IB Economics/Macroeconomics/Demand-side and Supply-side policies

Demand-side policies

• Shifts in the aggregate demand curve/demand-side policies

• Fiscal policy
• Interest rates as a tool of monetary policies

• Strengths and weaknesses of these policies

Higher level extension topic

• Multiplier effect:

• calculation of multiplier

• Accelerator
• “Crowding out"

Shifts in the aggregate supply curve/supply-side policies

Market-Oriented

Reduction in Income Tax

Reduction in Corporation Tax

Reduction in Trade Union power

Reduction/elimination of minimum wage

Reduction in Benefit allowances

Deregulation

Privatisation

Interventionist

Education and Training

Research and Developement

Provision of Infrastructure

Improvements in Information

Interest rates as a tool of monetary policies

• Monetary Policy

This is when the central bank* tries to control the economy by changing interest rates and the money supply *(e.g. Federal Reserve, Bank of England. UK split from govt. in 1997)

• The interest rate is the cost of borrowing money
• The money supply is how much money/credit there is available for people to borrow
• Changes in the interest rate will either encourage or discourage people to borrow money hence influencing aggregate demand
• Changes in money supply will make it easier or harder for people to borrow money hence influencing aggregate demand
• If interest rate goes down, consumption will go up and investment will go up (firms will borrow money to invest) and so aggregate demand will go up.
• If money supply goes up, it is easier to borrow money, credit is available therefore aggregate demand will increase

Expectations

• Expectations of higher income: if you think your salary will rise you will tend to spend more.
• If there is an expectation of higher prices in the future you will tend to buy more goods in the present, and hence, increase spending.
• Expectation of higher profit: you will invest more money into machines/tools now.

Keynesian policy that consists of injections of demand into the circular flow of income stimulate further rounds of spending

Strengths and weaknesses of these policies

• The classical economists would let wages drop because they assume that all other things are equal, but Keynes points out that all other things are not equal since a decrease in wages leads to a decrease in income, which leads to decreased aggregate demand, which means decreased production from firms, which means less output and even more unemployment.

Keynes argued that in order to get out of recessions and have any chance for long-term economic growth, the government must take an active role in encouraging aggregate demand, by increasing government spending or decreasing taxes.

• Critiques of Fiscal Policy
• Congress is too slow to act. Government policies often come too late.
• Crowding out effects: It is possible that a change in government expenditures could be offset by a change in private expenditures in the opposite direction.
• Real business cycle critique: Increases in aggregate demand are only going to lead to inflationary gaps, since they are an artificial component of the economy, and so inflation will result, but nothing real will change (like the output or unemployment rate).
• Public choice critique: Politicians are interested in being reelected. Expansionary fiscal policy is a popular political move, but the unpopularity of contractionary fiscal policy (raising taxes or cutting spending) makes it difficult to enact. Fiscal policy cannot be effective if it is only used in one direction.

• supply side economics critique: Taxes and government spending negatively affect people’s incentives to work, save, and invest. The economy would grow faster if the government were scaled back.