Demand-Side Policies (Edexcel A Level Economics A)
Revision Note
Written by: Steve Vorster
Reviewed by: Jenna Quinn
Demand-side Policies
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 independent of government
The Bank's Monetary Policy Committee meets 8 times a year to set policy
Monetary Policy Instruments
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 QE explained
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
Before Explaining a Mechanism From the Diagram Above, Key Terminology Can Be Reviewed Below
Official Rate | Market Rates | Asset Prices |
Exchange Rate | Net External Demand | Inflation |
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 Instruments
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 indirect tax and prices rise→ less disposable income available for other purchases → 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
Government Budget (Fiscal) Deficit and Surplus
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
Direct and Indirect Taxation
The main source of government revenue is taxation
Direct taxes are taxes imposed on an individual and/or organisation's income or 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 the spending on goods and services
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.
Diagrams to Illustrate Demand-side Policies
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
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
Contractionary policies include
Increasing taxes; increasing interest rates; decreasing government spending; decreasing/stopping quantitative easing
The Role of the Bank of England
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
Without further intervention, the likely state of the economy a few months ahead | Rate of real GDP growth | Current level of CPI Inflation |
Interest rate elasticity | State of the property market | Unemployment figures |
Business and consumer confidence | Global outlook | The exchange rates |
Demand-side Policies During the Great Depression & 2008 Global Financial Crisis
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 and 2008 Financial Crisis
| Fiscal Policy | Monetary Policy |
---|---|---|
Great Depression |
|
|
Great Depression |
|
|
2008 Financial Crisis |
|
|
2008 Financial Crisis |
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|
Strengths & Weaknesses of Demand-side Policies
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
Examiner Tips and Tricks
When evaluating any demand-side policy, avoid generalisations and focus on the effects of the specific policy mentioned. To strengthen any response, fully develop each transmission mechanism as this is part of your 'chains of reasoning'. Always conclude by explaining the likely impact on the real GDP and average price levels.
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