Demand-side policies(demand management)Focus: shift AD in the AD/AS model to achieve the

goals of price stability, FE and economic growth. Based on the idea that short-term fluctuations of

Real GDP are due to actions of firms and consumers that affect AD, causing inflationary and recessionary gaps.

They try to counteract the effect of those actions and bring AD to the FE level of real GDP.

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

Discretionary and non-discretionary policy.Stabilization policies

Discretionary policy: active and purposeful government intervention to influence AD (the policy is at the discretion of the gov). Two types:

1. Fiscal Policy2. Monetary Policy

Non-discretionary policy. AD is also influenced by automatic stabilisers, which work to reduce the size of economic fluctuations.

Fiscal and monetary policies intended to reduce the size of short-run economic fluctuations are called stabilisation policies.

The government budgetSources of government revenue

1. Taxes, both direct and indirect (T).2. Sales of goods and services (transportation,

electricity, water, …)3. Sale of state-owned enterprises

(privatisation).Types of government expenditure

1. Current (day-to-day) expenditures2. Capital expenditures, including public

investments or the production of physical capital (building roads, airports, harbours,…)

3. Transfer payments for the purpose of income redistribution

Current and capital expenditures are included under G. Transfer payments do not represent value of new output produced.

Government budget: a plan of a country’s tax revenues and expenditures over a period of time (a year).If G=T: balanced budgetIf G>T: budget deficit Gov needs to borrowIf G<T: budget surplus

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

The role of Fiscal Policy (FP)Definition: manipulations by the government

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

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

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

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

Expansionary Fiscal Policy In a recessionary gap (Y<YFE), the gov can

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

Expansionary FP can consist of:1. ↑ G2. ↓ personal income taxes3. ↓ business taxes4. a combination of the three.

An increase in G has a direct impact on AD

A decrease in T affects AD in a 2-step process:↓T → ↑Disposable income Yd / ↑After-tax

businesses profits → ↑C / ↑I → ↑ ADThe gov can increase G and lower taxes at the

same time by borrowing to finance the excess of spending over tax revenues.

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 PolicyIn an inflationary gap (Y>YFE), the gov can

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

Contractionary FP can consist of:1.↓ G2.↑ personal income taxes3.↑ business taxes4.a combination of the three.

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

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

businesses profits → ↓ C / ↓ I → ↓ ADFigures 12.1 (expansionary FP) and 12.2

(contractionary FP).Keynesian model with the ratchet effect (Fig

12.2 c)

The role of automatic stabilisers Definition: factors that automatically, without any

action by government authorities, work toward stabilising the economy by reducing the short-term fluctuations of the business cycle. They represent non-discretionary policy.

1. Progressive income taxes2. Unemployment benefits

Progressive taxation. As income increases, the fraction of income paid as taxes increases (increasing tax rate).

Proportional taxation. As income increases, the fraction of income paid as taxes remains constant (constant tax rate).

Progressive income taxesDuring an expansion, real GDP increases and

tax revenues automatically increase, causing disposable income to be lower than otherwise. This acts to dampen AD, counteracting the economic expansion. In a recession, with real GDP and incomes falling, government tax revenues decrease, causing disposable income to be higher than it would otherwise be. This exerts upward pressure on AD, reducing the severity of the recession.

The more progressive an income tax system, the greater the stabilising effect on economic activity.

Unemployment benefitsIn a recession, as real GDP falls and UE

increases, UE benefits rise. The presence of UE benefits allows unemployed workers to maintain their consumption to some extent, as their benefits partially replace their lost income, lessening the downward pressure on AD.

In an expansion, UE benefits are reduced as UE falls. Therefore, consumption increases less than it would in the absence of UE benefits.

Fiscal policy and long term growth

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

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

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

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

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

2. Directly (Figure 9.15): By encouraging investment through lower

business taxes, thereby contributing to new capital formation and technological innovations.

By directing a portion of Ga. to the development of physical capital goods, such as

infrastructure (roads, telecommunications,...), as well as on R&D, which improves technology and therefore the quality of capital goods. This improves the productivity of labour.

b. to the development of human capital, such as training and education programmes that increase the quality of the labor force and improve the productivity of labour.

All these factors work to increase potential output, thus supporting long-term economic growth.

Evaluating Fiscal PolicyStrengths of Fiscal Policy1. Pulling an economy out of a deep recession.2. Combating rapid and escalating inflation.3. Ability to target sectors of the economy.

Changes in the composition of gov spending depending on gov priorities can affect specific sectors:

Education Health care, focusing on particular social groups that

may be in greater need. Infrastructure and its location, focusing if necessary on

economically depressed regions. Other merit goods

4. Direct impact of gov spending (G) on AD. Changes in taxes are less direct, as they work by changing consumers’ disposable income and firms’ after-tax profit.

5. Ability to affect potential output. FP can affect Yp and long-term economic growth indirectly (by creating a stable economic environment) and directly through investments in human capital and physical capital and through offering incentives to firms to invest.

Weaknesses of Fiscal Policy1. Problems of timing. FP is subject to time

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

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

economy.

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

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

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

4. Inability to deal with supply-side causes of instability. Ex: FP is unable to deal with stagflation.

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

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

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

country.Commercial banks are financial institutions

whose main functions are to hold deposits for their customers (consumers and firms), to make loans to their customers, to transfer funds by cheque and electronically from one bank to another and to buy government bonds.

The Central bank is usually a government financial institution with a number of important responsibilities:

1. Banker to the gov. Among other, the CB manages the government’s borrowing by selling bonds to commercial banks and the public, and acts as an adviser to the gov on financial and banking matters.

2. Banker to commercial banks, by holding deposits for them and make loans to them in times of need.

3. Regulator of commercial banks, making sure they operate with appropriate levels of cash and according to rules that ensure the safety of the financial system.

4. Conduct monetary policy, through changes in the supply of money or the rate of interest. It usually also responsible for the determination of exchange rates.

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

The money market and the rate of interestMP impacts AD indirectly through the rate of

interest.Interest is the payment (per unit of time) for

the use of borrowed money. Usually expressed as % of the principal to be paid per year. This % is called the rate of interest.

Money is anything that is acceptable as payment for g&s (ie, coins and paper money as well as checking accounts)

The money market is a market where the demand for money and the supply of money determine the equilibrium rate of interest. The horizontal axis measures the quantity of money in the economy, and the vertical axis measures the rate of interest.

The rate of interest is the price of money services.

The Demand for money, Dm, shows the relationship between the rate of interest and the quantity of money demanded. Dm is downward sloping.

i

Qe

Dm

Quantity of money

Rate of interest

Sm

Why is Dm downward sloping? Money allows economic agents to carry out their

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

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

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

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

The Supply of money, Sm, is fixed at a level that is decided upon by the CB, does not depend on i.

The point of intersection between Dm and Sm determines the equilibrium rate of interest.

Monetary policy is carried out by the CB, through changes in the money supply, which shift the Sm curve. Rate

of interest

Quantity of money

Sm1 Sm2Sm3

Dm

i1

i3

i2

↑Sm → ↓ie ↓Sm → ↑ie

Q3

Q1

Q2

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 Sm so that the actual ie will become equal to the target i.

In the real world there are many interest rates and it varies from country to country which one central banks target. In the UK, the CB targets the ‘base rate’, which is the

interest rate at which the Bank of England lends to commercial banks.

In the US, the Federal Reserve targets the ‘federal funds rate’, the interest rate at which commercial banks borrow and lend from each other over a 24-hour period.

The ECB targets the ‘minimum refinancing rate’, which is the interest rate paid by commercial banks when they borrow from their respective national central banks.

The role of Monetary PolicyChanges in i affect two components of AD:

C, as some consumption is financed by borrowing.

I, as firms borrow money in order to finance their investment expenditures.

Therefore:↑ i → ↓ C , ↓ I → ↓ AD and AD shifts left↓ i → ↑ C , ↑ I → ↑ AD and AD shifts right

Expansionary (easy money) Policy

In a recessionary gap (Y<YFE), the CB increases Sm, causing the interest rate to decrease.

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

AD1AD2

SRAS

LRAS

Real GDP

PL

YPYrec

PL

Real GDP

K-AS

AD2

AD1

Yrec YP

The effects of the AD increase are different depending on the shape of the AS curves:In the monetarist model there is a smaller

increase in real GDP and a larger increase in the price level compared to the Keynesian model.

Contractionay (tight money) Policy

In an inflationary gap (Y>YFE), the CB decreases Sm, causing the interest rate to increase.

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

AD1

AD2

Yinf

SRAS

LRAS

Real GDP

PL

YP

If AD falls within the downward sloping part of the AS curve in the Keynesian model, the effects on the price level and real GDP are similar to those in the monetarist model. But if AD decreases in the horizontal part of the AS curve, there would be a larger fall in real GDP and a smaller fall in the price level in the Keynesian model.

The ratchet effect also applies here.

Monetary policy and inflation targetingAs we have seen, MP can be used to achieve the

goals of FE and a low and stable rate of inflation.In recent years, more CBs (26 in total) around

the world pursue a kind of MP that aims at maintaining a particular targeted rate of inflation. Examples: New Zealand (first one, 20 years ago), Australia, Canada, UK, EU, Brazil, Mexico, among others.

Defined by IMF as ‘…the public announcement of medium-term numerical targets for inflation with an institutional commitment by the monetary authority to achieve these targets.’

Targets range between 1.6% and 2.5%, with one percentage point as a ‘tolerance’ margin.

Target set in terms of the consumer price index (CPI) but usually based on forecasts of future inflation based on the CPI.

If predicted inflation is higher (lower) than the target, they use contractionary (expansionay) policy to increase (decrease) i and lower (increase) AD, thus lowering (increasing) the rate of inflation.

Advantages of inflation targeting1.A lower rate of inflation.2.A more stable rate of inflation (less

fluctuations in the inflation rate)3.Improved ability of economic decision-makers

to anticipate the future rate of inflation. Public knowledge about the CB’s objectives on inflation reduces uncertainty and facilitates economic decision making.

4.Greater coordination between MP and FP. Gov can plan its FP to complement the CB’s monetary policy.

5.Greater CB transparency and accountability.

Disadvantages of inflation targetingReduced ability of the CB to pursue other

macroeconomic objectives. MP can then not be used for other goals, such as FE level of real GDP or exchange rate stability.

Reduced ability of the CB to respond to S-side shocks. This might require expansionary MP, which may mean a higher rate of inflation than the target.

Reduced ability of the CB to deal with unexpected events, such as financial crises.

Finding an appropriate inflation target. If it is too low, it may lead to higher UE; if it is too high, it could lead to the problems resulting from high inflation.

Difficulties of implementation, as it is based on forecasts, which are often highly unreliable.

Evaluating monetary policyStrengths of Monetary Policy1.Quick implementation. MP can be implemented

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

2.No political constraints: Even if a CB is not independent from the

government, MP is not subject to the same kinds of political pressures as fiscal policy since it does not involve changes in gov budget.

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

3. No crowding-out.4. Ability to adjust interest rates incrementally

(in small steps). This makes monetary policy better suited to ‘fine tuning’ the economy in comparison with FP. However, also subject to limitations.

5. Central bank independence. CB can take decisions that are in the best longer term interests of the economy, having greater freedom in pursuing policies that may be politically unpopular.

Weaknesses of Monetary Policy

1. Problems of timing. Although MP does not depend on the political process, it is still subject to time lags:

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

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

2. Possible ineffectiveness in recession. A tight money policy can effectively combat inflation. However, an easy money policy is less effective in a deep recession. In a recession, lower i would encourage C and I, increasing AD. This is under the assumption that banks will be willing to ↑ their lending to households and firms and that these will be willing to ↑ their borrowing and their spending. However, in a severe recession banks may be unwilling to ↑ their lending and if firms and consumers are pessimistic about the future they may avoid taking new loans and may even ↓ their I and C. This situation occurred in the 1930s during the Great Depression and in 2008.

3. Conflict between government objectives. Manipulation of interest rates affects also variables in the foreign sector of the economy, such as exchange rates. The pursuit of domestic objectives may conflict with the pursuit of objectives in the foreign sector.

4. Inability to deal with stagflation. MP is unable to deal effectively with S-side causes of instability, just like fiscal policy.

Inflation requires a contractionary policyUE requires an expansionary policy

Supply-side policies Supply-side policies focus on the production

and supply side of the economy, specifically on factors aimed at shifting the LRAS or Keynesian AS curves to the right. The objective is to increase potential output and achieve long-term economic growth.

They do not attempt to stabilise the economy , but they focus on increasing the quantity and quality of factors of production, as well as on institutional changes intended to improve the productive capacity of the economy.

Two types:1. Market-based policies emphasise the

importance of well functioning competitive markets in achieving growth in potential output. Favoured by monetarist/new classical economists.

2. Interventionist policies attempt to achieve growth in potential output by relying on gov intervention, rather than the market. Favoured by Keynesians.

Interventionist S-side policies They presuppose that the free market economy

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

1. Investment in human capital1. Training and education. More and better

training & education lead to an improvement in the quality of labour resources, increasing the productivity of labour. Public training & education programmes can help workers to become more employable, reducing the NRU. Education has positive externalities, justifying government intervention. Examples:

Setting up programmes for structurally unemployed workers

Assistance to young people in the form of grants or low interest loans

Offering subsidies to firms that hire structurally unemployed workers

Assisting workers to relocate to areas with more demand for labour through grants and subsidies (low cost housing)

Providing information on job availabilityEstablishing government projects in depressed

areas, resulting in new employment creation

2. Improved health care services and access to these, which leads to improvements in the quality of labour resources, as workers become healthier and more productive. Health care has positive externalities, which justifies government intervention.

2. Investment in new technology R&D makes technological advances possible,

and these are a very important factor behind increases in potential output and economic growth. R&D also has positive externalities, thus satisfying government intervention. Gov in many countries are involved in R&D and, in addition, they provide incentives to the private sector to engage in R&D (tax incentives, granting of patents).

Gov spending in support of new technology development leads to increases in AD over the short term and increases in YP over the longer term, shifting the LRAS or Keynesian AS curves to the right.

3. Investment in infrastructureInfrastructure is a type of physical capital

and therefore results from investment; it includes power, telecommunications, roads, dams, urban transport, airports and ports. Many types of infrastructure qualify as merit or public goods, thereby justifying gov intervention.

More and better infrastructure increases efficiencies in production as it lowers costs.

More and better infrastructure improves labour productivity.

Investments in infrastructure work to ↑AD over the short term but also contribute to ↑Yp and ↑ AS over the longer term.

4. Industrial policies They are government policies designed to

support the growth of the industrial sector of an economy.

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

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

Market-based S-side policiesEarly 1980s, some monetarist economists in

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

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

Theoretical justification An economy pursuing S-side policies will be

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

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

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

Increases in AS may address the problem of stagflation, which D-side policies cannot correct. (Page 256, Fig. 9.15).

S-side policies may aim at:1. Encouraging competition.2. Labour market reforms.3. Incentive-related policies.

1. Encouraging competition

A. Privatisation, involving a transfer of ownership of a firm from the public to the private sector, can increase efficiency due to improved management and operation of the privatised firm. Rationale: gov enterprises are often inefficient (admin costs, unproductive workers, burocracy), as govs do not face incentives to maximize profits.

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

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

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

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

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

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

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

monopolistic practices into smaller units,

By preventing mergers between firms that might result in excessive monopoly power.

F. Trade liberalisation. Free/freer trade increases competition between firms both domestically and globally, resultingin greater productive and allocative efficiency.

2. Labour market reforms

Also referred to as ‘increasing labour market flexibility’. The goal is:

• to make labour markets more competitive, • to make wages respond to D and S forces, • to lower labour costs,• increase employment by lowering the

NRU.• Lower costs of production → ↑ profits →

investment by firms → ↑ R&D, ↑ capital goods production → ↑ YP

1. Abolishing minimum wage legislation, which would reduce UE by allowing the equilibrium wage to fall. The benefits would include lower UE, greater firms profits (labour costs are lower), more investment and economic growth.

2. Weakening the power of labour trade unions, so that wages will be more responsive to S and D and more likely to fall if there is UE. Same benefits as above.

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

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

3. Incentive-related policies

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

↑ number of hours worked ↑ number of people interested in finding work ↑ number of years worked. ↓ in UE, as unemployed workers choose to

shorten the duration of their UE.All these factors may work to shift the LRAS curve

to the right.

2. Lowering taxes on capital gains and interest income (taxes paid on income received from interest on savings deposits). This will increase incentives to save, increasing the funds available for investment. More investment means a greater production of capital goods and an increase in potential output.

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

Evaluating S-side policies1. Time-lags. Most S-side policies work after

significant time lags, making their effects on AS over the longer term. The reason is that increased competition, labour market reforms, investments... need time to materialise and affect YP. However, interventionist policies also have an effect on AD over the short term. Therefore,

in a recession they have the advantage that they can help close a recessionary gap.

If an economy is experiencing inflation, they could add to inflationary pressures

2. Impact on economic growth1. Increases in YP. In addition to investments in

capital and new technologies, economic growth is encouraged by the development of institutions involving incentives and the promotion of the market system, allowing the well functioning of the private sector. There is general agreement among economists on the role of S-side policies in increasing YP.

2. Arguments favouring interventionist policies. 1. Major advantages of targeted gov support in areas

such as investment, R&D, training and education… as the market is unlikely to provide them.

2. Industrial policies allow the gov to support industries with the greatest possibilities for growth in the future (experience of Asian Tigers).

3. Questionable growth performance of many LDCs that adopted market-based S-side policies in the 1980s.

3. Arguments favouring market-based policies Gov interference in the market may lead to

inefficiencies and resource misallocation, while reliance on the market can achieve long term growth without these disadvantages.

Gov interference may result in less efficient arguments because of the influence of political pressures, lack of necessary information,… Gov may lack the ability to choose the right industries to support, leading to a poor allocation of resources.

Interventionist policies rely heavily on gov spending and use resources that have opportunity costs. Also , they require high taxes (disincentives to work) and a large gov sector (inefficiencies).

4. Incentive-related policies Tax cuts

D-side effect: ↑disposable income → ↑Consumption → ↑AD

S-side effect: incentives to work and save more. However, some economists think that S-side effects are

less important. First, workers may decide to work less and increase leisure time, and second, they may decide to consume more and save less, with no significant effects on saving and investment. In the Us, savings are at the lowest point in the past 80 years, after a series of tax cuts.

Disagreement on whether the growth occured in countries where tax cuts have been implemented is the result of these. Growth is the result of both d-side and s-side effects of d-side and s-side policies and it is very difficult to detect which particular policy has been responsible for each particular effect.

3. Ability to create employment (reduce NRU) Interventionist policies involving

investments in education and training can reduce UE by:

Enabling workers to acquire the skills necessary to meet the needs of employers (structural UE)

Providing assistance to workers to relocate (structural UE)

Providing information that reduces UE when workers are between jobs (frictional UE) or between seasons (seasonal UE)

In addition, better-educated and trained people are more employable.

Market-based policies involving labour market reforms may also contribute to ↓ NRU by making the labour market more responsive to S nad D.

On the other hand, market-based policies that focus on encouraging competition may increase UE over the short-term. For instance, privatised firms often try to cut costs by firing workers and deregulation has often led to increased UE. It is possible that this increase in UE ia reversed over the longer term as the economy begins to benefit from the broader effects of S-side policies.

4. Ability to reduce inflationary pressure. S-side policies are likely to reduce

inflationary pressures over the longer term, as they are intended to shift the LRAS curve to the right. As an economy grows, if increases in AD are matched by increases in AS, there will be little or no upward effect on the price level.

Increases in efficiency (due to increased competition) and lower wage costs (increased labour market flexibility) keep costs of production down, which reduces inflationary pressures.

5. Impact on the government budget. Interventionist policies (increased gov spending) and incentive-related market based policies (tax cuts) have negative effects on the gov budget.

6. Effects on equity (=greater income equality). S-side policies have mixed effects:

Interventionist policies focusing on investment in human capital are likely to have positive effects on equity over the longer term:

Educated and healthy workers are more likely to be employed, and income is likely to be relatively more equally distributed.

A lower NRU means more equality, as previously unemployed workers receive income.

Market-based policies tend to have negative effects: Greater competition may result in some UE, which

involves a loss of income. Labour market reforms result sometimes in reduced

protection for workers with very low incomes and with income uncertainties (minimum wage legislation, protection against being fired, UE benefits), which contributes to increasing income inequalities.

Tax cuts may also worsen income distribution. The argument that high taxes create disincentives to

work and save applies mainly to higher income groups who face higher tax rates. Therefore, to reverse this problem tax cuts must affect higher income groups, but this would make the tax system less progressive and income distribution would be less equal.

Since it is the wealthy who enjoy capital gains and earn most of the interest income and profits, tax cuts in these areas will affect wealthy people by increasing their after-tax incomes more than they will affect lower income groups.

Prices of products sold by privatised firms. If private firms have a degree of market power, they are likely to increase their prices above gov prices. As their products become less affordable, this may have negative effects for lower income groups, particularly if these firms provide necessities or merit goods.

7. Effects on the environment Market-based policies to increase competition

(privatisation, deregulation) may have negative effects on the environment because of the increased scope for activities leading to negative externalities affecting the environment.

8. Concluding comments Most economists believe that interventionist

and market-based policies should complement each other, and that the particular mix of policies will be different according to each country’s social and economic conditions.