (UK central bank) is responsible for setting monetary policy
  • The Bank's Monetary Policy Committee meets 8 times a year to set policy

• The two main instruments of monetary policy include
  • Incremental adjustments to the interest rate (usually not more than 0.25%)
  • Quantitative easing which increases the supply of money in the economy
    • The Central Bank creates new money and uses it to buy open-market assets
      
      
• When a policy decision is made, it creates a ripple effect through the economy and this effect is known as a transmission mechanism

Incremental Changes to Interest Rates

The transmission mechanisms of changes to the interest rate

Before Explaining a Mechanism from the Diagram Above, Key Terminology Can Be Reviewed Below

Example 1

• Official rate decreases by 0.25% → market rates decrease → loans are cheaper → consumers borrow more → consumption increases → AD increases → inflation increases
  
  

Example 2

• Official rate decreases by 0.25% → market rates decrease → mortgages are cheaper → property buyers borrow more → demand for houses increases → asset prices increase 
  
  

Example 3

• Official rate decreases by 0.25% → market rates decrease → buyers borrow more → asset prices increase → households with assets feel wealthier → consumption increases → AD increases → inflation increases

Example 4

• Official rate increases by 0.25% → hot money flows increase → the exchange rate appreciates → exports more expensive and imports cheaper → net exports reduce → AD decreases → inflation decreases

Example 5

• Official rate increases by 0.25% → market rates increase → existing loan repayments now more expensive to repay → discretionary income falls → consumption decreases → AD decreases → inflation decreases

Quantitative Easing Transmission Mechanism

• The Bank of England commits to buy £60bn of gilts a month → commercial banks receive cash for their gilts → liquidity in the market increases → commercial banks lower lending rates → consumers and firms borrow more → consumption and investment increase → AD increases → inflation increases

• Fiscal Policy involves the use of government spending and taxation to influence aggregate demand in the economy
• Government spending includes direct expenditure, but not transfer payments
  • Transfer payments are part of fiscal policy, but are not counted as government spending in the AD formula
    • Transfer payments enter the circular flow when the recipients spend them

Fiscal Policy Impacts

Example 1

• The Government increases VAT from 20% to 22% → consumers pay more tax → discretionary income reduces → consumption reduces → AD reduces → inflation eases
  
  

Example 2

• The Government decreases corporation tax → firms net profits increase → investment by firms increases → AD increases → inflation increases
  
  

Example 3

• The Government freezes/reduces public sector pay → consumer confidence falls → consumption decreases → AD decreases → inflation decreases
  
  

Example 4

• The Government increases the allowances in the Universal Credit (unemployment benefits) → household income increases → consumption increases → AD increases → inflation increases
  
  

• The Government Budget (Fiscal policy) is presented each year as a balanced budget, a budget deficit, or a budget surplus
  • A balanced budget means that government revenue = government expenditure
  • A budget deficit means that government revenue < government expenditure
  • A budget surplus means that government revenue > government expenditure
    
    
• A budget deficit has to be financed through public sector borrowing
  • This borrowing gets added to the public debt
    
    

• The main source of government revenue is taxation
  
  
• Direct taxes are taxes imposed on income and profits
  • They are paid directly to the government by the individual or firm 
    • E.g. Income tax, corporation tax, capital gains tax, national insurance contributions, inheritance tax
      
      
• Indirect taxes are imposed on spending
  • The supplier is responsible for sending payment to the government
    • Depending on the PED and PES producers are able to pass on a proportion of the indirect tax to the consumer
    •  The lower a consumer spends the less indirect tax they pay
    • E.g Value Added Tax (20% VAT rate in the UK in 2022), taxes on demerit goods, excise duties on fuel etc.
      
      

Expansionary Demand-side Policies

• Demand-side policies that aim to increase aggregate demand are called expansionary policies
• Expansionary monetary or fiscal policy will shift aggregate demand to the right
  
  

Classical diagram illustrating expansionary demand-side policies which increase real GDP (Y₁ →Y₂) and average price levels (AP₁ →AP₂)

Expansionary Policies Include

• Reducing taxes; decreasing interest rates; increasing government spending; increasing quantitative easing
  
  

Contractionary Demand-side Policies

• Demand-side policies that aim to decrease aggregate demand are called contractionary policies
• Contractionary monetary or fiscal policy will shift aggregate demand to the left
  
  

Keynesian diagram illustrating contractionary demand-side policies which decrease real GDP (Y_FE →Y₁) and average price levels (AP₁ →AP₂)

Contractionary Policies Include

• Increasing taxes; increasing interest rates; decreasing government spending; decreasing/stopping quantitative easing
  
  

• The Bank of England's Monetary Policy Committee (MPC) consists of nine members
  
  
• They meet 8 times a year to set the monetary policy
  • At this meeting they set the Bank Rate and discuss if quantitative easing is required (or should continue)
  • Policy is decided by majority vote
  • It can take up to two years for the full effects of decisions to be seen in the economy
    
    
• The single most important consideration in their deliberations is the inflation target of 2% CPI
  
  

A Table That Explains Some of the Factors That Influence the Decision Made by The MPC

• The Great Depression started in the USA in October 1929 and continued until the late 1930's
  • By 1932 the USA unemployment rate was around 25%
  • More than 9,000 banks closed during this decade
    • The flow of money in the economy was weak (poor liquidity)
      
      
• The Great Depression created a global slump
  • In the UK, unemployment doubled and exports halved leading to a major recession
    
    
• The 2008 Global Financial Crisis started in the USA in September 2008 with the collapse of the investment bank, Lehman Brothers
  • The crisis was inextricably linked to interest rates and risky lending in the property market
  • In total, about 10 million households lost their homes (roughly 1 in every 20 homes)
  • Unemployment doubled from around 5% to 10%
  • 489 Banks failed in the five-year period following the crisis - most were bailed out by central governments
    
    
• The 2008 Global Financial Crisis created a global slump
  • UK unemployment rose from 5.2% to 7.8%
    
    

A Summary of the Demand-side Policies Used During the Great Depression & 2008 Financial Crisis

Strengths of Monetary Policy

• The Bank of England operates independently from the Government (political process)
• Is able to consider the long-term outlook
• Targets inflation and maintains stable prices
• Depreciating the currency can increase exports

Weaknesses of Monetary Policy

• Conflicting goals e.g economic growth puts upward pressure on inflation
• Time lags between policy and the desired impact (up to 2 years)
• Expansionary policy is less effective in negative output gaps than when used with positive output gaps
  • Consumers may not respond to lower interest rates when confidence is low
• Cheaper credit can inflate asset prices in the long term
• The interest rate has limitations on downward adjustment
  

Strengths of Fiscal Policy

• Spending can be targeted on specific industries
• Short time lag as compared with monetary policy
• Redistributes income through taxation
• Reduces negative externalities through taxation
• Increased consumption of merit/public goods
• Short term government spending can lead to an increase in the long-run aggregate supply
  • E.g. Building a new airport immediately increases government spending and AD, but when it is built, the potential output will have increased

Weaknesses of Fiscal Policy

• Policies can fluctuate significantly as governing parties' change 
  • Long term infrastructure projects may lack follow-through
• Increased government spending can create budget deficits
  
  • Repaying this debt may lead to austerity on future generations
• Conflicts between objectives
  • E.g. Cutting taxes to increase economic growth may cause inflation