3.5-3.7 Demand and Supply Side Policies

• demand side policies

  policies that focus on changing aggregate demand in order to achieve goals of price stability, full employment, and economic growth, and minimise the fluctuations of the business cycle.
• supply side policies

  policies that focus on the production and supply side of the economy, aiming to increase potential output and shift the LRAS or Keynesian AS to the right
• 2 types of demand side policies

  monetary and fiscal policy
• 2 types of supply side policies

  market based and interventionist
• monetary policy


  central banks managing the economy by altering the supply of money and interest rates
• 5 goals of monetary policy

  1. low and stable rate inflation rate

  2. low unemployment

  3. reduce business cycle fluctuations

  4. promote stable economy for long term growth

  5. external balance (imports and exports)
• central bank


  an institution designed to oversee the banking system and regulate the quantity of money in the economy
• inflation targeting

  the public announcement of medium-term numerical targets for inflation with an institutional commitment by the monetary authority to achieve these targets
• advantages of inflation targeting

  1. low and stable rate of inflation

  2. improved ability of economic decision makers

  3. coordination between monetary and fiscal policy
• disadvantages of inflation targeting

  1. reduced ability to pursue full employment

  2. too much rigidity (in the case of shocks)

  3. difficult to calculate
• increase in the supply of money =

  decrease in interest rates
• money supply


  the quantity of money available in the economy
• money creation


  the process of commercial banks making loans
• minimum reserve requirement

  the minimum proportion of savings that commercial banks must keep in cash reserves.
• money multiplier

  1/reserve ratio
• open market operations

  the buying and selling of government securities/bonds to alter the supply of money
• minimum lending rate

  the interest rate charged by the central bank when it lends funds to commercial banks
• quantitative easing


  the introduction of new money into the money supply by a central bank by purchasing financial assets
• to lower the interest rate:

  money supply must increase
• nominal rate of interest

  the market rate that prevails at any moment in time
• real rate of interest


  nominal interest rate - rate of inflation
• deflationary gap


  when aggregate output is below potential output

  
• inflationary gap


  when aggregate output is above potential output

  
• which components of aggregate demand are affected by changes in interest rate?

  C + I
• expansionary monetary policy

  central bank increases money supply:

  1. commercial banks buy bonds

  2. decrease minimum reserve requirements

  3. increase minimum lending rate

  4. create new reserves electronically (QE)
• contractionary monetary policy


  central bank decreases money supply:

  1. commercial banks sell bonds

  2. increase minimum reserve requirements

  3. decrease minimum lending rate
• ratchet effect


  The price level moves up when there is an increase in AD, and then remains at the same level until there is a further increase in AD.
• 4 constraints on monetary policy

  1. possible ineffectiveness in a recession (interest rates cannot fall when approaching 0, low consumer and producer confidence banks fear lending)

  2. conflict between government objectives

  3. may become inflationary

  4. problematic for supply side causes of instability (stagflation or cost push inflation)
• 8 strengths of monetary policy

  1. can be incremental

  2. reversible

  3. flexible

  4. short time lags

  5. central bank independence

  6. limited political constraints

  7. no budget deficits

  8. no crowding out
• government budget


  a plan for government spending and revenues for a specified period, usually a year
• 3 sources of government revenue

  1. taxes

  2. sale of goods and services.

  3. sale of government owned enterprises or properties.
• 3 types of government expenditures

  1. current expenditures (wages, public healthcare services)

  2. capital expenditures (roads, airports)

  3. transfer payments (unemployment benefits, child allowances)
• balanced budget

  tax revenues = government expenditures
• fiscal policy


  the use of government spending and revenue collection to influence the economy
• 6 goals of fiscal policy

  1. low and stable rate inflation rate

  2. low unemployment

  3. reduce business cycle fluctuations

  4. promote stable economy for long term growth

  5. external balance (imports and exports)

  6. equitable distribution of income*
• which components of aggregate demand are affected by fiscal policy?

  C + I + G
• expansionary fiscal policy

  government increases aggregate demand and economic activity:

  1. increasing government spending

  2. decreasing personal income taxes

  3. decreasing business taxes
• contractionary fiscal policy


  government decreases aggregate demand and economic activity:

  1. decreasing government spending

  2. increasing personal income taxes

  3. increasing business taxes
• fiscal policy summary

  fiscal policy involves manipulations by the government of its own expenditures and taxes to influence to G, C or I components of aggregate demand.

  
  

  expansionary fiscal policy can be used when there is a recessionary gap and aims to shift the AD curve to the right, leading to equilibrium at the full employment level of real GDP (potential GDP).

  
  

  contractionary fiscal policy can be used when there is an inflationary gap and, and aims to shift the AD curve to the left leading to an equilibrium at the full employment level of real GDP (potential GDP)