CH 40 MACROECONOMIC

DEMAND SIDE POLICIES

Fiscal Policies
• AD is also affected by government fiscal policies
• Main areas of public spending – health, defence education, roads,
welfare benefits (unemployment benefits & state pension)
• Financed through taxes – income tax, taxes on spending, corporate tax
• Budget or fiscal deficit – government spending > government receipts
• Budget or fiscal surplus – government receipts > government spending
• Persistent budget deficit, builds up too much national debt
Demand Side Policies
• Demand side policies – policies used to manipulate AD.
• Reflationary policies – aimed at increasing AD
• Deflationary policies – aimed at decreasing AD
• Government use monetary & fiscal policies to achieve macroeconomic &
microeconomic objectives
• Types of Demand Side Policies
• Monetary policy – manipulation of monetary variables ( interest rate &
money supply by government to achieve objectives.
• Fiscal policy – use of taxes, government spending & borrowings to achieve
its objectives.
Monetary policy
• Instruments of policy – variables that government attempts
to control.
• E.g. interest rates, the money supply, tax rates or
government spending
• Two main monetary policy instruments
• Interest rate
• Quantitative Easing
Interest rate as monetary policy
instrument
• Interest rate is the price of money
• Lenders receive interest for loans supplied
• Borrowers pay interest for loans demanded
• Affects economy through influence on AD
• Higher interest rate – lower AD
• Lower interest rate – higher AD
Interest rate affects AD
• Consumer durables
• Consumers durables are bought on credit
• Higher interest rate – higher monthly repayment – lower sales – lower
consumption expenditure

• Housing market
• Houses are bought using mortgages
• Lower interest rate – lower mortgage repayments – houses affordable
• Three ways in which this affects AD
• ↑ demand for houses – new houses built – ↑ investment - ↑ AD
• Moving to new house - ↑ consumer expenditure - ↑ AD
• Moving to cheaper house – money released – used for consumer expenditure - ↑ AD
• Wealth Effect
• ↓ interest rate - ↑ asset prices
• ↓ interest rate - ↑ demand for houses - ↑ price of houses - ↑ homeowners wealth - ↑
consumer expenditure - ↑ AD
• Saving
• ↑ interest rate – ↑ savings - ↓ consumer expenditure - ↓ AD

• Investment
• ↓ interest rates – investments profitable - ↑ investment - ↑ AD
• ↑ consumption – firms need to invest to supply extra goods & services to consumers -
↑ investment - ↑ AD
• Exchange rate
• ↓ interest rate - ↓ return on investments – international investors switch money out of
domestic assets and invest in other countries – ↓ demand for domestic currency - ↑
supply of domestic currency - ↓ value of domestic currency (depreciation)
• Depreciation – exports cheaper & imports expensive - ↑ exports ↓ imports - ↑ net trade
- ↑ AD
Quantitative Easing as monetary policy
• Quantitative Easing – Central bank buys financial assets in
exchange for money to ↑ borrowing & lending in the economy
• Base rate – interest rate charged by central bank on
commercial bank.
• ↑ investment & consumption - ↑ AD
• Changes in lending criteria
• Central bank change the rules to require a lender (banks) to apply an interest rate test to check that a
borrower could afford to pay a higher interest rate.

• Reserve asset liquidity requirement

• Liquidity ratio: proportion of liquid assets to total assets for commercial banks.
Role of Central banks in the conduct of
monetary policy
• Inflation targeting
• Banker to government
• Banker to the banks – Lender of last resort
Fiscal policy & AD
• Both fiscal & monetary policy used to influence AD
• Constant tax revenues, ↑ government spending  ↑ AD
• Constant government spending, ↓ tax rates  ↑ AD
• ↓ income tax  ↑ disposable income  ↑ consumption  ↑ AD
• ↓ indirect tax  ↓ price of consumer goods  ↑ consumption  ↑ AD
• ↓ corporate tax  ↑ investment  ↑ AD

• Both government spending & taxes ↑  ↑ AD

• ↑ tax < ↑ government spending

• Both government spending & taxes ↓  ↑ AD

• ↓ tax > ↓ government spending
• Expansionary fiscal policy (↑ government spending/ ↓ tax rates)  ↑ AD
• ↑ budget deficit or ↓ budget surplus
• Contractionary fiscal policy ( ↓ government spending/ ↑ tax rates)  ↓ AD
• ↓ Budget deficit or ↑ budget surplus
• Neutral fiscal policy (∆ government spending or tax)  no ∆ AD
• No ∆ budget surplus or deficit

• Rise in government spending  AD ↑ multiple times ( multiplier effect)

• Small leakages from circular flow of income  multiplier effect larger
• Modern economy, leakages are large, multiplier value is small.
• Keynes argument – small multiplier can still have significant impact on output if economy is
below full employment.