Demand Side Policies

Fiscal policy

gov. manipulates taxation and government spending in order to change AD and thus output and APL

Expansionary fiscal policy

eliminate deflationary gap

• increase gov spending

• reduce taxes

• increased disposable income

• increases consumption

• shifts AD outwards

  • Prices increase as well

Contractionary fiscal policy

eliminate inflationary gap

• reduce government spending

• increase taxes

• reduces disposable income

• reduces consumption

• shifts AD inwards

  • Prices decrease as well

Deflationary gap

LRAS lower than AD/SRAS intersection

Inflationary gap

LRAS higher than AD/SRAS intersection

Strengths of fiscal policy

• Target specific parts of AD

• Effective in the past

• Automatic stabilizers

  • progressive taxes

  • unemployment benefits

Limitations of fiscal policy

• lag time (especially in democracies)

• political constraints (contractionary policy)

• effect on net exports

• unsustainable gov.debt (expansionary policy)

• Crowding out effect

Net export effects (fiscal policy) → contractionary policy

• increased interest rates = net exports become lower since theyre more expensive for other countries to buy

• However increased interest rate incentivises foreigners to store their money in that currency

• increases demand for the currency

• increases investment in that currency thus increasing money supply

• increased money supply lowers interest rates and thus increases AD

Reduces some of the effects of contractionary fiscal policy

Crowding out effect

For expansionary policy when the gov is in a deficit

• gov borrows money from the same market as firms (loanable funds market)

• increases demand for loanable funds

• Increased demand = increased interest rates

• increased interest rate = reduced private investment

• thus governments crowd out private investment

real interest rate

nominal interest rate - rate of inflation

monetary policy

the control of the money supply by central banks which changes interest rates in order to shift AD

central bank

Bank which creates and controls the supply of money

• usually independant of the government

Tools of Monetary Policy

1. Open market operations

2. Changes in the central bank minimum lending rate

3. Minimum reserve ratio

4. Quantitative Easing

Open market Operations

The government buys and sells bond to change the money supply

• Buying bonds = expansionary

  • Increases money supply

  • Reduces interest rates

  • increases disposable income

  • incentivises + increases consumption

  • Increases AD

• Selling Bonds = contractionary

  • decreases money supply

  • increases interest rates

  • decreases disposable income

  • decreases consumption

  • Decreases AD

minimum lending rate

the rate central bank charges private, commercial banks to borrow money

Minimum reserve ratio

% of deposits that commercial banks are legally required to hold

• expansionary = reducing

• contractionary = increasing

Quantitative Easing

ONLY EXPANSIONARY

Central bank purchases assets from commercial banks with newly printed money

• interest rates fall

• disposable income increases

• consumption increases

• AD should increase

• exchange rates fall

Assets

private equity bonds

What parts of AD do an increase in interest rates affect the most and why?

1. Investment

   • Increased interest rates make it harder for companies to invest

2. Consumption: durable goods

   • Increased interest rates disincentivize purchasing durable goods like houses and cars

3. Consumption: reduced spending

   • Increased interest rates incentivise saving

4. Net exports

   • Net export effect (increased investment and increased money supply)

PROs and CONs of monetary policy

PROs

• No time lags

• No crowding out

• No political influences

  • independent from the gov.

• Ability to fine tune the economy

CONs

• may be ineffective in a recession

  • can’t force consumers to buy if there’s low consumer and business confidence

• Liquidity trap

  • Buisnesses will only lower interest rates to a certain point

• Blunt tool

  • can’t target specific sectors

• Expansionary policy may be inflationary

  • not good for stagflation