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Unit 2.4 Demand and Supply-Side Policies U nit Overview. 3.4 Demand-side and supply-side policies Sh ifts in the AD curve / demand-side policies ·fiscal policy ·interest rates as a tool of monetary policy Shifts in the AS curve / supply-side policies

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slide1

Unit 2.4 Demand and Supply-Side Policies

Unit Overview

3.4 Demand-side and supply-side policies

Shifts in the AD curve / demand-side policies

·fiscal policy

·interest rates as a tool of monetary policy

Shifts in the AS curve / supply-side policies

Strengths and weaknesses of these policies

Higher level only:

Multiplier

·calculation of multiplier

Accelerator

"Crowding out"

Money, banking, and financial markets (AP only)

·Measures of money supply

·Banks and creation of money

·Money demand

·Money market

·Loanable funds market

Central bank and control of the money supply (AP only)

·Tools of central bank policy

·Quantity theory of money

·Real versus nominal interest rates

Blog posts: "Fiscal policy"

Blog posts: "Monetary policy"

Blog posts: "Supply-side economics"

Blog posts: "Multiplier effect"

slide2

Demand and Supply-Side Policies

Demand-side Policies

Demand-side policies: Macroeconomic policies undertaken by a government aimed at increasing or decreasing Aggregate Demand (total spending on goods and services) in the economy

PL

LRAS

SRAS

Fiscal policy:Changes in government spending and/or taxation aimed at increasing or decreasing aggregate demand

Monetary Policy:Changes in the supply of money by a nation's central bank aimed at raising or lowering the prevailing interest rates in the economy, which subsequently affect the level of consumer and investment spending

Pe

AD

When would policymakers want to implement demand-side policies?

Yfe

real GDP

NOT when an economy is producing at its full-employment level!

If AD is excessively strong, contractionary demand-side policies can be used to reduce spending. If AD is weak, expansionary demand-side policies can be used to increase spending

slide3

Demand and Supply-Side Policies

Supply-side Policies

Supply-side policies: Macroeconomic policies taken by a government or central bank aimed at increasing productivity, lowering firms' costs, and increasing the level of aggregate supply in the economy. Classical economists advocate use of supply-side policies to solve macroeconomic problems.

Reduction in income taxes:increases incentive to work since workers get to keep more of their hard earned wages

Reduction in corporate taxes:increases incentive to invest in new capital. An increase in the nation's capital stock increases potential output of the economy

Reduction in trade union power: Unions fight for higher wages, which increases firms' costs. Lower wages will lower costs to firms and increase their ability to produce more output

Reduction or elimination of minimum wages: Lower minimum wage will lower firms' costs, increasing their potential output and aggregate supply

Reduction in unemployment benefits: Generous benefits for the unemployed reduce the incentive to find work, reducing the supply of available labor. Fewer benefits increase supply of labor and AS

Deregulation:Burdensome regulations of business can increase costs for firms. Deregulating business operations will lower firms' costs and increase AS

Privatization:Transferring state-run firms to the private sector may lead to greater efficiency as firms compete to minimize costs and maximize profits

Anything that increases the quantity or the quality of productive resources or decreases firms' costs will increase AS

slide4

Demand and Supply-Side Policies

Fiscal Policy

Expansionary Fiscal Policy:An increase in government spending and/or a decrease in taxes aimed at increasing the total amount of spending in an economy, lowering unemployment and increasing total output and growth.

Example:the 2009 American Recovery and Reinvestment Act is a $784 spending and tax cut package aimed at getting the US out of recession:

"In the face of an economic crisis, the magnitude of which we have not seen since the Great Depression, the American Recovery and Reinvestment Act represents a strategic -- and significant -- investment in our country’s future.

The Act will create or save three to four million jobs, 90 percent of them in the private sector. It will provide more than $150 billion to low-income and vulnerable households -- spurring increased economic activity that will save or create more than one million jobs.

These measures are necessary to help the millions of families whose lives have been upended by the economic crisis. But, this Act will do more than provide short-term stimulus. By modernizing our health care, improving our schools, modernizing our infrastructure, and investing in the clean energy technologies of the future, the Act will lay the foundation for a robust and sustainable 21st century economy."

slide5

Demand and Supply-Side Policies

Fiscal Policy

The ARRA: How will each of the components of the ARRA lead to an increase in Aggregate Demand, a decrease in unemployment and an increase in GDP in America?

slide6

Demand and Supply-Side Policies

Fiscal Policy

The ARRA: How will each of the components of the ARRA lead to an increase in Aggregate Demand, a decrease in unemployment and an increase in GDP in America? What are the potential supply-side effects of the program?

Education and training Protecting the vulnerable Energy Health Care

State and local fiscal relief Infrastructure and Science Tax Relief

slide7

Demand and Supply-Side Policies

Fiscal Policy

Demand-side: Increase purchasing power of poor and unemployed, increase C

Supply-side: Could create disincentive to seek employment, shift AS left?

The ARRA:Possible Demand and Supply-side effects

Demand-side: relieve state budget shortages, better able to pay state employees

Demand-side: Jobs in community colleges and public school

Supply-side: more productive and skilled workforce

Demand-side: Increased investment in new technologies. Supply-side: improve efficiency of energy resources, productive capacity of nation

Demand-side: Increased employment in health sector. Supply-side: improved health increases productivity of labor force

Demand-side: New investment and employment by construction firms Supply-side: modern infra-structure improves efficiency, communication, transportation

Demand-side: More disposable income increases consumption, higher expected returns increases investment Supply-side: New capital makes firms and workers more efficient, increasing nation's productive capacity

slide8

Demand and Supply-Side Policies

Fiscal Policy

Expansionary fiscal policy:Graphical analysis

PL

LRAS

SRAS

The problem:Low confidence and expectations about the future cause private C and I to fall to (AD), demand-deficient recession and unemployment result

The fix:A tax break for households and firms, combined with new government spending on infrastructure, education and health, stimulate aggregate demand

P1

The result:An increase in government spending and higher disposable income for households, combined with higher expected rates of return on investments by firms stimulate private spending in the economy.

Pe

AD2(after multiplier)

AD1(with stimulus)

AD

·The initial change in G is multiplied through successive increases in C and I.

·The ultimate increase in GDP is greater than the initial increase in G

·Output returns close to the full employment level

·Unemployment returns close to the NRU

Yfe

Ye

real GDP

slide9

Demand and Supply-Side Policies

Fiscal Policy

Expansionary fiscal policy:Supply-side effects

How will a decrease in taxes affect Aggregate Supply?

PL

LRAS1

SRAS

·Lower business taxes will encourage new investment in capital

·Greater capital stock increases the nation's productive capacity

·AS may shift out

Pe

Pe1

How will an increase in Government spending affect AS? TWO VIEWS

AD2

·If gov't invests in infrastructure, education, health and other projects that increase productivity of nation's resources, AS may shift out

·If gov't spending causes interest rates to rise, it may "crowd out" private investment in capital and decrease the size of the nation's capital stock, causing AS to shift left

Yfe

Yfe1

real GDP

slide10

Demand and Supply-Side Policies

Fiscal Policy

Contractionary fiscal policy:Graphical analysis

PL

The problem:Excessive spending in the economy has forced unemployment below the natural rate and the price level up as firms compete for scarce resources

LRAS

SRAS

Pe

The fix:Government cuts spending on particular projects, increases income and business taxes

P1

AD

The result:Disposable income among households falls, reducing consumer spending. Expected rates of returns on new capital falls, lowering investment. Government spending falls, reducing overall demand in the economy

AD1(with fiscal policy)

AD2(after multiplier)

·The initial decline in G, C and I multiplies itself through successive reductions in spending

·The ultimate decrease in GDP is greater than the initial decrease in G

Ye

Yfe

real GDP

·Output returns close to the full employment level

·Unemployment returns close to the NRU

·Inflation returns to a stable rate

slide11

Demand and Supply-Side Policies

Fiscal Policy - Spending Multiplier

Policy options - G or T? What's more effective at stimulating AD, an increase in government spending or a decrease in taxes?

·Some economists tend to favor higher G during recessions and higher taxes during inflationary times if they are concerned about unmet social needs or infrastructure.

·Others tend to favor lower T for recessions and lower G during inflationary periods when they think government is too large and inefficient.

Scenario: Government wants to boost output by 200 billion dollars. Assume the nation's MPC = .55. What should the government do, cut taxes or increase government spending?

Spending Multiplier (K) = 1/1-MPC =1/.45 =2.22

200b = 2.22 (ΔSpending)

ΔSpending = 90b

ΔGDP = K x ΔSpending

To achieve $200b of GDP growth, government spending must increase by $90b. So how large of a tax cut is needed to achieve the same change in GDP?

We must know the Tax Multiplier

slide12

Demand and Supply-Side Policies

Fiscal Policy - Tax Multiplier

Tax Multiplier: A measure of the change in GDP caused by changes in government taxes

Tax Multiplier = -MPC/MPS (or the MRL)

Tax multiplier (Tm) = -.55/.45 =-1.22

200b = -1.22 (ΔTaxes)

ΔTaxes = -164b

ΔGDP = Tm x ΔTaxes

By how much would the government have to cut taxes to achieve the desired increase in GDP?

Answer: $164 billion

Rationale: 45% of any tax cut will go towards savings, purchase of imports or debt repayment, all of which are leakages from the circular flow. Only 55% will turn into new spending in the economy

By how much would the government have to increase spending to achieve the desired increase in GDP?

Answer: $90 billion

Rationale: An increase in government spending represents a direct injection into the economy, as none of it will be leaked in the form of savings, purchase of imports or debt repayment

slide13

Demand and Supply-Side Policies

Fiscal Policy

Automatic stabilizers in Fiscal Policy:Built-in stability arises because net taxes (taxes minus transfers and subsidies) change with GDP. It is desirable for spending to rise when the economy is slumping and vice versa when the economy is becoming inflationary.

Built-in stability in fiscal policy

·Tax revenues automatically increase when national income increases because there is more income to tax. Revenues fall with GDP because incomes fall.

·With a decline in national income, government spending automatically increases as more people collect unemployment benefits, food stamps, and welfare. When national income increases government support for households and firms is automatically rolled back, leading to a more balanced budget

T

Balanced budget

G and T (billions $)

G

Real GDP

·The size of automatic stability depends on responsiveness of changes in taxes to changes in GDP:

The more progressive the tax system, the greater the economy’s built-in stability.

slide14

Demand and Supply-Side Policies

The Money Market

Dt

ir

The Money Market: an introduction

Money Demand: the public wants to hold money for two main reasons.

·Transactions demand, Dt: is money kept for purchases and will vary directly with GDP. The more output, the more money the public will demand to buy that output

·Asset demand, Da: is money kept as a store of value for later use. Asset demand varies inversely with the interest rate, since that is the opportunity cost of holding idle money.

·Total Demand for Money, Dm:Total demand will equal the sum of the total amount of money demanded for transactions and for assets.

Qm

Transaction demand

ir

Da

Qm

Asset demand

ir

Sm

ie

Dm

Qm

Total demand for money

slide15

Demand and Supply-Side Policies

Evaluating Fiscal and Monetary Policies

Crowding-out effect:when a deficit-financed increase in government spending drives up interest rates, thereby directing productive resources away from the private sector towards the public sector

Question: How do governments get money to finance their budgets if they lower taxes at the same time that they increase spending (expansionary fiscal policy)?

Answer:they borrow from the public by issuing new government bonds

BOND (definition):The general term for a long-term loan in which a borrower agrees to pay a lender an interest rate (usually fixed) over the length of the loan and then repay the principal at the date of maturity. Bond maturities are usually 10 years or more, with 30 years quite common. Bonds are used by corporations and federal, state, and local governments to raise funds. (source: www.amosweb.com/)

What causes crowding out?

·When the government issues new bonds to finance its budget deficits, the supply of bonds increases in the bond market, lowering the bond price and increasing the interest rates on bonds

·The higher return on government bonds directs savings away from commercial banks, decreasing the supply of loanable funds to for the private sector to invest with, driving up commercial interest rates

·The increase in borrowing by the government may lead to a decline in private investment, thus "crowding-out" private enterprise in the economy

·Crowding-out can also refer to the re-allocation of physical resources (labor, land and capital) away from the private sector towards the public sector as the government embarks on projects requiring large inputs of productive resources.

slide16

Demand and Supply-Side Policies

Evaluating Fiscal and Monetary Policies

Crowding-out effect:Graphical representation

Two ways to illustrate crowding-out:

·The impact on the Money Market

·The impact on the Loanable Funds Market (AP only)

Crowding-out in the Money Market (IB and AP)

Money Market

Investment Demand

S

S1

Interpretation: The government's "transaction demand" for money increases as it must finance its budget deficit, shifting money demand out, driving up interest rates

Interest rate

7%

Interest rate

5%

Private investment is "crowded-out" due to increased government borrowing

D2

DI

Dmoney

Q2

Q1

Q1

Quantity of Investment

Quantity of money

slide17

Demand and Supply-Side Policies

Evaluating Fiscal and Monetary Policies

Crowding-out effect:Graphical representation

The Loanable Funds Market (AP only): the loanable funds market is a hypothetical market that brings savers and borrowers together, also bringing together the money available in commercial banks and lending institutions available for firms and households to finance expenditures, either investments or consumption (source: Wikipedia)

·Savers supply the loanable funds; for instance

·In return, borrowers demand loanable funds

Loanable Funds

SLF: There is a direct relationship between the interest rate and the supply of loanable funds because at higher interest rates, savers want their money in banks and other institutions to earn the generous return

SLF

Interest Rate

DLF: There is an inverse relationship between the interest rate and the demand for loanable funds because at lower interest rates households and firms want to take money out of savings to consume and invest

ire

DLF

Qe

Blog Post - "Loanable Funds vs. Money Market: what’s the difference?"

Quantity of Loanable Funds

slide18

Demand and Supply-Side Policies

Evaluating Fiscal and Monetary Policies

Crowding-out effect:Graphical representation

Crowding out in the Loanable Funds Market (AP only):

·Public borrowing directs funds away from the private market for loanable funds as investors are attracted to the higher interest rates on government bonds. The supply of loanable funds in the private sector decreases

·Fewer funds available in commercial banks drive the interest rate up, which decreases the level of private investment

Loanable Funds

Investment Demand

SLF

S1

Interest Rate

6%

Interest rate

5%

Private investment is "crowded-out" due to increased government borrowing

DI

DLF

Q2

Q1

Qe

Qe

Quantity of Loanable Funds

Quantity of Investment

Blog posts: "the Crowding-out effect"

slide19

Demand and Supply-Side Policies

Evaluating Fiscal and Monetary Policies

ThinkEconomics ~ Economic Policy Tools

Follow the link above for a great practice activity with fiscal and monetary policies and their effect on AD/AS. The following is from the ThinkEconomics site:

To achieve the economic goals of low unemployment and stable prices, the Congress and the President can use two fiscal policy instruments, government spending and taxation to affect real GDP and the price level. In addition, the Federal Reserve can use three monetary policy instruments, open market operations and changes in the discount rate and required reserve ratio to change real GDP and the price level.

An increase in government spending G or a decrease in autonomous taxes, ceteris paribus, increase aggregate demand, thereby increasing both the equilibrium level of real GDP, Q*, and the equilibrium price level P*. Alternatively, a decrease in government spending G or an increase in autonomous taxes, ceteris paribus, decrease aggregate demand, thereby decreasing both the equilibrium level of real GDP, Q*, and the equilibrium price level P*.

A Federal Reserve (Fed) open market purchase of U.S. securities, a decrease in the discount rate or a decrease in the required reserve ratio increase the money supply, thereby increasing aggregate demand and the equilibrium level of real GDP, Q*, and the equilibrium price level, P*. Alternatively, a Fed open market sale of U.S. securities, an increase in the discount rate or an increase in the required reserve ratio decrease the money supply, thereby decreasing aggregate demand and the equilibrium level of real GDP, Q*, and the equilibrium price level, P*.

slide20

Demand and Supply-Side Policies

Practice Problems

Illustrating the macroeconomy

Analyse the impact of the following scenarios on the US economy. Remember - the scenarios could impact either AS or AD, or both! It is often easier, initially, to analyse the effect on just one area - just make it clear why you have chosen to use AS or AD. In some cases, the scenario could affect more than one variable. Think carefully about how you would analyze such cases.

·Government announces a large increase in spending on health and education.

Impact on ADImpact on AS

·Washington announces tax exemption scheme on new investments for small to medium sized businesses.

Impact on ADImpact on AS

·Average wage rises way above inflation for the third month running.

Impact on ADImpact on AS

·Exchange rate appreciation knocks export hopes for manufacturing.

Impact on ADImpact on AS

·Share prices tumble, wiping 20% off company values.

Impact on ADImpact on AS

·Surveys show clear signs of optimism for the future of the economy.

Impact on ADImpact on AS

slide21

Demand and Supply-Side Policies

Practice Problems

·American productivity levels at their highest level for 10 years.

Impact on ADImpact on AS

·Government 'stealth taxes' increase tax burden to highest level for 50 years.

Impact on ADImpact on AS

·Expansion in numbers of students attending higher education exceeds government targets.

Impact on ADImpact on AS

·Federal Reserve signals rise in interest rates of ½%.

Impact on ADImpact on AS

·No rate rise in US but UK and EU central banks increase interest rates.

Impact on ADImpact on AS

·Radical reform of welfare spending should help government cut spending as a proportion of GDP.

Impact on ADImpact on AS

·Stability of inflation cheers business leaders.

Impact on ADImpact on AS

·United States leads the way in nano-technology development

Impact on ADImpact on AS

slide22

Demand and Supply-Side Policies

Classical vs. Keynesian

Classical vs. Keynesian policies: Classical economists are sometimes referred to as "supply-siders", Keynesians as "demand-siders" Why is this?

PL

LRAS

SRAS

Talk to a Classical economist, and they will advise

‘Don’t just do something, sit there!’

while a Keynesian will advise,

'Don't just sit there, do something!"

Pe

AD

With partners, discuss and illustrate the various policy responses to the following macroeconomic problems.

Yfe

real GDP

Group C:

·Problem: Increased demand from abroad for exports fuels domestic inflation

·Keynesian response

·Classical response

Group D:

·Proble: Embargo placed on country's exports

·Keynesian response

·Classical response

Group A:

·Problem: sharp rise in oil prices

·Keynesian response

·Classical response

Group B:

·Problem: Stock market bubble bursts

·Keynesian response

·Classical response