2.6.2 Demand-side policies

• Demand-side policies


  Policies designed to increase consumer demand, so that total production in the economy increases
• Monetary policy


  Used by the government to control the money flow of the economy, done with interest rates and quantitative easing, conducted by the Bank of England which is independent from the government
• Fiscal policy

  Uses government spending and revenues from taxation to influence AD, conducted by the government
• Monetary policy instruments


  1. Interest rates

  2. Asset purchases to increase the money supply: Quantitative Easing (QE)
• Interest rates


  • The Monetary Policy Committee (MPC) alters interest rates to control the supply of money, they are independent from the government and meet each month to discuss the rate
  • High interest rates encourage saving and discourage borrowing, used during high inflation
  • Low interest rates encourage borrowing and spending, used during low inflation
• Quantitative Easing (QE)

  Used by banks to stimulate the economy when standard monetary policy is no longer effective, has inflationary effects since it increases the money supply and can reduce the value of the currency, used where inflation is low and interest rates cannot be lowered further
• Limitations of monetary policy

  • Banks might not pass the base rate onto consumers
  • Consumers might be unable to borrow because banks are unwilling to lend
  • Interest rates will be more effective when consumer and firm confidence is high
• Fiscal policy instruments


  Government spending and taxation
• Expansionary fiscal policy


  Aims to increase AD by increasing government spending or reducing taxes, leads to a worsening of the government budget deficit
• Deflationary fiscal policy


  Aims to decrease AD by cutting government spending or raising taxes, leads to an improvement of the government budget deficit
• Government budget (fiscal) surplus and deficit

  A government has a budget deficit when expenditure exceeds tax receipts, a government has a budget surplus when tax receipts exceed expenditure, the debt is the accumulation of the government deficit over time
• Direct and indirect taxes

  • Direct taxes (income tax, corporation tax, NICs, inheritance tax)
  • Indirect taxes (VAT, fuel duty)
• Types of indirect taxes

  • Ad valorem taxes (percentages, e.g. VAT)
  • Specific taxes (set tax per unit, e.g. fuel duty)
• Limitations of fiscal policy

  • Governments might have imperfect information about the economy
  • Significant time lag involved
  • Borrowing from private sector can lead to crowding out
  • Effectiveness depends on size of multiplier
  • Ineffective if interest rates are high
  • Difficulties paying back debt if government spends too much
• The Great Depression initiated in 1929, and by 1933 real GDP had fallen by 30% and the unemployment rate increased to 25%. It lasted for over a decade.
• Keynes shifted macroeconomic thought from a focus on AS to AD, emphasising the use of demand-side policies, fiscal and monetary, to close gaps between actual and potential output.
• AD fell during The Great Depression, and with this, investment fell. Consumer and firm confidence plummeted.
• The Federal Reserve implemented contractionary monetary policy during the first few years of The Great Depression, and the money supply fell between 1929 and 1933 as 1/3 of US banks failed.
• The onset of WWII made the US government use expansionary fiscal policy, spending on the war, which helped The Great Depression come to an end.
• Roosevelt's New Deal in the US meant the US government increased its expenditure on public infrastructure and employment, although it is debated whether this fiscal stimulus or the spending on the war helped end The Great Depression.
• The UK government aimed to balance their budget by cutting public sector wages and raising income tax, which actually worsened the situation as it was deflationary.
• The Federal Reserve cut interest rates from 6% to 4%, and later raised them to maintain the dollar's value, as large quantities of dollars were converted into gold, weakening the dollar.
• In 1931, the UK government abandoned the gold standard, which caused the pound to depreciate by 25% and made the UK more competitive, and the government also reduced interest rates, which further helped the economy improve.
• Before the Global Financial Crisis, asset prices were high and rising, and there was a boom in economic demand. There were risky bank loans and mortgages, especially in the US where government securities were backed by subprime mortgages.
• The UK government used expansionary fiscal policy shortly after the financial crisis, cutting VAT from 17.5% to 15% in an attempt to increase consumer spending, and received less tax revenue due to the recession, leading to an increase in government borrowing.
• UK interest rates were cut from 5% when the crisis had just started in 2008, and eventually reached the historic low of 0.5%. Since the economy was still in recession, the bank employed a programme of QE, initially injecting £75bn and now £375bn.
• Since the bank is concerned about the sustainability of the UK's economic recovery, interest rates are being held low and QE is not being reduced, particularly because of the low inflation rates the UK has had.