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 a inflationary gap (Y>YIn a 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 LRAS curve : shifting the LRAS 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