Demand-side and Supply-side policies Demand-side policies Based

Demand-side and Supply-side policies

Demand-side policies 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. n Objectives: bring the AD to the FE level of Real GDP. n D-side policies can also impact on economic growth, that is, increase potential GDP (shift LRAS curve to the right). IB exam question of this year!! n

Fiscal Policy (FP) Definition: manipulations by the government of its own expenditures and taxes in order to influence the level of AD. n Government receives revenues from income and business taxes, T. n Government expenditures: G n If G=T: balanced budget n If G>T: budget deficit Gov needs to borrow n If G<T: budget surplus n n Public/Government Debt is the gov’s accumulation of deficits minus surpluses.

n FP can affect AD through 3 components: G. Direct impact on AD n C. FP, through changes in income taxes, affects the disposable income of consumers, which affects their consumption expenditures. n I. Through changes in business taxes, FP affects the after tax profits of firms, which has an impact on their level of investment expenditures. n

Expansionary Fiscal Policy n n 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. 2. 3. 4. ↑G ↓ personal income taxes ↓ business taxes a combination of the three.

n n 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 → ↑ AD n n 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 Policy In an inflationary gap (Y>YFE), the gov can decrease AD with expansionary FP, which works to contract AD and the level of economic activity. n Contractionary FP can consist of: n 1. ↓ G 2. ↑ personal income taxes 3. ↑ business taxes 4. a combination of the three.

A decrease in G has a direct impact on AD n An increase in T affects AD in a 2 -step process: n ↑ T → ↓ Disposable income Yd / ↓ After-tax businesses profits → ↓ C / ↓ I → ↓ AD n Figures 9. 1 and 9. 2.

Monetary Policy (MP) Carried out by the Central Bank (CB) of each country. n The CB is a (government) financial institution whose purpose is to control the supply of money, determine the rate of interest, oversee the banking system and carry out monetary policy. n In the countries which form the European Monetary Union (EMU), monetary policy is carried out by the European Central Bank (ECB), located in Frankfurt. n

MP impacts AD indirectly through the rate of interest. n 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. n The money market is a market where the demand for money and the supply of money determine the equilibrium rate of interest. n The rate of interest is the price of money services. n The Demand for money is downward sloping. n

n Why is Dm downward sloping? (Fig. 9. 3) Money allows economic agents to carry out their buying and selling exchanges. n 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). n 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. n The higher i, the higher the opportunity cost of holding money and the lower the quantity of money demanded. n

The Supply of money, Sm, is fixed at a level that is decided upon by the CB. Sm does not depend on i. n Monetary policy is carried out by the CB, through changes in the money supply, which are undertaken in order to influence the rate of interest: ↑Sm → ↓ie ↓Sm → ↑ie n 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. n

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

Expansionary (easy money) Policy In a recessionary gap (Y<YFE), the CB increases Sm, causing the interest rate to decrease. n 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. n I is more sensitive than C to changes in i, so the increase in I will have a greater impact on AD than the increase in C. n

Contractionay (tight money) Policy In an inflationary gap (Y>YFE), the CB decreases Sm, causing the interest rate to increase. n 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. n I is more sensitive than C to changes in i, so the increase in I will have a greater impact on AD than the increase in C. n

Strengths and weaknesses of D-side policies for short-term stabilization Strengths of Fiscal Policy 1. 2. The strength of FP is to pull an economy out of a deep recession, or when the economy finds itself in the horizontal segment of the AS curve. Remember Keynes and the Great Depression of the 1930 s! Combating rapid and escalating inflation.

Weaknesses of Fiscal Policy 1. Problems of timing. FP is subject to time lags: n n n 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. 3. Problems of inadequate information. The gov relies on statistical information and forecasts for its policy decisions. Inaccuracies may then lead to inappropriate policies. 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.

4. 5. 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. 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.

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.

Strengths of Monetary Policy 1. 2. Quick implementation. MP can be implemented more quickly than FP because it does not have to go through the political process. No political constraints: n n MP not subject to political pressures, does not involve changes in gov budget. CB in many countries is independent of the governing political party.

3. 4. No crowding-out effect. Better suited to fine tuning of the economy in comparison with FP. Above factors make MP more accurate wrt achieving output, price level and employment objectives. However, also subject to limitations.

Weaknesses of Monetary Policy 1. Problems of timing. Although MP does not depend on the political process, it is still sunject to time lags: n n 2. 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. Problems of inadequate information.

3. 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 interest rates 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 1930 s and there were fears that it would occur in 2008. Weakenesses of both n If the economy is experiencing stagflation (↓Y+↑PL), neither FP or MP can bring the economy back to the macroeconomic equilibrium. These policies cannot resolve both inflation and UE at the same time.

Inflation requires a contractionary policy n UE requires an expansionary policy n Fiscal or monetary policy? n Keynesians believe that FP is more effective in achieving stabilization. n Neoclassical economists have believed that MP is more effective. n Today economists agree in that they are most effective when used together.

n According to most economists: because of its greater speed and flexibility, MP is better suited to dealing with short-term stabilization, particularly when there is an inflationary gap. n FP should focus on creating a stable fiscal environment, involving avoidance of very large and persistent budget deficits or surpluses. n FP should be used to complement MP in the event of strong economic downturns to prevent a serious recession, or to pull an economy out of a serious recession (autumn 2008). n

D-side policies 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. n n 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.

n 2. 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). Directly (Figure 9. 4): n n By encouraging investment through lower business taxes (FP) or lower interest rates (MP), thereby contributing to new capital formation and technological innovations that increase YP. By directing a portion of G a. b. c. to the development of infrastructure (roads, telecommunications, . . . ) which increases the quantity of capital goods. On R&D, which increases technology. On training and education, that increase the quality of the labor force and can also help lower the NRU.

Supply-side policies n n Objective: shifting the LRAS curve (not the SRAS!!), in order to achieve long-term economic growth. Two types: 1. 2. Market-oriented, favoured by neoclassical economists, who emphasize the importance of well -functioning competitive markets in bringing about shifts in the LRAS curve. Interventionist, favoured by Keynesians. They attempt to increase LRAS by relying on gov intervention, rather than the market.

Market-oriented S-side policies Early 1980 s, some neoclassical economists in the UK and the US emphasize the importance of the supply-side of the economy in the growth of real GDP. Margaret Thatcher and Ronald Reagan adopted this view. n Since real GDP tends automatically (according to the neoclassicals) towards long-run FE equilibrium, the focus of gov policies should be less on stabilization and more on achieving increases in potential output (shifts of LRAS). n

Theoretical justification n n An economy pursuing S-side policies will be able to achieve rapid growth, price stability and FE at the same time. The reason is that a stable price level and FE are expected to follow as a consequence of policies that promote growth (ie, increasing AS). In the neoclassical view, inflationary and recessionary gaps are automatically eliminated. Therefore, as long as the economy can move from one long-run equilibirum to another, there will be no UE.

n n n If increases in AS match increases in AD (Fig. 9. 4) the price level does not need to increase. Therefore economic policy should focus on increasing AS (shifting both LRAS ans SRAS) so that this will at least match increases in AD. Increases in AS may address the problem of stagflation, which D-side policies cannot correct. (Page 262, Fig. 9. 5). S-side policies may aim at: 1. 2. 3. 4. Reducing the size of the gov sector and increase competition. Improving incentives by lowering taxes. Making labour mkt more responsive to S and D. Liberalizing international trade and capital flows.

1. Reducing the size of the gov sector and increasing competition n Rationale: a large gov sector may be inefficient (admin costs, unproductive workers, burocracy), as govs do not face incentives to maximize profits. A. Privatization. Leads to increased efficiency. B. Private financing of public sector projects. A private firm undertakes to build, finance and operate public services and the gov buys the services from the private firms. Increases competition, efficiency and quality.

C. D. Contracting out to the private sector (outsourcing). Increased competition, improved efficiency, lower costs and improved quality. Deregulation. Elimination or reduction of gov regulation of private sector activities. n n Economic regulation: government control of prices and output, which offers firms protection against competition. Ex: transport, airlines, tv broadcasting, electricity, . . . Social regulation: protection of consumers against undesirable impacts of private sector activities in areas like food, pharmaceuticals, worker protection agains injuries and pollution control. Some economists argue that social regulation is excessive.

E. Restricting monopoly power can result in increased competition, greater scope for the forces of S and D, increased efficiency, lower costs and improved quality. Ways of restricting monopoly power: n n n By enforcing anti-monopoly legislation, By breaking up large firms wngaging in monopolistic practices into smaller units, By preventing mergers between firms that might result in excessive monopoly power.

Strengths of these policies. Reduction of gov control of economic activities and the transfer to the private sector can give rise to more competition, greater efficiency and lower costs of production, with possibly increased quality of goods and services. Weakenesses n Privatization. A public monopoly may become a private monopoly. Private firms are likely to ↑ prices, which may damage lower income groups. There may also be negative effects on employment if private firms lay off workers when trying to cut costs.

n Private financing activities. n Prices might be higher than when the government is the provider. n Loss of gov control over the project and reduced project flexibility. n The concern that firms may not pay sufficient attention to population safety needs and that these may be sacrificed as a consequence of trying to keep costs low. n Outsourcing. n Loss of flexibility to respond to changing market conditions. n When outside firms are involved: loss of internal talent that could have been used, gov job losses and job losses for the country as a whole.

n Deregulation. n Sometimes leads to higher prices and lower quality services. n Frequently led to increased UE, due to increased competitive pressure. n The financial crisis led to broad recognition of the need to increase the regulation of financial services, as well as to a partial nationalization of some financial services institutions. n Social deregulation is unlikely to be in the public interest.

2. Improving incentives by lowering taxes 1. Lowering personal income taxes. The gov can ↑ or ↓ personal income taxes as part of fiscal policy, thereby ↓ or ↑ AD. S-side economists argue that changes in income taxes have an even greater impact on AS. They claim that tax cuts will give rise to higher after-tax incomes, and this is an incentive for people to provide more work. This can happen through

n n ↑ number of hours worked ↑ number of people interested in finding work ↑ number of years worked. ↓ in UE, as unemployed workers choose to shorten the duration of their UE. All these factors may work to shift the LRAS curve to the right. 2. Lowering taxes on interest income (taxes paid on income received from interest on savings deposits). This will increase incentives to save, increasing the funds available for I, which will increase the production of capital, which increases potential output.

3. Lowering business taxes increases AD by increasing I. S-side economists argue that this is a S-side measure, since the increase in aftertax profits increases the financial resources of firms to produce new and improved capital goods and pursue technological innovations. Both these effects increase potential output.

Strengths of these policies. If they work as intended, tax cuts would give rise to: increases in the quantity of labour and capital resources, n a reduction in UE, n increased saving, n increased I and n more R&D and technological innovations, n All of which contribute to increasing YP.

Weaknesses of these policies. n n n Some economists argue that tax policies may have a larger impact on AD than AS. Income tax cuts may result in people supplying less work if they decide to use their extra after-tax income to increase their leisure time. Also, consumers may decide to use their higher disposable income to consume more rather than to save, which will have an impact on AD. Tax cuts may give rise to increasing inflation. If the impacts of tax cuts are greater on AD than on AS, then they may create inflation. They may worsen income distribution, as it is the wealthy who earn most of the interest income and business profits, and therefore these tax cuts will affect wealthy people by increasing their after-tax incomes more then they will affect theo other population groups.

n Tax cuts are likely to increase gov’s budget deficit unless they are accompanied by decreases in gov spending. But decreases in G (contractionary FP) may not be appropriate if the economy is contracting (downward phase of the business cycle). Tax cuts were implemented in the 1980 s in the Uk and in the US, but economists disagree on whether or not these have worked to increase YP. The reason is that whatever growth has occurred has been the result of both D-side and S-side effects of D-side and S-side policies, being very diffciult to isolate the effect of a particular policy.

3. Increasing labour market flexibility 1. 2. 3. Abolishing minimum wage legislation, so that wages become more flexible in the downward direction. The effects will be lower UE, greater firms profits (labour costs are lower) and increased capital goods production and economic growth due to increased firm profits. Weakening the power of labour trade unions, so that wages will be more responsive to S and D. Same benefits as above. Reducing UE benefits, which are argued to have the effect of lowering the incentive to search for a new job. The effect would be lower UE.

4. Reducing job security (laws that protect workers against being hired making it costly for firms to fire workers). It is argued that firms would be more likely to hire new workers if they know they can fire them easily and without cost when they are no longer needed. Also, reducing job security would decrease firm’s labour costs, increasing profits.

Strengths of these policies. n If wages can fall when there is UE, this will reduce firms’ costs of production and give rise to increased profits, higher employment and profits. Weaknesses of these policies. Some economists argue that paying workers a higher than equilibrium wage encourages them to work harder, increasing their productivity, which increases demand for labour (↓ UE). n These policies involve changes in legislation that provide protection for workers with very low incomes. Reducing protection results in lower wages and job insecurity, increasing income inequalities. n

n UE benefits can play an important role in a recession, as they compensate for the loss of income of the unemployed, helping maintaining the level of consumption spending

4. Liberalizing international trade & capital flows Freer trade and freer capital movements between countries increase global competition, improving the allocation of resources within countries and globally.

Interventionist S-side policies n 1. They presuppose that the free market economy cannot by itself achieve the desired results in terms of increasing potential output. Therefore, gov intervention is necessary in some areas: Public training and education programmes can provide skills to workers, which may become more employable and more productive. This also improves the quality of labour resources, increasing production possibilities.

2. 3. Improved health care services and access to these, which leads to improvements in the quality of labour services. R&D makes technological advances possible, and these are a very important factor behind increases in potential output and economic growth. Gov in many countries are involved in R&D and, in addition, they provide incentives to the private sector to engage in R&D (tax incentives, granting of patents).

4. 5. Provision of job information (employment agencies), which decreases the time the unemployed spend trying to locate jobs, helping lower the level of UE. Support for small and medium-sized enterprises (SMEs), in the form of tax exemptions, grants, low interest loans and business guidance. This promotes efficiency, more capital formation, more employment possibilities and therefore increases in potential output.

6. 7. Support for ‘infant industries’. These are newly emerging industries (in developing countries) which sometimes receive gov support (grants, subsidies, tax exemptions, export protection). This also provides support for growth of the private sector. Improvements in infrastructure, which decrease production costs. Infrastructure is a type of physical capital and includes power, telecommunications, roads, dams, urban transport, airports and ports.

n Strengths of industrial policies. (Definition: policies designed to support the growth of the industrial sector of an economy, shifting the LRAS curve or the K-AS curve to the right) 1. 2. 3. They offer opportunities for gov support in particular areas that would not materialize as needed if left to the market. Industrial policies allow the gov to support particular industries that are believed to offer the greates possibilities for growth in the future. A number of policies can be useful in lowering certain kinds of UE.

n Weakenesses of interventionist policies. 1. 2. Gov interference may lead to inefficiencies and resource misallocation, whereas reliance on the market through market-oriented S-side policies will achieve the desired impacts on long-term growth while avoiding these disadvantages. The use of tax revenues for the support of interventionist activities uses resources that might have better alternative uses elsewhere. Supporters of market solutions argue that large amounts of tax revenues are needed in order to provide all the support services. This implies high taxes (disincentive to work) and large gov sector (promotes inefficiencies).

Interactions between D-side and S-side policies n n n S-side policies have also D-side effects, for example, lower income taxes may provide incentives to work harder and longer, but also, increase consumption spending. In the real world, given the complex interactions between the different polices, it is difficult to identify what particular policy is responsible for what effect. Economists generally agree that S-side policies play a very important role in increasing potential output.

n They disagree on: 1. 2. n Whether market-oriented or interventionist policies are more effective. The importance of S-side effects of D-side policies in causing growth. Some economists (Keynesians) argue that these can be very important, while others (neoclassicals) argue that they are less so. Growth in real GDP involves increases in both AD and AS.