Demand-Side Policies

This section explains demand-side policies covering, the distinction between monetary and fiscal policy, and the strengths and weaknesses of demand-side policies.  Demand-side policies are designed to manage the overall level of demand in the economy, aiming to influence aggregate demand (AD). These policies are used to stabilise the economy, reduce unemployment, and control inflation by targeting the components of AD: consumption, investment, government spending, and net exports. Demand-side policies can be monetary or fiscal, each employing different tools and strategies.

Distinction Between Monetary and Fiscal Policy

Monetary Policy
Monetary policy refers to the actions taken by a country’s central bank (in the UK, the Bank of England) to control the money supply and interest rates to influence economic activity. Its main objective is to maintain price stability (low and stable inflation) and support economic growth.

Fiscal Policy
Fiscal policy involves government decisions on public spending and taxation. The goal of fiscal policy is to influence the level of aggregate demand (AD) and economic activity. Governments use fiscal policy to manage the economy, either stimulating it in times of recession or cooling it during periods of inflation.

Monetary Policy Instruments

The Bank of England uses several instruments to influence aggregate demand, including:

Interest Rates:

• The monetary policy committee (MPC) of the Bank of England sets the official bank rate, which influences interest rates across the economy. By raising or lowering interest rates, the MPC can affect borrowing costs for consumers and businesses, thereby influencing their spending and investment decisions.
• Lower interest rates: Encourage borrowing and spending, leading to higher aggregate demand and economic activity. This is typically used in times of recession.
• Higher interest rates: Discourage borrowing and spending, helping to control inflation. This is typically used when the economy is overheating.

Example: In response to the Global Financial Crisis of 2008, the Bank of England lowered interest rates to historic lows to stimulate economic activity.

Asset Purchases to Increase the Money Supply (Quantitative Easing):

• Quantitative easing (QE) involves the central bank purchasing assets, such as government bonds, from commercial banks and other financial institutions. This increases the money supply and encourages banks to lend more freely, thus stimulating investment and consumption.
• The goal is to lower long-term interest rates, increase the money supply, and boost economic demand when interest rates are already low and traditional monetary policy tools are less effective.

Example: In the aftermath of the Global Financial Crisis of 2008, the Bank of England implemented QE to inject money into the economy, as interest rates were already near zero.

Fiscal Policy Instruments

Fiscal policy is concerned with government spending and taxation decisions to influence aggregate demand. The main instruments include:

Government Spending:

• The government can increase spending on public services, infrastructure, and welfare, which directly boosts aggregate demand. Increased government spending creates jobs and can have a multiplier effect on the economy.
• Example: During a recession, the government may decide to invest in public infrastructure projects, such as roads or schools, to stimulate economic activity.

Taxation:

• By changing tax rates, the government can influence consumer spending and business investment. Lower taxes generally encourage more spending, while higher taxes tend to reduce disposable income and consumption.
• Example: A reduction in income tax might lead to higher disposable income, boosting consumer spending and increasing aggregate demand.

Distinction Between Government Budget (Fiscal) Deficit and Surplus

Fiscal Deficit:

• A deficit occurs when government expenditure exceeds government revenue (e.g., tax receipts). To finance the deficit, the government may need to borrow money, often through the issuance of government bonds.
• A fiscal deficit can be used to stimulate the economy, especially during periods of economic downturn, as higher government spending can boost demand.

Example: During the Global Financial Crisis of 2008, many governments ran fiscal deficits to finance stimulus packages aimed at reviving economic growth.

Fiscal Surplus:

• A surplus occurs when government revenue exceeds expenditure. This situation typically arises when the economy is growing strongly and tax revenues increase, while government spending remains stable.
• A fiscal surplus may be used to pay down national debt or to reduce taxes.

Example: In times of economic expansion, such as the pre-financial crisis period, the government might run a fiscal surplus to strengthen public finances.

Distinction Between, and Examples of, Direct and Indirect Taxation

Direct Taxation:

• Direct taxes are levied directly on individuals or businesses and are paid directly to the government. These include income tax, corporation tax, and inheritance tax.
• These taxes are progressive, meaning the tax rate increases as income or profits increase.

Example: Income tax is a direct tax as it is paid directly by individuals based on their earnings.

Indirect Taxation:

• Indirect taxes are taxes on goods and services, paid by consumers at the point of sale. The seller collects the tax and passes it on to the government. Common examples are Value Added Tax (VAT) and excise duties.
• Indirect taxes are generally regressive, meaning they take a larger percentage of income from lower-income households.

Example: VAT is an indirect tax that is added to most goods and services in the UK.

Use of AD/AS Diagrams to Illustrate Demand-Side Policies

Demand-side policies aim to shift the aggregate demand (AD) curve in order to influence the level of economic output and employment. These policies are illustrated using AD/AS (Aggregate Demand/Aggregate Supply) diagrams:

Monetary Policy (Shifting AD):

• Lower interest rates shift the AD curve to the right, increasing consumption and investment. This is often used during periods of recession or low inflation.
• Higher interest rates shift the AD curve to the left, reducing consumption and investment to control inflation.

Fiscal Policy (Shifting AD):

• Increased government spending shifts the AD curve to the right, increasing economic output and employment.
• Tax reductions also shift the AD curve to the right by increasing disposable income and boosting consumption.

The Role of the Bank of England

Monetary Policy Committee (MPC):

• The Monetary Policy Committee is responsible for setting the official bank rate in the UK. The MPC’s primary goal is to achieve the government’s inflation target (currently 2%) while also supporting economic growth and employment.
• The MPC meets regularly to assess economic conditions and adjust monetary policy as needed, using tools like interest rates and quantitative easing.

Example: If inflation is rising above target, the MPC may decide to increase interest rates to reduce demand and bring inflation back in line with the target.

Awareness of Demand-Side Policies in the Great Depression and the Global Financial Crisis of 2008

The Great Depression (1930s):

• During the Great Depression, demand-side policies were largely absent or underdeveloped. However, in response to the downturn, New Deal programmes in the US focused on public works and government spending to boost demand and provide jobs. These policies were designed to stimulate economic activity and combat widespread unemployment.

Example: In the US, President Roosevelt’s New Deal included large-scale infrastructure projects to create jobs and stimulate demand.

The Global Financial Crisis (2008):

• In response to the 2008 financial crisis, demand-side policies were heavily used in both the US and the UK. Central banks implemented monetary easing (lowering interest rates and introducing quantitative easing), while governments introduced fiscal stimulus packages to boost demand, such as increased government spending and tax cuts.

Example: The UK government, under Prime Minister Gordon Brown, introduced a stimulus package in 2008, including increased public sector investment and cuts in VAT, while the Bank of England slashed interest rates and initiated quantitative easing.

Strengths and Weaknesses of Demand-Side Policies

Strengths:

Effective in Recessions: Demand-side policies, particularly fiscal stimulus and monetary easing, can be highly effective in boosting economic activity and reducing unemployment during recessions.

Support for Recovery: Policies like government spending and interest rate cuts can help recover from economic downturns by increasing demand in the economy, boosting investment, and stimulating consumer spending.

Weaknesses:

Time Lags: Both monetary and fiscal policies take time to implement and take effect, meaning their impact may be delayed, particularly in the case of fiscal policy.

Inflation Risk: Over-reliance on demand-side policies can lead to inflation if demand grows too quickly relative to supply, especially if the economy is already operating close to full capacity.

Government Debt: Persistent fiscal deficits, if used to fund demand-side policies, can lead to higher public sector debt, raising concerns about long-term sustainability and future tax burdens.

Effectiveness in Long-Term Growth: While effective in managing short-term fluctuations, demand-side policies alone may not lead to sustained long-term economic growth. Supply-side reforms (such as improving productivity) may also be necessary.

Summary

Demand-side policies are essential tools for managing aggregate demand and stabilising the economy. By influencing consumer spending, investment, and government expenditure, these policies can be used to tackle inflation, reduce unemployment, and stimulate economic growth. However, the effectiveness of these policies depends on the broader economic context and the ability of policymakers to manage potential trade-offs, such as inflation and government debt.