3.4 Demand-side and supply-side policies

Shifts in the AD curve / demand-side policies·fiscal policy·interest rates as a tool of monetary policyShifts in the AS curve / supply-side policiesStrengths and weaknesses of these policies

Higher level only:Multiplier·calculation of multiplierAccelerator"Crowding out"

Money, banking, and financial markets (AP only)·Measures of money supply·Banks and creation of money·Money demand·Money market·Loanable funds market

Central bank and control of the money supply (AP only)·Tools of central bank policy·Quantity theory of money·Real versus nominal interest rates

Unit 2.4 Demand and Supply-Side Policies Unit Overview

Blog posts: "Fiscal policy"

Blog posts: "Monetary policy"

Blog posts: "Supply-side economics"

Blog posts: "Multiplier effect"

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Demand and Supply-Side Policies Demand-side Policies

Demand-side policies: Macroeconomic policies undertaken by a government aimed at increasing or decreasing Aggregate Demand (total spending on goods and services) in the economy

Fiscal policy: Changes in government spending and/or taxation aimed at increasing or decreasing aggregate demand

Monetary Policy: Changes in the supply of money by a nation's central bank aimed at raising or lowering the prevailing interest rates in the economy, which subsequently affect the level of consumer and investment spending

When would policymakers want to implement demand-side policies?

NOT when an economy is producing at its full-employment level!

If AD is excessively strong, contractionary demand-side policies can be used to reduce spending. If AD is weak, expansionary demand-side policies can be used to increase spending

Demand and Supply-Side Policies Supply-side Policies

Supply-side policies: Macroeconomic policies taken by a government or central bank aimed at increasing productivity, lowering firms' costs, and increasing the level of aggregate supply in the economy. Classical economists advocate use of supply-side policies to solve macroeconomic problems.

Reduction in income taxes: increases incentive to work since workers get to keep more of their hard earned wages

Reduction in corporate taxes: increases incentive to invest in new capital. An increase in the nation's capital stock increases potential output of the economy

Reduction in trade union power: Unions fight for higher wages, which increases firms' costs. Lower wages will lower costs to firms and increase their ability to produce more output

Reduction or elimination of minimum wages: Lower minimum wage will lower firms' costs, increasing their potential output and aggregate supply

Reduction in unemployment benefits: Generous benefits for the unemployed reduce the incentive to find work, reducing the supply of available labor. Fewer benefits increase supply of labor and AS

Deregulation: Burdensome regulations of business can increase costs for firms. Deregulating business operations will lower firms' costs and increase AS

Privatization: Transferring state-run firms to the private sector may lead to greater efficiency as firms compete to minimize costs and maximize profitsAnything that increases the quantity or the quality of productive resources or decreases firms' costs will increase AS

Demand and Supply-Side Policies Fiscal Policy

Expansionary Fiscal Policy: An increase in government spending and/or a decrease in taxes aimed at increasing the total amount of spending in an economy, lowering unemployment and increasing total output and growth.

Example: the 2009 American Recovery and Reinvestment Act is a $784 spending and tax cut package aimed at getting the US out of recession:

"In the face of an economic crisis, the magnitude of which we have not seen since the Great Depression, the American Recovery and Reinvestment Act represents a strategic -- and significant -- investment in our country’s future.

The Act will create or save three to four million jobs, 90 percent of them in the private sector. It will provide more than $150 billion to low-income and vulnerable households -- spurring increased economic activity that will save or create more than one million jobs.

These measures are necessary to help the millions of families whose lives have been upended by the economic crisis. But, this Act will do more than provide short-term stimulus. By modernizing our health care, improving our schools, modernizing our infrastructure, and investing in the clean energy technologies of the future, the Act will lay the foundation for a robust and sustainable 21st century economy."

The ARRA: How will each of the components of the ARRA lead to an increase in Aggregate Demand, a decrease in unemployment and an increase in GDP in America?

Demand and Supply-Side Policies Fiscal Policy

Education and training Protecting the vulnerable Energy Health Care

State and local fiscal relief Infrastructure and Science Tax Relief

Demand and Supply-Side Policies Fiscal Policy

The ARRA: How will each of the components of the ARRA lead to an increase in Aggregate Demand, a decrease in unemployment and an increase in GDP in America? What are the potential supply-side effects of the program?

Demand-side: Jobs in community colleges and public schoolSupply-side: more productive and skilled workforce

Demand-side: relieve state budget shortages, better able to pay state employees

Demand-side: Increase purchasing power of poor and unemployed, increase CSupply-side: Could create disincentive to seek employment, shift AS left?

Demand-side: Increased investment in new technologies. Supply-side: improve efficiency of energy resources, productive capacity of nation

Demand-side: Increased employment in health sector. Supply-side: improved health increases productivity of labor force

Demand-side: New investment and employment by construction firms Supply-side: modern infra-structure improves efficiency, communication, transportation

Demand-side: More disposable income increases consumption, higher expected returns increases investment Supply-side: New capital makes firms and workers more efficient, increasing nation's productive capacity

The ARRA: Possible Demand and Supply-side effects

Demand and Supply-Side Policies Fiscal Policy

Demand and Supply-Side Policies Fiscal Policy

Expansionary fiscal policy: Graphical analysis

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The problem: Low confidence and expectations about the future cause private C and I to fall to (AD), demand-deficient recession and unemployment resultThe fix: A tax break for households and firms, combined with new government spending on infrastructure, education and health, stimulate aggregate demand

The result: An increase in government spending and higher disposable income for households, combined with higher expected rates of return on investments by firms stimulate private spending in the economy.

·The initial change in G is multiplied through successive increases in C and I. ·The ultimate increase in GDP is greater than the initial increase in G·Output returns close to the full employment level·Unemployment returns close to the NRU

Demand and Supply-Side Policies Fiscal Policy

Expansionary fiscal policy: Supply-side effects

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How will a decrease in taxes affect Aggregate Supply?

·Lower business taxes will encourage new investment in capital·Greater capital stock increases the nation's productive capacity·AS may shift out

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How will an increase in Government spending affect AS? TWO VIEWS

·If gov't invests in infrastructure, education, health and other projects that increase productivity of nation's resources, AS may shift out·If gov't spending causes interest rates to rise, it may "crowd out" private investment in capital and decrease the size of the nation's capital stock, causing AS to shift left

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Demand and Supply-Side Policies Fiscal Policy

Contractionary fiscal policy: Graphical analysisThe problem: Excessive spending in the economy has forced unemployment below the natural rate and the price level up as firms compete for scarce resources

The fix: Government cuts spending on particular projects, increases income and business taxes

The result: Disposable income among households falls, reducing consumer spending. Expected rates of returns on new capital falls, lowering investment. Government spending falls, reducing overall demand in the economy

·The initial decline in G, C and I multiplies itself through successive reductions in spending·The ultimate decrease in GDP is greater than the initial decrease in G·Output returns close to the full employment level·Unemployment returns close to the NRU·Inflation returns to a stable rate

Spending Multiplier (K) = 1/1-MPC = 1/.45 = 2.22

ΔGDP = K x ΔSpending 200b = 2.22 (ΔSpending) ΔSpending = 90b

·Some economists tend to favor higher G during recessions and higher taxes during inflationary times if they are concerned about unmet social needs or infrastructure.·Others tend to favor lower T for recessions and lower G during inflationary periods when they think government is too large and inefficient.

Scenario: Government wants to boost output by 200 billion dollars. Assume the nation's MPC = .55. What should the government do, cut taxes or increase government spending?

Demand and Supply-Side Policies Fiscal Policy - Spending Multiplier

Policy options - G or T? What's more effective at stimulating AD, an increase in government spending or a decrease in taxes?

To achieve $200b of GDP growth, government spending must increase by $90b. So how large of a tax cut is needed to achieve the same change in GDP?

We must know the Tax Multiplier

Tax Multiplier = -MPC/MPS (or the MRL)Tax multiplier (Tm) = -.55/.45 = -1.22

ΔGDP = Tm x ΔTaxes 200b = -1.22 (ΔTaxes) ΔTaxes = -164b

By how much would the government have to cut taxes to achieve the desired increase in GDP?Answer: $164 billion

Rationale: 45% of any tax cut will go towards savings, purchase of imports or debt repayment, all of which are leakages from the circular flow. Only 55% will turn into new spending in the economy

By how much would the government have to increase spending to achieve the desired increase in GDP? Answer: $90 billion

Rationale: An increase in government spending represents a direct injection into the economy, as none of it will be leaked in the form of savings, purchase of imports or debt repayment

Tax Multiplier: A measure of the change in GDP caused by changes in government taxes

Demand and Supply-Side Policies Fiscal Policy - Tax Multiplier

Automatic stabilizers in Fiscal Policy: Built-in stability arises because net taxes (taxes minus transfers and subsidies) change with GDP. It is desirable for spending to rise when the economy is slumping and vice versa when the economy is becoming inflationary.

·Tax revenues automatically increase when national income increases because there is more income to tax. Revenues fall with GDP because incomes fall.

·With a decline in national income, government spending automatically increases as more people collect unemployment benefits, food stamps, and welfare. When national income increases government support for households and firms is automatically rolled back, leading to a more balanced budget

·The size of automatic stability depends on responsiveness of changes in taxes to changes in GDP:

The more progressive the tax system, the greater the economy’s built-in stability.

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Demand and Supply-Side Policies Fiscal Policy

Demand and Supply-Side Policies The Money Market

The Money Market: an introduction

Money Demand: the public wants to hold money for two main reasons.

·Transactions demand, Dt: is money kept for purchases and will vary directly with GDP. The more output, the more money the public will demand to buy that output

·Asset demand, Da: is money kept as a store of value for later use. Asset demand varies inversely with the interest rate, since that is the opportunity cost of holding idle money.

·Total Demand for Money, Dm: Total demand will equal the sum of the total amount of money demanded for transactions and for assets.

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What causes crowding out?·When the government issues new bonds to finance its budget deficits, the supply of bonds

increases in the bond market, lowering the bond price and increasing the interest rates on bonds·The higher return on government bonds directs savings away from commercial banks, decreasing the supply of loanable funds to for the private sector to invest with, driving up commercial interest rates·The increase in borrowing by the government may lead to a decline in private investment, thus "crowding-out" private enterprise in the economy·Crowding-out can also refer to the re-allocation of physical resources (labor, land and capital) away from the private sector towards the public sector as the government embarks on projects requiring large inputs of productive resources.

Demand and Supply-Side Policies Evaluating Fiscal and Monetary Policies

Crowding-out effect: when a deficit-financed increase in government spending drives up interest rates, thereby directing productive resources away from the private sector towards the public sector

Question: How do governments get money to finance their budgets if they lower taxes at the same time that they increase spending (expansionary fiscal policy)?Answer: they borrow from the public by issuing new government bondsBOND (definition): The general term for a long-term loan in which a borrower agrees to pay a lender an interest rate (usually fixed) over the length of the loan and then repay the principal at the date of maturity. Bond maturities are usually 10 years or more, with 30 years quite common. Bonds are used by corporations and federal, state, and local governments to raise funds. (source: www.amosweb.com/)

Demand and Supply-Side Policies Evaluating Fiscal and Monetary Policies

Crowding-out effect: Graphical representation

Two ways to illustrate crowding-out:·The impact on the Money Market·The impact on the Loanable Funds Market (AP only)Crowding-out in the Money Market (IB and AP)

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Interpretation: The government's "transaction demand" for money increases as it must finance its budget deficit, shifting money demand out, driving up interest rates

Private investment is "crowded-out" due to increased

government borrowing

Demand and Supply-Side Policies Evaluating Fiscal and Monetary Policies

Crowding-out effect: Graphical representation

The Loanable Funds Market (AP only): the loanable funds market is a hypothetical market that brings savers and borrowers together, also bringing together the money available in commercial banks and lending institutions available for firms and households to finance expenditures, either investments or consumption (source: Wikipedia)·Savers supply the loanable funds; for instance·In return, borrowers demand loanable funds

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SLF: There is a direct relationship between the interest rate and the supply of loanable funds because at higher interest rates, savers want their money in banks and other institutions to earn the generous return

DLF: There is an inverse relationship between the interest rate and the demand for loanable funds because at lower interest rates households and firms want to take money out of savings to consume and invest

Blog Post - "Loanable Funds vs. Money Market: what’s the difference?"

Demand and Supply-Side Policies Evaluating Fiscal and Monetary Policies

Crowding-out effect: Graphical representation

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Private investment is "crowded-out" due to increased

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Crowding out in the Loanable Funds Market (AP only): ·Public borrowing directs funds away from the private market for loanable funds as investors are attracted to the higher interest rates on government bonds. The supply of loanable funds in the private sector decreases·Fewer funds available in commercial banks drive the interest rate up, which decreases the level of private investment

Blog posts: "the Crowding-out effect"

To achieve the economic goals of low unemployment and stable prices, the Congress and the President can use two fiscal policy instruments, government spending and taxation to affect real GDP and the price level. In addition, the Federal Reserve can use three monetary policy instruments, open market operations and changes in the discount rate and required reserve ratio to change real GDP and the price level. An increase in government spending G or a decrease in autonomous taxes, ceteris paribus, increase aggregate demand, thereby increasing both the equilibrium level of real GDP, Q*, and the equilibrium price level P*. Alternatively, a decrease in government spending G or an increase in autonomous taxes, ceteris paribus, decrease aggregate demand, thereby decreasing both the equilibrium level of real GDP, Q*, and the equilibrium price level P*. A Federal Reserve (Fed) open market purchase of U.S. securities, a decrease in the discount rate or a decrease in the required reserve ratio increase the money supply, thereby increasing aggregate demand and the equilibrium level of real GDP, Q*, and the equilibrium price level, P*. Alternatively, a Fed open market sale of U.S. securities, an increase in the discount rate or an increase in the required reserve ratio decrease the money supply, thereby decreasing aggregate demand and the equilibrium level of real GDP, Q*, and the equilibrium price level, P*.

Demand and Supply-Side Policies Evaluating Fiscal and Monetary Policies

ThinkEconomics ~ Economic Policy Tools

Follow the link above for a great practice activity with fiscal and monetary policies and their effect on AD/AS. The following is from the ThinkEconomics site:

Demand and Supply-Side Policies Practice Problems

Analyse the impact of the following scenarios on the US economy. Remember - the scenarios could impact either AS or AD, or both! It is often easier, initially, to analyse the effect on just one area - just make it clear why you have chosen to use AS or AD. In some cases, the scenario could affect more than one variable. Think carefully about how you would analyze such cases.

·Government announces a large increase in spending on health and education. Impact on AD Impact on AS

·Washington announces tax exemption scheme on new investments for small to medium sized businesses. Impact on AD Impact on AS

·Average wage rises way above inflation for the third month running. Impact on AD Impact on AS

·Exchange rate appreciation knocks export hopes for manufacturing. Impact on AD Impact on AS

·Share prices tumble, wiping 20% off company values. Impact on AD Impact on AS

·Surveys show clear signs of optimism for the future of the economy. Impact on AD Impact on AS

Illustrating the macroeconomy

·American productivity levels at their highest level for 10 years. Impact on AD Impact on AS

·Government 'stealth taxes' increase tax burden to highest level for 50 years. Impact on AD Impact on AS

·Expansion in numbers of students attending higher education exceeds government targets. Impact on AD Impact on AS

·Federal Reserve signals rise in interest rates of ½%. Impact on AD Impact on AS

·No rate rise in US but UK and EU central banks increase interest rates. Impact on AD Impact on AS

·Radical reform of welfare spending should help government cut spending as a proportion of GDP. Impact on AD Impact on AS

·Stability of inflation cheers business leaders. Impact on AD Impact on AS

·United States leads the way in nano-technology development Impact on AD Impact on AS

Demand and Supply-Side Policies Practice Problems

Group A:·Problem: sharp rise in oil prices·Keynesian response·Classical response

Group B:·Problem: Stock market bubble bursts·Keynesian response·Classical response

Group C:·Problem: Increased demand from abroad for exports fuels domestic inflation·Keynesian response·Classical response

Group D:·Proble: Embargo placed on country's exports·Keynesian response·Classical response

Demand and Supply-Side Policies Classical vs. Keynesian

Classical vs. Keynesian policies: Classical economists are sometimes referred to as "supply-siders", Keynesians as "demand-siders" Why is this?

Talk to a Classical economist, and they will advise

‘Don’t just do something, sit there!’

while a Keynesian will advise,

'Don't just sit there, do something!"

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With partners, discuss and illustrate the various policy responses to the following macroeconomic problems.

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