2.6.2 Demand-side policies

What are demand-slide policies?

Demand side policies are policies designed to manipulate consumer demand

What is the difference between expansionary policy and deflationary policy?

Expansionary policy is aimed at increasing AD to bring about growth, whilst deflationary policy attempts to decrease AD to control inflation

What is monetary policy?

Monetary policy is where the central bank or regulatory authority attempts to control the level of AD by altering base interest rates or the amount of money in the economy

What is fiscal policy?

Fiscal policy is use of borrowing, govt spending and taxation to manipulate the level of AD and improve macroeconomic performance

What are the 2 monetary policy instruments?

2 Monetary policy instruments=

• interest rates

• asset purchases to increase the money supply (quantitative easing)

What is the interest rate as a form of demand management?

The interest rate is the price of money and the MPC are able to change the official base rate in order to tackle inflation.

This is called the repo rate, the rate the Bank of England will charge for short-term loans to other banks or financial institutions.

A change in the repo rate affects market rates offered by banks to consumers and businesses as the Bank of England is the lender of last resort.

If they are short of money, they will have to borrow from the Bank at the repo rate and therefore they need to make sure that their interest rates are based on this rate so that they are able to make a reasonable return.

What four key mechanisms will make a rise in interest rates cause a fall in AD?

4 key mechanisms that a rise in interest rates causes a fall in AD=

• The rise in interest rates will increase the cost of borrowing for firms and consumers. This will lead to a fall in investment and consumption, reducing AD. Two particular areas of consumption that will decrease are consumer durables and houses. Higher interest rates require higher rates of return for investment. It also makes savings more attractive, as the interest earnt on them will be higher.

• Since less people are borrowing and more are saving, there is a fall in demand for assets such as stocks, shares and government bonds. This leads to a fall in prices for these assets . Therefore, consumers will experience a negative wealth effect since the value of their assets fall, which will lead to a fall in consumption. Moreover, investment is less attractive since firms are likely to see lower profits if prices fall. AD falls because of the fall in consumption and investment.

• People will become less confident about borrowing and spending if interest rates rise. The fall in consumer and business confidence leads to a fall in consumption and investment, causing a fall in AD. On top of this, other loans, such as mortgages, will become more expensive to repay and so consumers have to dedicate more of their income to paying back these debts. This means they have less income to spend on goods and services, so consumption will fall, causing AD to fall.

• Higher rates will increase the incentive for foreigners to hold their money in British banks as they can see a higher rate of return. As a result, there will be increased demand for pounds and the value of the pound will rise . This means that imports will be cheaper, and exports will be more expensive. This decreases net trade and therefore AD.

What are the problems with interests rates as a method of D management?

Problems with interest rates as a method of D management=

• Firstly, the exchange rate may be affected so much that exports fall significantly and imports rise significantly, causing a balance of trade deficit.

• Moreover, changes in interest rates take up to 2 years to have their full effect and small changes in interest rates may not affect people’s decisions.

• Sometimes, interest rates are so low that they cannot be decreased any further to stimulate demand. This is a particular issue for many countries today, and something most people never thought would be a problem.

• There are a range of different interest rates and not all of them are affected by the Bank of England base rate.

• A lack of confidence in the economy may mean that, no matter how low interest rates are, consumers and businesses do not want to borrow or banks do not want to lend to them.

• High interest rates over a long period of time will discourage investment and decrease LRAS.

What is quantitative easing (QE) as a form of D management?

Quantitative easing (QE) is when the Bank of England buys assets (e.g govt bonds from commercial banks and other financial institutions- insurance companies, pension funds) in exchange for money in order to increase money supply and get money moving around the economy during times of very low demand.

‘Quantitative’ means a set amount of money is being created and ‘easing’ refers to reducing pressure on banks. It can prevent the liquidity trap, where even low interest rates cannot stimulate AD

What is one way of buying assets- QE?

One way of buying assets is for the Bank of England to increase the size of banks’ accounts at the Bank of England, called the ‘reserves’, which encourages them to lend money.

Following the financial crisis, the Bank of England found that many banks preferred to keep their money in reserves rather than lending it out so buying assets from the bank did not have the effect they wanted.

As a result, the Bank bought securities or bonds from private sector institutions such as insurance companies, pension funds and banks.

What are the effects of QE as a form of D management?

• Since the bank is buying assets, there is a rise in demand and so asset prices rise . This causes a positive wealth effect since shares, houses etc. are worth more so people will increase their consumption. Moreover, the cost of borrowing will decrease as higher asset prices mean lower yields (money earnt from assets), making it cheaper for households and businesses to finance spending.

• Moreover, the money supply increases . Private sector companies receive more money which they can spend on goods and services or other financial assets, which may increase investment or consumption and therefore increase AD. It may also push asset prices up further. Banks have higher reserves, meaning they can increase their lending to households and businesses so both consumption and investment increase as people can buy on credit.

• Commercial banks may lower their interest rates as they are receiving so much money from the Bank of England and so can offer very low interest deals to their customers. The increased money supply will mean that the price of money falls; interest rates are the price of money. This will encourage borrowing, and therefore increase investment and consumption so increase AD. If many banks decide to lower their interest rates, the same mechanisms will apply as those following a reduction in the base rate.

What are the limitations of using QE as a form of D management?

Limitations of using QR as a form of D management=

• It is very risky and, if not controlled properly, could cause high inflation and even hyperinflation.

• Others say it would only lead to increased demand for second hand goods which pushes up prices but does not increase aggregate demand. For example, it would not lead to more new houses being built but only second hand houses becoming more expensive.

• There is no guarantee that higher asset prices lead into higher consumption through the wealth effect, especially if confidence remains low.

• It had a large effect on the housing market by stimulating demand and leading to rapid price rises since 2013, helping to worsen the issues of geographical mobility. It also led to rising share prices which increases inequality, since the rich grow richer whilst the poor see none of the gains.

• It was not meant to be permanent and there are concerns that banks and economies are too dependent on quantitative easing, particularly within the Eurozone.

What is the monetary policy is controlled by?

Monetary policy is controlled by the Bank of England rather than the government. The Monetary Policy Committee (MPC) makes the most important decisions, including the Bank of England base rate and the actions over quantitative easing.

What is the main aim of the Bank of England?

Their main aim is keep inflation at 2% and if it goes below 1% or above 3% the governor of the Bank of England has to write a letter to the Chancellor of the Exchequer explaining why this is happened and what the Bank of England is doing to bring it back to the target. They use CPI in order to see whether this target has been met.

What is the MPC made up of?

The Committee is made up of nine people: five are from of the Bank of England, including the Governor of the Bank of England, and the other four are independent outside experts, mainly economists

What has the MPC done since 2009?

Since 2009, the MPC has kept the bank rate at 0.5% and policy has become focussed on boosting economic growth and employment. It was reduced to 0.25% following the Brexit vote but rose again in November 2017 due to the inflation that the weak pound brought about. They plan to raise the interest rate once the negative output gap has been eliminated and the economy is growing strongly.

What is the 2 main ways the govt can influence AD through fiscal policy?

2 main ways the govt can influence AD through fiscal policy=

• A rise in income tax will cause a fall in disposable income. This will lead to a reduction in consumption and thus decrease AD. Alternatively, a rise in corporation tax will decrease a firm’s post-tax profits. This will lead to a reduction in investment and thus decrease AD.

• A rise in government spending will increase AD since it is one component

What is the difference between direct taxes and indirect taxes?

Direct taxes are paid directly to the government by the individual taxpayer. An indirect tax is where the person charged with paying the money to the government is able to pass on the cost to someone else i.e. the supplier can pass on the burden to indirect tax to the consumer. The four highest revenue raising taxes are income tax, national insurance, VAT and corporation tax . Other taxes include council tax, excise duties, capital gains tax, inheritance taxes and stamp duty land tax.

What is income tax?

Income tax is a direct tax and is the biggest source of revenue for the government, around 25% of all taxation revenue. It is paid as a percentage of income and all income earned below a certain threshold is not taxed (£11,850 as of Summer 2018). The basic rate is 20%, the higher rate is 40% and 45% is the additional rate for incomes over £150,000.

What is VAT?

VAT is an indirect tax and the standard rate of VAT is 20%. Not all goods pay the standard rate, for example food and children clothes aren’t charged and domestic fuel/power are charged 5%.

What are the limitations of fiscal policy?

Limitations of fiscal policy=

• Government spending also impacts LRAS. For example, by cutting government spending to reduce AD, the government may be reducing the quality of education or spending on research and technology.

• Taxes and spending have an impact on inequality, so some decisions aimed to reduce/increase demand may increase income inequality. They also have an impact on incentives, for example high taxes reduce incentives.

• The government also has to worry about political issues, for example they may be unwilling to raise taxes in order to reduce demand as this may lead to them being voted out of government

• Expansionary fiscal policy is difficult to undertake during a period of austerity. The government needs to consider the effect of policies on the budget.

• The impact of fiscal policy depends on the multiplier : the bigger the multiplier, the bigger the impact on AD. Classical economists argue that the multiplier is almost zero whilst Keynesian economists argue that it can be large if targeted correctly.

What are some evaluation of demand side policies?

Evaluation of demand side policies=

• Classical economists argue that any demand management, whether fiscal or monetary, will have no effect on long-run output so supply side policies should be used. They believe that increasing AD during a depression will have no effect other than to increase prices. If the economy is in short-run disequilibrium, it will quickly return to long run equilibrium, whilst Keynesians argue that it can be in long-run equilibrium for years.

• On a Keynesian LRAS, the impact of changes in AD d epend on where the economy is operating : if the economy is at full employment then a rise in AD will only lead to higher prices. However, if unemployment is very high, then a rise in AD will only lead to higher output.

• Both policies see significant time lags between their introduction and their full effect.

• The biggest issue of demand-side policies is that, in most cases, an expansionary policy is inflationary whilst a deflationary policy brings unemployment. This depends on the elasticity of the curve and the curve which you perceive to be correct (Keynesian or classical), but holds in most scenarios. Thus, through demand management, the government cannot bring about both low and stable inflation and high economic growth/low unemployment.

What is monetary policy useful for?

Monetary policy is useful as the government is able to increase demand without having to increase their spending, which would result in a larger fiscal deficit. Classicists argue that if demand management is going to be done only monetary policy should be used.

What is fiscal policy useful for?

Fiscal policy can have significant impacts on the supply side of the economy, for example increases in spending on education to increase AD will also increase LRAS. Moreover, it is more effective at targeting specific groups and reduce poverty, for example by increasing benefits it can increase AD and reduce inequality.

What are the causes of the Great Depression (1929)?

Causes of the Great Depression=

• The Great Depression was set off by the Wall Street Crash of 1929 when there was a sharp fall in share prices on the New York Stock Exchange, but economists have different views in what they believed caused the following depression:

• Firstly, it may have been caused by the loss of consumer and business confidence: shareholders lost money in the crash, others became worried about what would happen, and firms cut back investment which led to a downward spiral in AD.

• Moreover, it could have been caused by the US banking system . Banks had lent too much during the 1920s, which had created an unsustainable boom and the system was unable to deal with issues following the crash. The government allowed banks to fail after the crash, which decreased confidence further and reduced loans to businesses and consumers, causing a fall in AD.

• Protectionism may also have been another cause of the Great Depression. It reduced world trade which decreased AD and lowered confidence. Firms involved in exports were no longer able to pay bank their loans, which caused bank failures in the USA. America introduced the Smoot-Hawley Tariff Act in 1930 which decreased imports to the USA. Countries which traded with America saw a reduction in exports which decreased in AD in their countries. American also suffered from a fall in exports as other countries retaliated.

• The UK was also affected by its commitment to the gold standard, in which its currency was fixed to the value of gold and therefore fixed to other currencies. It left the gold standard in 1914 but re-joined in 1925 at the 1914 level and value, despite the fact the value of the pound had fallen. The rejoining of the gold standard meant the pound was appreciated rapidly and exports fell as they became more expensive. The UK went into the Great Depression with an overvalued exchange rate.

What were the UK policy responses to the Great Depression (1929)?

UK policy responses to the Great Depression=

• The UK government believed that balancing the government budget was key to recovery and that borrowing money would prevent the private sector from doing so. They introduced an emergency budget which cut public sector wages and unemployment benefit by 10% and raised income tax from 22.5% to 25%. This reduced AD at a time when it needed to be increased.

• The pound came under attack from speculators and needed to be defended to prevent the UK being forced out of the gold standard. A balanced budget meant the UK didn’t have to borrow from abroad, which helped the exchange rate as did the high interest rates used to defend the high exchange rate. However, the high interest rates also decreased demand.

• The UK was forced to leave the gold standard on 21st September 1931 due to continued speculation against it. This caused the value of the pound to fall by 25% compared to other currencies and allowed the Bank of England to cut interest rates by 2.5%, both of which helped the increase AD by increasing exports or increasing consumption/investment.

• There was recovery in London and the South East but Wales, the north and Scotland did not reach full employment until 1941.

What were the USA policy responses to the Great Depression?

USA policy responses to the Great Depression=

• The US government originally had the same view over a balanced budget as the UK.

• However, Franklin Roosevelt was elected in 1932 with his New Deal which promised public sector investment, work schemes for the unemployed and fiscal stimulus.

• The USA reached full employment in 1943 (two years after joining the war- the same as Britain). Roosevelt’s New Deal is an example of Keynesian expansionary fiscal policy but can be argued it was not large enough to be successful, although it did have a large impact as the US unemployment figure was so high.

What was the Global Financial Crisis (2008/9)?

There are many parallels between the Great Depression and the Global Financial Crisis: both were started in the US and spread throughout the world and both had large, long term effects on the economy. However, the Global Financial Crisis was much less severe than the Great Depression.

What were the causes of the Global Financial Crisis (2008/9)?

Causes of the Global Financial Crisis (2008/9)=

• The 2008 crisis was started by issues in mortgage lending in the USA. In the early 2000s, relatively poor people were encouraged by the government and banks to take out mortgages to buy their own homes. This was an example of moral hazard, as the bank workers saw higher bonuses for selling more mortgages. They were given low interest rates on the loan for the first few years, but many were no longer able to continue paying with the higher repayments. Houses were repossessed, demand fell, and prices fell meaning the value of the houses was now less than the mortgage of the house. This is known as negative equity.

• At the same time, banks had been grouping ‘prime’ mortgages (people who were likely to pay back their loans) and ‘sub-prime’ mortgages (those who weren’t) and selling packages to other banks and investors as if they were all prime mortgages. The aim was to reduce risk since it meant no bank was highly dependent on risky mortgages. However, it increased risk as many were now holding assets worth less than they had paid for them; it spread the effects of the housing crash and the unpaid loans.

• When this was revealed, there was a fall in confidence and banks stopped lending between each other, fearing that they would lose money if the other bank were to collapse. Similar events occurred in the UK, Ireland, Spain and Portugal. Northern Rock Building Society was the first affected in the UK in 2007 with too many loans not being repaid, and savers beginning to withdraw their money. In 2008, Lehman Brothers, an investment bank, was allowed to fail. This caused panic as people believed bank after bank would be allowed to collapse, leading to losses for savers.

What were the UK and USA policy responses to the Global Financial Crisis (2008/9)?

UK and USA policy responses to the Global Financial Crisis (2008/9)=

• Both governments were forced to nationalise banks and building societies and guarantee savers their money in order to prevent the chaos of a collapsed banking system. For example, the British government bought Northern Rock and most of Royal Bank of Scotland and Lloyds Bank.

• They used expansionary monetary policies with record low interest rates and quantitative easing. The Bank of England said the QE led to lower unemployment and higher growth than would otherwise have been the case.

• However, the USA government had a more expansionary fiscal policy and this is perhaps why it recovered faster. In 2010, the UK prioritised reducing National Debt over providing a fiscal stimulus, but the USA did not make this decision until 2013.