2.6.2 Demand-side policies

MONETARY & FISCAL POLICY

MONETARY POLICY = MANIPULATION MONETARY VARIABLES INFLUENCE LEVEL OF AD.

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FISCAL POLICY = MANIPULATION GOVERNMENT SPENDING & TAXATION TO INFLUENCE LEVEL OF AD.

MONETARY POLICY INSTRUMENTS

SETTING OF MONETARY VARIABLES - INTEREST RATES & QUANTITATIVE EASING (QE).

INTEREST RATES

COST OF BORROWING, REWARD FOR SAVING

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TO REDUCE AD:

• IF RATE OF INFLATION ABOVE TARGET LEVEL, MONETARY POLICY COMMITTEE (MPC) RAISE BASE INTEREST RATE TO DECREASE AD.

• C + I + (X - M) FALL, AD SHIFTS LEFT.

TO INCREASE AD:

• IF RATE OF INFLATION BELOW TARGET LEVEL, MPC REDUCE BASE INTEREST RATES TO INCREASE AD.

• C + I + (X - M) RISE, AD SHIFTS RIGHT.

QUANTITATIVE EASING (QE)

OCCURS WHEN CENTRAL BANK BUYS GOV. BONDS OR OTHER SECURITIES TO INCREASE MONEY SUPPLY IN THE ECONOMY.

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TO STIMULATE AD:

• AFTER 2008, INTEREST RATES ALONE COULD NOT STIMULATE AD.

• CENTRAL BANKS PURCAHSE LONG-TERM ASSETS IN THE MONEY OR CAPITAL MARKETS.

• AS DEMAND FOR THESE ASSETS INCREASED, THEIR PRICES ROSE, MEANING YIELD (INTEREST RATES) ON THEM FELL.

FISCAL POLICY INSTRUMENTS

GOVERNMENT EXPENDITURE = TOTAL AMOUNT OF MONEY SPENT BY GOV. ON GOODS AND SERVICES TO INFLUENCE THE ECONOMY.

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DIRECT TAXES = (ON INCOMES) RISE IN DIRECT TAX MEANS REDUCES DISPOSABLE INCOMES AND REDUCED INCENTIVES TO WORK. E.G. INCOME TAX.

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INDIRECT TAXES = (ON SPENDING) RISE IN INDIRECT TAX MEANS COST OF LIVING INCREASES. E.G. VAT.

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TO DECREASE AD:

• GOV. WOULD REDUCE GOV. EXPENDITURE AND/OR DECREASE TAXES. DEFLATIONARY

TO INCREASE AD:

• GOV. WOULD INCREASE GOV. EXPENDITURE AND/OR INCREASE TAXES. REFLATIONARY

BUDGET/FISCAL DEFICIT & SURPLUS

DEFICIT = GOV. SPENDS MORE THAN IT RECEIVES IN TAXATION. INCREASE IN AD.

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SURPLUS = GOV. SPENDS LESS THAN IT RECEIVES IN TAXATION. DECREASE IN AD.

AD VALOREM TAXES

= A PERCENTAGE OF THE PRICE OF A PRODUCT OR SERVICE.

SUPPLY CURVE SHIFTS LEFT + STEEPER

SPECIFIC TAX

= SET AMOUNT OF TAX ON EACH UNIT CONSUMED.

SUPPLY CURVE SHIFTS LEFT + PARALELL