Demand-Side Policies (Edexcel A Level Economics A)

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

  • 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

• 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

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 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

Government Budget (Fiscal) Deficit & 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 & Indirect Taxation

• 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.

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

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

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