Ch 17 - Demand Management (demand-side policies)

Fiscal policy: involves the government changing the levels of taxations and government spending in order to influence aggregate demand and the level of economic activity * AD is the total level of planned expenditure in an economy

Purpose of Fiscal policy:

1. Stimulate economic growth during a period of recession 2. Keep inflation low 3. Stabilise economic growth * Often simultaneously used monetary policy * Governments prefer using monetary policy to stabilise the economy * Fiscal policy depends on size of multiplier

Expansionary fiscal policy: * Involves increasing AD * Government will increase spending and cut taxes * Lower taxes increase government spending → more disposable income * Will worsen the government budget, governments will need to increase borrowing

Deflationary Fiscal policy: * Decreasing AD * Governments will cut government spending and increase taxes * Higher taxes → reduce consumer spending * Improves government budget deficit

Fine tuning: maintaining a steady rate of economic growth using fiscal policy * If growth is below the trend rate of growth, governments cut taxes to boost spending and economic growth → tax increases, consumption decreases * If growth is too fast + inflationary, governments increase tax to decrease/slow down consumer spending and reduce economic growth

Limitations of fine tuning: * Time lags: government spending takes several to integrate in the economy * Political costs: increasing taxes imposes problems on consumers * Difficulty forecasting: predicting the state of the economy requires the government to have plenty of info on the likeliness of growth

Demand Management policies: efforts to influence the level of aggregate demand (AD) in an economy. Main types: monetary and fiscal policy * Consumer confidence is an indirect factor since it helps encourage investments and encourage consumers to spend

Monetary policy: involves cutting or raising interest rates * Lower interest rates make it cheaper to borrow leading a boost in consumer spending and investment * Lower interest rates reduce the value of the exchange rate (making exports more competitive and boosting export demand) * Set by banks * Independent in selling rates but have to meet the government inflation target * Cutting interest rates may fail to boost spending, some banks could be unwilling to offer loans which makes lowering interest rates ineffective

Quantitative easing: when banks buy bonds to lower the interest rates on savings and loans * Reduces long term interest rates and boosts the money supply

Aim of monetary policy: * Low inflation: enables higher investments in the long term * Stable economic growth maintains a sustainable rate of economic growth +keeps unemployment low

Based on the trends of the banks, they can choose: * Higher inflation + higher growth → increase interest rates * Lower growth + decrease in inflation rates → lower interest rates

Expansionary monetary policy: expands monetary supply faster than usual or lowering short term interest rates * If central bank predicts inflation rates dropping below the government’s target, they will cut interest rates * Lower interest rates stimulate economic activity * Lower interest rates reduce borrowing costs * Increases disposable income of consumers

Contractionary monetary policy: * Central bank increases interest rates to reduce rate of economic growth and reduce inflationary pressure * Increase in interest rates causes fall in consumer spending and investment leading to lower inflation
Cost push inflation: occurs when the economy experiences rising prices due to higher costs of production and higher costs of raw material
Demand pull inflation: occurs when aggregate demand grows faster than aggregate supply