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Demand-side Policies

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by

Ciaran Fitzpatrick

on 11 April 2013

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Transcript of Demand-side Policies

Discretionary Policies
at the discretion of the government

Fiscal Policy
Monetary Policy Balanced Budget
Tax Revenues = Government Expenditures

Budget Deficit
Expenditures are greater than tax revenues

Budget Surplus
Expenditures are smaller than tax revenues Fiscal Policy
manipulation by the government of its own expenditures and taxes in order to influence the level of AD

Can influence G, I, and C

Monetary Policy
Carried out by the Central Bank

Change interest rates to influence AD

Lower interest rates to encourage I and C --- Recessionary Gap

Raise Interest Rates to discourage I and C --- Inflationary Gap Strengths & Weaknesses of Demand-side Fiscal Policies COMBATING A DEEP RECESSION
Keynes stated
Prices and wages are inflexible in the downward direction
Low Aggregate Demand could keep the economy stuck in a recessionary gap indefinitely Strengths of Fiscal Policy The strength of Fiscal Policy is to help pull an Economy out of a deep recession
or
When the economy finds itself on the horizontal segement of the AS curve Combating Rapid & Escalating Inflation

Contractionary Fiscal Policy can be an effective way to bring rapidly rising inflation under control Weaknesses of Fiscal Policy Timing problems
Lag until problem is recognized
Lag until the appropriate policy is decided upon
Lag until policy takes effect Inadequate Information
Statistical data and future forecasts may be inaccurate Political Constraints
Government spending and taxation are subject to political pressures Crowding-out Effect
Possible impacts on Real GDP with increased Government spending (Expansionary Fiscal Policy)
Government spending financed by borrowing
Can result in higher interest rates
In turn this could reduce Private Spending
Which can reverse the impact of Governments Fiscal Policy In a recession, tax cuts may not be very effective in increasing Aggregate Demand
Tax cuts are less effective in a recession than increases in governmetn spending
Part of the increase in after tax income is saved by the consumer (leakage) Inability to fine tune the Economy
Fiscal policy can lead the economy in a general direction
It cannot control or bring the economy to a specific point Strengths of Monetary Policy Relatively quick implementation
Not subject to the political circus that Fiscal policy faces No political constraints
Not subject to political pressures
Does not involve making changes to Government budgets No Crowding-out Effect
Monetary policy counterpart to Expansionary Fiscal Policy is an easy money supply
Leads to LOWER interest rates not higher Better suited to "fine tuning" the economy
May be more accurate with respect to achieving output, price level and employment objectives
It is subject to limitations Weakness of Monetary Policy Timing
Though Monetary Policy can be adjusted more rapidly than Fiscal Policy, it is still subject to time lags
Lag until problem is recognized
Lag until policy takes effect Inadequate Information
Statistical information and future forecast may be inaccurate Possible ineffectiveness in recessions
Monetary policy can work effectively to combat inflation by tightening the money supply
Easy money to combat a deep recession can be ineffective
Lower interest rates try to encourage lending
However, banks may not be confident in lending to businesses during deep recessions Fiscal & Monetary Policies attempt to reverse the undesirable shifts in AD that cause business cycle fluctuations We know if there is a recessionary gap caused by a leftward shift in AD
Results in unemployment and falling price levels

Potentially corrected by expansionary fiscal & monetary policy that shift the AD curve rightward to the full employment level of Real GDP Inflationary Gap caused by a rightward shift in AD curve
Gives rise to more than Full Employment
Rising price levels

Potentially corrected by contractionary Fiscal & Monetary Policy that shift AD curve leftward to the Full Employment level of real GDP Stagflation
Falling Real GDP & rising price level simultaneously

Fiscal and Monetary Policy cannot address both inflation & unemployment at the same time
Inflation requires contractionary policy
Unemployment requires an expansionary policy Demand-side Policies and Long-term Economic Growth Demand-side policies focus mainly on short-term stabilization
however
They can contribute to long-term growth of Potential GDP Demand-side policies can indirectly & directly
Stable macroeconomic environment (indirectly)
Leading to Aggregate expenditures that result in growth of Potential GDP (directly) Stable economic environments promote business growth and investment Demand-side policies can impact directlly on the growth of potential GDP
Encourage investment through lower business taxes (fiscal policies) or lower interest rates (monetary policy)
Contributing
New capital formation
R&D that promotes technological innovations Also,
Direct portion of Government spending to infrastructure development
Increases quantity of goods
Improves technology
Training and education improves These Demand-side policies produce increases in AD, so that AD shifts from AD to AD*
However they
Impact AS because of the increase in the quantity of capital goods, improvement in labor so that both LRAS and SRAS curves shift to the right
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