2.6.2 - Demand-side policies

• Demand side policies are policies designed to manipulate consumer demand
• Expansionary policy is aimed at increasing AD to bring about growth
• contractionary policy attempts to decrease AD to control inflation
• Monetary policy is where the central bank or regulatory authority attempts to control the level of AD by altering base interest rates or the amount of money in the economy
• Fiscal policy is use of borrowing, government spending and taxation to manipulate the level of aggregate demand and improve macroeconomic performance
• Monetary Polices:

  • Interest rates: The interest rate is the price of money and the MPC are able to change the official base rate in order to tackle inflation
• Monetary policies

  A rise in interest rates causes a fall in AD through four key mechanisms:

  • The rise in interest rates will increase the cost of borrowing for firms and consumers. This will lead to a fall in investment and consumption, reducing AD
  • There is a fall in demand for assets such as stocks, shares and government bonds. This leads to a fall in prices for these assets .
  • People will become less confident about borrowing and spending if interest rates rise
  • Higher rates will increase the incentive for foreigners to hold their money in British banks as they can see a higher rate of return
• Quantitative easing

  • Since the bank is buying assets, there is a rise in demand and so asset prices rise . This causes a positive wealth effect since shares, houses etc. are worth more so people will increase their consumption. Moreover, the cost of borrowing will decrease as higher asset prices mean lower yields (money earnt from assets), making it cheaper for households and businesses to finance spending
• Quantitative easing

  • Commercial banks may lower their interest rates as they are receiving so much money from the Bank of England and so can offer very low interest deals to their customers. The increased money supply will mean that the price of money falls; interest rates are the price of money. This will encourage borrowing, and therefore increase investment and consumption so increase AD. If many banks decide to lower their interest rates, the same mechanisms will apply as those following a reduction in the base rate.
• Problems with using quantitative easing:

  • It is very risky and, if not controlled properly, could cause high inflation and even hyperinflation.
  • There is no guarantee that higher asset prices lead into higher consumption through the wealth effect, especially if confidence remains low.
• Problems with quantitative easing

  • It had a large effect on the housing market by stimulating demand and leading to rapid price rises since 2013, helping to worsen the issues of geographical mobility. It also led to rising share prices which increases inequality, since the rich grow richer whilst the poor see none of the gains.
  • It was not meant to be permanent and there are concerns that banks and economies are too dependent on quantitative easing, particularly within the Eurozone.
• A budget surplus is when the government receives more money than they spend.
• A budget deficit is when the government spends more money than they receive