Demand-side and Supply-side policies Tragakes 2011, pp. 320-352

1. Demand-side and Supply-side policiesTragakes 2011, pp. 320-352

2. 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

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

4. Fiscal Policy

5. The government budget • Sources of government revenue • Taxes, both direct and indirect (T). • Sales of goods and services (transportation, electricity, water, …) • Sale of state-owned enterprises (privatisation). • Types of government expenditure • Current (day-to-day) expenditures • Capital expenditures, including public investments or the production of physical capital (building roads, airports, harbours,…) • Transfer payments for the purpose of income redistribution

6. 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 budget • If G>T: budget deficit Gov needs to borrow • If G<T: budget surplus • Public/Government Debt is the gov’s accumulation of deficits minus surpluses.

7. 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 AD • C. 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.

8. 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: • ↑ G • ↓ personal income taxes • ↓ business taxes • a combination of the three. • An increase in G has a direct impact on AD

9. A decrease in T affects AD in a 2-step process: ↓T → ↑Disposable income Yd / ↑After-tax businesses profits → ↑C / ↑I →↑ AD • The 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.

10. Contractionary Fiscal Policy • In an inflationary gap (Y>YFE), the gov can decrease AD with contractionary FP, which works to contract AD and the level of economic activity. • Contractionary FP can consist of: • ↓ G • ↑ personal income taxes • ↑ business taxes • a combination of the three.

11. A decrease in G has a direct impact on AD • An increase in T affects AD in a 2-step process: ↑ T → ↓Disposable income Yd / ↓After-tax businesses profits → ↓C / ↓I → ↓ AD • Figures 12.1 (expansionary FP) and 12.2 (contractionary FP). • Keynesian model with the ratchet effect (Fig 12.2 c)

12. 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. • Progressive income taxes • 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).

13. Progressive income taxes • During 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.

14. Unemployment benefits • In 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.

15. Fiscal policy and long term growth D-side policies can contribute to ↑ the level of potential GDP in two ways: • 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).

16. 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 G • 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. • 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.

17. Evaluating Fiscal Policy Strengths of Fiscal Policy • Pulling an economy out of a deep recession. • Combating rapid and escalating inflation. • 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

18. 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. • 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.

19. Weaknesses of Fiscal Policy • 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.

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

21. 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. • 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.

22. Monetary Policy

23. 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:

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

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

26. The money market and the rate of interest • MP 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.

27. 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. Rate of interest Sm i Dm Qe Quantity of money

28. 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.

29. 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 ↑Sm→ ↓ie ↓Sm→ ↑ie Sm3 Sm1 Sm2 i3 i1 i2 Dm Quantity of money Q3 Q1 Q2

30. 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.

31. The role of Monetary Policy • Changes in i affect two components of AD: • C, as some consumption is financed by borrowing. • I, as firms borrow money in order to finance their investment expenditures. • Therefore: ↑ i → ↓ C , ↓ I → ↓ AD and AD shifts left ↓i → ↑ C , ↑ I →↑ AD and AD shifts right

32. Expansionary (easy money) Policy • In a recessionary gap (Y<YFE), the CB increases Sm, causing the interest rate to decrease. • A lower i means a lower cost of borrowing, so consumers and firms are likely to borrow and spend more: ↓i → ↑ C and ↑ I →↑ AD. PL K-AS LRAS PL SRAS AD2 AD2 AD1 AD1 Real GDP Real GDP Yrec YP Yrec YP

33. The effects of the AD increase are different depending on the shape of the AS curves: • In the monetarist model there is a smaller increase in real GDP and a larger increase in the price level compared to the Keynesian model.

34. Contractionay (tight money) Policy • In an inflationary gap (Y>YFE), the CB decreases Sm, causing the interest rate to increase. • A higher i means a higher cost of borrowing, so consumers and firms are likely to borrow and spend less: ↑ i → ↓ C and ↓ I → ↓ AD. PL LRAS SRAS AD1 AD2 Real GDP YP Yinf

35. If AD falls within the downward sloping part of the AS curve in the Keynesian model, the effects on the price level and real GDP are similar to those in the monetarist model. But if AD decreases in the horizontal part of the AS curve, there would be a larger fall in real GDP and a smaller fall in the price level in the Keynesian model. • The ratchet effect also applies here.

36. Monetary policy and inflation targeting • As we have seen, MP can be used to achieve the goals of FE and a low and stable rate of inflation. • In recent years, more CBs (26 in total) around the world pursue a kind of MP that aims at maintaining a particular targeted rate of inflation. Examples: New Zealand (first one, 20 years ago), Australia, Canada, UK, EU, Brazil, Mexico, among others. • Defined by IMF as ‘…the public announcement of medium-term numerical targets for inflation with an institutional commitment by the monetary authority to achieve these targets.’

37. Targets range between 1.6% and 2.5%, with one percentage point as a ‘tolerance’ margin. • Target set in terms of the consumer price index (CPI) but usually based on forecasts of future inflation based on the CPI. • If predicted inflation is higher (lower) than the target, they use contractionary (expansionay) policy to increase (decrease) i and lower (increase) AD, thus lowering (increasing) the rate of inflation.

38. Advantages of inflation targeting • A lower rate of inflation. • A more stable rate of inflation (less fluctuations in the inflation rate) • Improved ability of economic decision-makers to anticipate the future rate of inflation. Public knowledge about the CB’s objectives on inflation reduces uncertainty and facilitates economic decision making. • Greater coordination between MP and FP. Gov can plan its FP to complement the CB’s monetary policy. • Greater CB transparency and accountability.

39. Disadvantages of inflation targeting • Reduced ability of the CB to pursue other macroeconomic objectives. MP can then not be used for other goals, such as FE level of real GDP or exchange rate stability. • Reduced ability of the CB to respond to S-side shocks. This might require expansionary MP, which may mean a higher rate of inflation than the target. • Reduced ability of the CB to deal with unexpected events, such as financial crises. • Finding an appropriate inflation target. If it is too low, it may lead to higher UE; if it is too high, it could lead to the problems resulting from high inflation. • Difficulties of implementation, as it is based on forecasts, which are often highly unreliable.

40. Evaluating monetary policy Strengths of Monetary Policy • Quick implementation. MP can be implemented more quickly than FP because it does not have to go through the political process. • No political constraints: • Even if a CB is not independent from the government, MP is not subject to the same kinds of political pressures as fiscal policy since it does not involve changes in gov budget. • CB in many countries is independent of the governing political party.

41. No crowding-out. • Ability to adjust interest rates incrementally (in small steps). This makes monetary policy better suited to ‘fine tuning’ the economy in comparison with FP. However, also subject to limitations. • Central bank independence. CB can take decisions that are in the best longer term interests of the economy, having greater freedom in pursuing policies that may be politically unpopular.

42. Weaknesses of Monetary Policy • Problems of timing. Although MP does not depend on the political process, it is still subject to time lags: • A lag until the problem is recognized . • A lag until the policy takes effect in the economy. Changes in interest rates can take several months to have an impact on AD, Y and PL. This time lags becomes longer if there is pessimism in the economy.

43. Possible ineffectiveness in recession. A tight money policy can effectively combat inflation. However, an easy money policy is less effective in a deep recession. In a recession, lower i would encourage C and I, increasing AD. This is under the assumption that banks will be willing to ↑ their lending to households and firms and that these will be willing to ↑ their borrowing and their spending. However, in a severe recession banks may be unwilling to ↑ their lending and if firms and consumers are pessimistic about the future they may avoid taking new loans and may even ↓ their I and C. This situation occurred in the 1930s during the Great Depression and in 2008.

44. Conflict between government objectives. Manipulation of interest rates affects also variables in the foreign sector of the economy, such as exchange rates. The pursuit of domestic objectives may conflict with the pursuit of objectives in the foreign sector. • Inability to deal with stagflation. MP is unable to deal effectively with S-side causes of instability, just like fiscal policy. • Inflation requires a contractionary policy • UE requires an expansionary policy