demand-side-policies

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 (opens in a new tab)

• 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 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