Demand-side policies(demand management)Focus: shift AD in the AD/AS model to achieve the

goals of price stability, FE and economic growth. Based on the idea that short-term fluctuations of

Real GDP are due to actions of firms and consumers that affect AD, causing inflationary and recessionary gaps.

They try to counteract the effect of those actions and bring AD to the FE level of real GDP.

D-side policies can also impact on economic growth, that is, increase potential GDP (shift LRAS curve to the right). IB exam question last year!!

Discretionary and non-discretionary policy.Stabilization policies

Discretionary policy: active and purposeful government intervention to influence AD (the policy is at the discretion of the gov). Two types:

1. Fiscal Policy2. Monetary Policy

Non-discretionary policy. AD is also influenced by automatic stabilisers, which work to reduce the size of economic fluctuations.

Fiscal and monetary policies intended to reduce the size of short-run economic fluctuations are called stabilisation policies.

The government budgetSources of government revenue

1. Taxes, both direct and indirect (T).2. Sales of goods and services (transportation,

electricity, water, …)3. Sale of state-owned enterprises

(privatisation).Types of government expenditure

1. Current (day-to-day) expenditures2. Capital expenditures, including public

investments or the production of physical capital (building roads, airports, harbours,…)

3. Transfer payments for the purpose of income redistribution

Current and capital expenditures are included under G. Transfer payments do not represent value of new output produced.

Government budget: a plan of a country’s tax revenues and expenditures over a period of time (a year).If G=T: balanced budgetIf G>T: budget deficit Gov needs to borrowIf G<T: budget surplus

Public/Government Debt is the gov’s accumulation of deficits minus surpluses.

The role of Fiscal Policy (FP)Definition: manipulations by the government

of its own expenditures and taxes in order to influence the level of AD.

FP can affect AD through 3 components: G. Direct impact on ADC. FP, through changes in income taxes, affects

the disposable income of consumers, which affects their consumption expenditures.

I. Through changes in business taxes, FP affects the after tax profits of firms, which has an impact on their level of investment expenditures.

Expansionary Fiscal Policy In a recessionary gap (Y<YFE), the gov can

increase AD with expansionary FP, which works to expand the level of economic activity.

Expansionary FP can consist of:1. ↑ G2. ↓ personal income taxes3. ↓ business taxes4. a combination of the three.

An increase in G has a direct impact on AD

A decrease in T affects AD in a 2-step process:↓T → ↑Disposable income Yd / ↑After-tax

businesses profits → ↑C / ↑I → ↑ ADThe gov can increase G and lower taxes at the

same time by borrowing to finance the excess of spending over tax revenues.

The increase in real GDP will be smaller in the neoclassical model than in the Keynesian one, because of the upward sloping neoclassical AS curve.

The increase in the PL will be smaller in the Keynesian model, where the increase in AD may result in no increase in the PL at all if the AD shift occurs entirely within the horizontal segment of the Keynesian AS curve.

Contractionary Fiscal PolicyIn an inflationary gap (Y>YFE), the gov can

decrease AD with expansionary FP, which works to contract AD and the level of economic activity.

Contractionary FP can consist of:1.↓ G2.↑ personal income taxes3.↑ business taxes4.a combination of the three.

A decrease in G has a direct impact on ADAn increase in T affects AD in a 2-step

process:↑ T → ↓ Disposable income Yd / ↓ After-tax

businesses profits → ↓ C / ↓ I → ↓ ADFigures 12.1 (expansionary FP) and 12.2

(contractionary FP).Keynesian model with the ratchet effect (Fig

12.2 c)

The role of automatic stabilisers Definition: factors that automatically, without any

action by government authorities, work toward stabilising the economy by reducing the short-term fluctuations of the business cycle. They represent non-discretionary policy.

1. Progressive income taxes2. Unemployment benefits

Progressive taxation. As income increases, the fraction of income paid as taxes increases (increasing tax rate).

Proportional taxation. As income increases, the fraction of income paid as taxes remains constant (constant tax rate).

Progressive income taxesDuring an expansion, real GDP increases and

tax revenues automatically increase, causing disposable income to be lower than otherwise. This acts to dampen AD, counteracting the economic expansion. In a recession, with real GDP and incomes falling, government tax revenues decrease, causing disposable income to be higher than it would otherwise be. This exerts upward pressure on AD, reducing the severity of the recession.

The more progressive an income tax system, the greater the stabilising effect on economic activity.

Unemployment benefitsIn a recession, as real GDP falls and UE

increases, UE benefits rise. The presence of UE benefits allows unemployed workers to maintain their consumption to some extent, as their benefits partially replace their lost income, lessening the downward pressure on AD.

In an expansion, UE benefits are reduced as UE falls. Therefore, consumption increases less than it would in the absence of UE benefits.

Fiscal policy and long term growth

D-side policies can contribute to ↑ the level of potential GDP in two ways:

1. Indirectly, by providing a stable macroeconomic environment in which consumers and firms can plan and carry out their economic activities.

Firms must make decisions on investment in capital goods and whether, how and in what areas to pursue R&D and technological innovations.

Both the formation of capital goods and technological changes are important factors in increasing potential GDP.

In order to be able to plan over long periods of time, firms need economic stability, ie, avoidance of sharp economic upturns (inflation) and downturns (recession and UE).

2. Directly (Figure 9.15): By encouraging investment through lower

business taxes, thereby contributing to new capital formation and technological innovations.

By directing a portion of Ga. to the development of physical capital goods, such

as infrastructure (roads, telecommunications,...), as well as on R&D, which improves technology and therefore the quality of capital goods. This improves the productivity of labour.

b. to the development of human capital, such as training and education programmes that increase the quality of the labor force and improve the productivity of labour.

All these factors work to increase potential output, thus supporting long-term economic growth.

Evaluating Fiscal PolicyStrengths of Fiscal Policy1. Pulling an economy out of a deep recession.2. Combating rapid and escalating inflation.3. Ability to target sectors of the economy.

Changes in the composition of gov spending depending on gov priorities can affect specific sectors:

Education Health care, focusing on particular social groups that

may be in greater need. Infrastructure and its location, focusing if necessary on

economically depressed regions. Other merit goods

4. Direct impact of gov spending (G) on AD. Changes in taxes are less direct, as they work by changing consumers’ disposable income and firms’ after-tax profit.

5. Ability to affect potential output. FP can affect Yp and long-term economic growth indirectly (by creating a stable economic environment) and directly through investments in human capital and physical capital and through offering incentives to firms to invest.

Weaknesses of Fiscal Policy1. Problems of timing. FP is subject to time

lags: A lag until the problem is recognized . A lag until the appropriate policy is decided

upon by the gov. A lag until the policy takes effect in the

economy.

By the time the policy has taken effect the problem may have become less or more severe, so that the policy is no longer the appropriate one.

2. Political constraints. Gov spending and taxation are subject to numerous pressures that are unrelated to fiscal policy considerations. Spending in public and merit goods is undertaken for its own sake and cannot easily be cut. Taxes are politically unpopular and might be avoided even though they might be necessary.

3. Crowding-out effect. The increase in interest rate caused by deficit spending can lead to lower investment spending by private firms. A greater G is offset by a lower I.

4. Inability to deal with supply-side causes of instability. Ex: FP is unable to deal with stagflation.

5. In a recession, tax cuts may not be very effective in increasing AD. Part of the increase in after-tax income is saved. If this share becomes larger due to pessimistic future expectations, the impacts of tax cuts on AD will be even weaker. Increases in G are more powerful.

6. Inability to fine tune the economy. FP can lead the economy in a general direction of smaller or larger AD, but it cannot be used to reach a precise target with respect to the level of output, employment and the price level. It is not possible to use FP to keep real GDP at or very close to its potential level. There are many factors affecting AD that the gov cannot control.

Monetary Policy (MP)Carried out by the Central Bank (CB) of each

country.Commercial banks are financial institutions

whose main functions are to hold deposits for their customers (consumers and firms), to make loans to their customers, to transfer funds by cheque and electronically from one bank to another and to buy government bonds.

The Central bank is usually a government financial institution with a number of important responsibilities:

1. Banker to the gov. Among other, the CB manages the government’s borrowing by selling bonds to commercial banks and the public, and acts as an adviser to the gov on financial and banking matters.

2. Banker to commercial banks, by holding deposits for them and make loans to them in times of need.

3. Regulator of commercial banks, making sure they operate with appropriate levels of cash and according to rules that ensure the safety of the financial system.

4. Conduct monetary policy, through changes in the supply of money or the rate of interest. It usually also responsible for the determination of exchange rates.

In the countries which form the European Monetary Union (EMU), monetary policy is carried out by the European Central Bank (ECB), located in Frankfurt.

The money market and the rate of interestMP impacts AD indirectly through the rate of

interest.Interest is the payment (per unit of time) for

the use of borrowed money. Usually expressed as % of the principal to be paid per year. This % is called the rate of interest.

Money is anything that is acceptable as payment for g&s (ie, coins and paper money as well as checking accounts)

The money market is a market where the demand for money and the supply of money determine the equilibrium rate of interest. The horizontal axis measures the quantity of money in the economy, and the vertical axis measures the rate of interest.

The rate of interest is the price of money services.

The Demand for money, Dm, shows the relationship between the rate of interest and the quantity of money demanded. Dm is downward sloping.

i

Qe

Dm

Quantity of money

Rate of interest

Sm

Why is Dm downward sloping? Money allows economic agents to carry out

their buying and selling exchanges.Money can be used as a form of saving when

used to buy bonds (a certificate issued by the gov or a firm that promises to pay interest at various intervals until the date when the money is repaid to the bond holder).

So, interest is the opportunity cost of holding money, as you could have received that interest if you had saved the money instead of holding it.

The higher i, the higher the opportunity cost of holding money and the lower the quantity of money demanded.

The Supply of money, Sm, is fixed at a level that is decided upon by the CB. does not depend on i.

The point of intersection between Dm and Sm determines the equilibrium rate of interest.

Monetary policy is carried out by the CB, through changes in the money supply, which shift the Sm curve. Rate

of interest

Quantity of money

Sm1 Sm2Sm3

Dm

i1

i3

i2

↑Sm → ↓ie ↓Sm → ↑ie

Q3

Q1

Q2

In practice, the CB can target either the money supply or the interest rate. Most central banks target the interest rate: decide upon i and then adjust Sm so that the actual ie will become equal to the target i.

In the real world there are many interest rates and it varies from country to country which one central banks target. In the UK, the CB targets the ‘base rate’, which is the

interest rate at which the Bank of England lends to commercial banks.

In the US, the Federal Reserve targets the ‘federal funds rate’, the interest rate at which commercial banks borrow and lend from each other over a 24-hour period.

The ECB targets the ‘minimum refinancing rate’, which is the interest rate paid by commercial banks when they borrow from their respective national central banks.