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

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• 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

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• 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

  

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• 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

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• 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

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• 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

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• 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

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• 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

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• 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

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• 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

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• 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

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• 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

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