• Demand-side policies?aim to shift?aggregate demand (AD)?in an economy
• There are two categories of demand-side policies
  • Fiscal policy?and?monetary policy
• Fiscal policy?involves the use of government?spending?and?taxation?to influence AD
  • The?government is responsible for?setting fiscal policy
  • The UK Government presents their?fiscal policies?to the country each year when it delivers the?Government budget
• Monetary policy?involves adjusting?interest rates?and the?money supply?so as to influence AD
  • The?Bank of England?(UK central bank) is responsible for setting?monetary policy
  • The Bank's?Monetary Policy Committee?meets 8 times a year to set policy

• The?two main instruments?of monetary policy include
  • Incremental?adjustments to the interest rate?(usually not more than 0.25%)
  • Quantitative easing?which increases the supply of money in the economy
    • The Central Bank creates new money and uses it to buy open-market assets
• When a policy decision is made, it creates a?ripple effect through the economy?and this effect is known as a?transmission mechanism

Incremental Changes to Interest Rates

The transmission mechanisms of changes to the interest rate

Before Explaining a Mechanism from the Diagram Above, Key Terminology Can Be Reviewed Below

Example 1

• Official rate decreases by 0.25% → market rates decrease → loans are cheaper → consumers borrow more → consumption increases → AD increases → inflation increases

Example 2

• Official rate decreases by 0.25% → market rates decrease → mortgages are cheaper → property buyers borrow more → demand for houses increases → asset prices increase

Example 3

• Official rate decreases by 0.25% → market rates decrease → buyers borrow more → asset prices increase → households with assets feel wealthier → consumption increases → AD increases → inflation increases

Example 4

• Official rate increases by 0.25% →?hot money flows increase?→ the exchange rate appreciates → exports more expensive and imports cheaper → net exports reduce → AD decreases → inflation decreases

Example 5

• Official rate increases by 0.25% → market rates increase → existing loan repayments now more expensive to repay → discretionary income falls → consumption decreases → AD decreases → inflation decreases

Quantitative Easing Transmission Mechanism

• The?Bank of England?commits to buy ￡60bn of?gilts?a month → commercial banks receive cash for their gilts →?liquidity?in the market increases → commercial banks lower?lending rates?→ consumers and firms borrow more → consumption and investment increase → AD increases → inflation increases

• Fiscal Policy involves the use of?government spending?and?taxation?to influence aggregate demand in the economy
• Government spending includes direct expenditure, but not transfer payments
  • Transfer payments?are part of fiscal policy, but are not counted as government spending in the?AD?formula
    • Transfer payments enter the?circular flow?when the recipients spend them

Fiscal Policy Impacts

Example 1

• The Government increases VAT from 20% to 22% → consumers pay more tax →?discretionary income reduces → consumption reduces → AD reduces → inflation eases

Example 2

• The Government decreases corporation tax → firms net profits increase → investment by firms increases → AD increases → inflation increases

Example 3

• The Government freezes/reduces public sector pay → consumer confidence falls → consumption decreases → AD decreases → inflation decreases

Example 4

• The Government increases the allowances in the Universal Credit (unemployment benefits) → household income increases → consumption increases → AD increases → inflation increases

• The?Government Budget?(Fiscal policy) is presented each year as a balanced budget, a budget deficit, or a budget surplus
  • A?balanced budget?means that?government revenue = government expenditure
  • A?budget deficit?means that?government revenue < government expenditure
  • A?budget surplus?means that?government revenue > government expenditure
• A budget deficit has to be financed through?public sector borrowing
  • This borrowing gets added to the?public debt

• The main source of government revenue is?taxation
• Direct taxes?are taxes imposed on?income and profits
  • They are?paid directly?to the government by the individual or firm
    • E.g. Income tax, corporation tax,?capital gains tax, national insurance contributions, inheritance tax
• Indirect taxes?are imposed on?spending
  • The?supplier?is responsible for sending payment to the government
    • Depending on the?PED?and?PES?producers are able to pass on a proportion of the indirect tax to the consumer
    • ?The?lower?a consumer spends the?less indirect tax?they pay
    • E.g Value Added Tax (20% VAT rate in the UK in 2022), taxes on?demerit goods, excise duties on fuel etc.

Expansionary Demand-side Policies

• Demand-side policies?that aim to?increase aggregate demand?are called?expansionary policies
• Expansionary monetary or fiscal policy will shift aggregate demand to the right

Classical diagram illustrating expansionary demand-side policies which increase real GDP (Y1?→Y2) and average price levels (AP1?→AP2)

Expansionary Policies Include

• Reducing taxes; decreasing interest rates; increasing government spending; increasing quantitative easing

Contractionary Demand-side Policies

• Demand-side policies?that aim to?decrease aggregate demand?are called?contractionary policies
• Contractionary monetary?or?fiscal policy?will shift aggregate demand to the?left

Keynesian diagram illustrating contractionary demand-side policies which decrease real GDP (YFE?→Y1) and average price levels (AP1?→AP2)

Contractionary Policies Include

• Increasing taxes; increasing interest rates; decreasing government spending; decreasing/stopping quantitative easing

• The Bank of England's?Monetary Policy Committee (MPC)?consists of nine members
• They meet 8 times a year to set the?monetary policy
  • At this meeting they set the?Bank Rate?and discuss if?quantitative easing?is required (or should continue)
  • Policy is decided by?majority vote
  • It can take up to two years for the full effects of decisions to be seen in the economy
• The single most important consideration in their deliberations is the?inflation target of 2%?CPI

A Table That Explains Some of the Factors That Influence the Decision Made by The MPC

• The?Great Depression?started in the USA in October 1929 and continued until the late 1930's
  • By 1932 the USA?unemployment rate?was around?25%
  • More than 9,000 banks closed during this decade
    • The flow of money in the economy was weak (poor liquidity)
• The?Great Depression?created a global slump
  • In the UK,?unemployment doubled?and?exports halved?leading to a major recession
• The?2008 Global Financial Crisis?started in the USA in September 2008 with the collapse of the investment bank, Lehman Brothers
  • The crisis was inextricably linked to?interest rates and risky lending?in the property market
  • In total, about 10 million households lost their homes (roughly 1 in every 20 homes)
  • Unemployment doubled?from around 5% to 10%
  • 489 Banks failed in the five-year period following the crisis -?most were bailed out by central governments
• The?2008 Global Financial Crisis?created a global slump
  • UK?unemployment?rose from 5.2% to 7.8%

A Summary of the Demand-side Policies Used During the Great Depression & 2008 Financial Crisis

Strengths of Monetary Policy

• The Bank of England operates?independently?from the Government (political process)
• Is able to consider the?long-term outlook
• Targets inflation and maintains?stable prices
• Depreciating the currency can increase exports

Weaknesses?of Monetary Policy

• Conflicting goals?e.g economic growth puts upward pressure on?inflation
• Time lags?between policy and the desired impact (up to 2 years)
• Expansionary policy is?less effective in negative output gaps?than when used with positive output gaps
  • Consumers may not respond to lower interest rates when?confidence is low
• Cheaper credit can?inflate asset prices?in the long term
• The interest rate has limitations on?downward adjustment

Strengths of Fiscal Policy

• Spending can be?targeted?on specific industries
• Short time lag?as compared with monetary policy
• Redistributes income?through taxation
• Reduces?negative externalities?through taxation
• Increased consumption of merit/public goods
• Short term government spending can lead to an increase in the?long-run aggregate supply
  • E.g. Building a new airport?immediately?increases government spending and AD, but when it is built, the potential output will have increased

Weaknesses of Fiscal Policy

• Policies can fluctuate significantly as?governing parties' change
  • Long term?infrastructure projects may lack follow-through
• Increased government spending can create budget deficits
  • Repaying this debt may lead to?austerity?on future generations
• Conflicts?between objectives
  • E.g. Cutting taxes to increase economic growth may cause inflation