Demand-side and supply side policies

Chapter 13

Demand-side policies: policies focused on changing aggregate demand → reducing short-time

fluctuations of the business cycle → divided into monetary and fiscal policies

Monetary policy: policies introduced by the Central Bank that aim to achieve several goals:
1. Low and stable inflation
2. Low unemployment
3. Reduced business cycle fluctuations
4. Stable economic growth
5. External balance: situation in which revenues from exports are balanced by spending on
imports

Inflation targeting: public announcement of targets for inflation with a commitment to achieve
them by the Central Bank → provides greater stability, however can also hinder efforts to achieve
full employment, makes the central bank less able to respond to supply-side shocks

Responsibilities of the central bank:

1. Banker to the government: holds government cash, receives and makes payments for the
government, and manages government borrowing (selling of bonds)
2. Banker to commercial banks: Holds deposits and allows commercial banks to borrow
money
3. Regulator of commercial banks: regulates and supervises commercial banks → ensures
they operate with sufficient cash levels
4. Conduct monetary policy: Responsible for monetary policy → controls the supply of
money and manages interest rates

Determining the rate of interest: increased money supply leads to falling interest rates, and vice
versa → this allows the central bank to manage interest rates by changing the supply of money

How commercial banks create money: take deposits, and hold a certain amount of it (minimum
reserve requirement) but lend out the rest of it → ‘new’ money has been ‘created’

1
Monetary multiplier:
reserveratio

Tools of monetary policy:

1. Open market operations: central bank uses bonds to change the supply of money →
selling bonds will decrease money supply (because people have to pay for the bonds) →
buying bonds will increase the money supply (same principle)
 2. Minimum reserve requirement: if it is lower, banks can lend more money, so increased
money supply, vice versa
3. Minimum lending rate: interest that the central bank charges when it lends money to
commercial banks → if it is lower, more money supply
4. Quantitative easing: similar to buying bonds → larger scale → central bank buys assets
owned by commercial banks → creates electronic reserves that allow commercial banks to
lend more money

Real interest rates: interest rate corrected for inflation

Nominal interest rates: interest rates as given by the bank, not corrected

Expansionary monetary policy: implemented during a deflationary gap → lack of aggregate

demand → central bank increase money supply, causing interest rates to fall, incentivising
borrowing and increased spending → real GDP grows

Contractionary monetary policy: implemented during an inflationary gap → central bank

reduces money supply, leading to higher interest rates, reduced borrowing and lower
investment/consumer spending

Constraints on monetary policy:

1. Ineffective during a recession: interest rates can only go so low (0) → low consumer and
business confidence way hinder efforts to increase AD
2. Risks of high inflation
3. Ineffective when dealing with stagflation/cost-push inflation: doesn’t work with supply-
side policies
4. Conflict between government objectives

Strengths of monetary policy:

1. Incremental interest rate changes: becomes possible to ‘fine-tune’ the economy
2. Reversible and flexible: monetary policy is easily reversible or changed
3. Short time lags: implemented quickly and time lags before it takes effect are short
(compared to fiscal policy)
4. Independent body: central bank is separate from the government, allowing for policies that
consider the long-term health of the economy
5. Doesn’t cause budget deficits/debt

The government budget:

1. Sources of revenue:
a. Taxes
b. Public goods and services that are paid for by consumers
c. Sale of government-owned assets
2. Types of expenditure:
a. Current expenditures: government spending on day-to-day expenses → wages
and salaries, interest payments etc.
 b. Capital expenditures: public investments (roads, airports, hospitals etc.)
c. Transfer payments: payments made from the government to vulnerable groups

Fiscal policy: manipulations by the government of its expenditures and revenue to influence
aggregate demand → goals are the same as monetary policy + equitable distribution of income →
only impacts government, consumption and investment spending (CIG)

Expansionary fiscal policy: during a recessionary gap → consists of increasing government

spending, cutting taxes or both → helps to increase aggregate demand

Contractionary fiscal policy: inflationary gap → decrease government spending, increase taxes →

Evaluating fiscal policy:

1. Constraints:
a. Problems with time lags: takes time for issues to be recognised by government
officials → time for policymakers to agree on policies to implement → time for
policy to have an impact
b. Political constraints: tax increases are unpopular → cutting taxes is popular → may
be more likely, even when not beneficial to the economy
c. Sustainable debt: expansionary policy causes an increased budget deficit → may
lead to unsustainable levels of debt
d. Tax cuts may be ineffective during a recession: people may save money rather than
spend the extra money gained through paying less tax
e. Difficult to ‘fine-tune’ the economy: cannot aim to reach a precise target for AD
f. May be inflationary
g. Does not deal with stagflation/cost-push inflation: demand-side policy, so
ineffective at dealing with supply-side issues
h. Crowding out: if the government increases spending → can cause higher interest
rates (borrowing money → more money in the economy → higher interest) →
leads to lower levels of investment, meaning that despite government spending
increases, overall expenditure may not change
2. Strengths:
a. Can pull economies out of deep recession: e.g. Great Depression
b. Allows government to target certain sectors of the economy
c. Direct impact on aggregate demand: increasing government spending increases one
of the components of AD
d. Can be effective in dealing with rapid inflation
e. Automatic stabilisers: factors that automatically work towards stabilising the
economy → progressive taxes and unemployment benefits → reduces fluctuations
in the business cycle
The Keynesian multiplier: change in real GDP divided by the initial change in expenditure →
usually greater than 1 → initial investment produces a chain of spending → causes the final change
in GDP to be larger than the initial investment

Marginal propensity to consume (MPC): fraction of additional income that consumers spend on
3
goods and services → e.g. if it is
, 75% of new GDP will go towards consumption, with 25%
4
1
‘leaking’ out of the economy due to savings or taxes → multiplier ¿
1−MPC

Supply-side policies: focus on the production and supply side of the economy → aimed at
increasing LRAS → market based or interventionist (government)

Goals of supply-side policies:

1. Promote long-term growth: aims to increase potential output → rightward shift in LRAS
or steeper business cycle growth trend
2. Improve competition and efficiency
3. Reduce costs of labour and reduce unemployment
4. Incentivise firms to invest in innovation
5. Reduce inflation

Market based supply-side policies: policies that aim to allow market forces to work properly →
include encouraging competition, labour market reforms, and incentive-related policies

Encouraging competition:
1. Privatisation: transferring ownership of firms from the public sector to private sector can
increase efficiency
2. Deregulation: eliminating government regulation of private sector → more efficient
3. Private sector contracting: Engaging in a contract with private firms to provide the
government with certain goods and services
4. Anti-monopoly regulation: restricting the market power of firms by enforcing anti-
monopoly legislation that forces large firms to be broken up into smaller units → more
competition (but not good if you want a functioning public transport system (or most
public goods and services really) → UK…)
5. Trade liberalization: allow trade to happen with less barriers → more efficiency
(comparative advantage etc.)

Labour market reforms (basically, poor people don’t matter as long as billionaires are happy):
1. Abolishing the minimum wage: reduces unemployment by allowing equilibrium wages
to fall → argued to provide lower unemployment, greater firm profits, more investment and
greater economic growth (debatable…)
2. Weakening the power of labour/trade unions: makes it harder for employees to demand
high wages → wages would become more flexible
 3. Reducing unemployment benefits: argued that they disincentivise people from looking
for a new job → cutting unemployment benefits is argued to potentially reduce the
natural rate of unemployment
4. Reducing job security: makes it easier for employers to fire workers → firms are more
likely to hire workers (?) because they know they can fire them easily if needed (????)

Incentive-related policies:
1. Lowering personal income taxes: can cause increase in AS as well as AD, because people
are more likely to work → higher supply of labour for more hours/years
2. Lower capital gains taxes (taxes on investments): encourage people to invest more
money → increasing savings that can be counted as investment
3. Lower business taxes: because firms would make higher profits, therefore they would have
more resources to invest in technological innovations

Interventionist supply-side policies: recognise that the market is unable to achieve socially
desirable results → government intervention is required
1. Training and education: more and better training and education improves the quality of
labour and also has several positive externalities → can include measures such as retraining
programs, providing low-interest loans, subsidising the employment of structurally
unemployed workers, increased information
2. Improved heath care services: if workers have access to good quality health care services
→ healthier and more productive
3. Investment in new technology: increases aggregate demand and increases potential output in
the long run
4. Investment in infrastructure: often includes merit/public goods → allows economic
activities to become more efficient and cheaper
5. Industrial policies: support for small and medium-sized firms and support for ‘infant
industries’ (new industries in developing countries)

Overlaps between demand-side and supply-side policies:

1. Demand-side effects of supply-side policies:
- Interventionist policies: government investment → increases the quantity/quality
of physical and human capital → also sees an increase in government spending,
shifting the AD curve to the right
- Market-based policies: increased investment encouraged by market-based policies
can lead to an increase in aggregate demand
2. Supply-side effects of demand-side policies:
- Fiscal policies: spending on capital goods and R&D can lead to better technology
and improve the quality of goods as well as increasing labour productivity
- Monetary policy: falling interest rates → encourages more spending → increases
output

Evaluating supply-side policies:

 1. Constraints:
a. Time lags: take significant amounts of time to have an effect
b. Possible increase in unemployment (market-based policies): can lead to loss of
government jobs → less jobs → increased competition can also push firms to
become more streamlined (fire lots of workers)
c. Equity (market-based policies): market-based policies are extremely inequitable,
favouring high-income individuals, while placing greater pressure on low-
income workers, who are at a higher risk of losing their jobs → cutting
unemployment benefits could then further cause people who lose their jobs to fall
into poverty
d. Negative impact on government budget: government loses tax revenues → lead to
a deficit
e. Negative environmental impact (market-based policies) : increased production of
goods that cause negative externalities
2. Strengths:
a. Improved resource allocation
b. Less burden on government finances (market-based policies)
c. Create unemployment: making wages more flexible leads to a more responsive
labour market
d. Reduce inflationary pressure
e. Target certain sectors of the economy (interventionist policies)

Policies for low unemployment:

1. Cyclical unemployment: policies include expansionary demand-side policies → monetary
policies allows for more incremental changes, with less time lags → however, may be less
effective during a deep recession → fiscal policy is then more effective, however, cannot
fine tune and has major time lags
2. Natural unemployment:
- Demand-side policies are generally not appropriate
- Fiscal policy can affect natural unemployment
- Interventionist supply-side policies: more effective → retraining programs, grants
to firms, information etc.

Policies for low and stable inflation:

1. Monetary policy: effective at dealing with demand-pull inflation → incremental and
easily reversible
2. Fiscal policy: effective as a complementary policy to monetary policy, but often
unpopular → most effective to deal with rapidly escalating inflation
3. Supply-side policies: don’t work for demand-pull inflation → more effective for cost-
push inflation