Demand-Side Policies – AS/A LEVELS/IB/IAL
Demand-Side Policies – AS/A LEVELS/IB/IAL
Level: AS Levels, A Level, GCSE – Exam Boards: Edexcel, AQA, OCR, WJEC, IB, Eduqas – Economics Revision Notes
Demand-Side Policies
Demand side policies impact the aggregate demand (AD) curve.
There are two demand side policies:
- Fiscal Policy – This is the control of government spending and taxation
- Monetary Policy – This is the manipulation of interest rates and money supply
Fiscal Policy
Fiscal Policy is controlled by the government and is used to manipulate the economy. Fiscal Policy is also used by the government to help it achieve its macro-economic objectives.
Fiscal Policy is also the governments budget policy. They decide on how, what and where to spend this budget on the economy. E.g. defence, healthcare and education. They must also decide on tax rates for individuals and firms.
Key terms – Fiscal Policy
Expansionary/ Reflationary/ Loose Fiscal Policy
This occurs when government spending is greater than taxation.
Contractionary/ Deflationary/Tight Fiscal Policy
This occurs when taxation is greater than government spending.
Discretionary (Fiscal) Policy
This occurs when the government purposely changes government spending or taxation.
Fiscal (Budget) Deficit
This occurs when government spending is greater than tax revenues collected.
Fiscal (Budget) Surplus
This occurs when tax revenues are greater than government spending.
Automatic (Fiscal) Stabilisers
During a recession government spending will automatically increase through benefit payments e.g. JSA. The government will also automatically receive less tax revenue due to less people being employed and paying taxes.
Problems with Fiscal Policy
- Time lags – Fiscal policy takes time to impact the economy.
- The budget is set once a year compared to the economic cycle which is continually changing.
- Poor information can lead to poor budget planning and decisions by the government.
Monetary Policy
Monetary Policy is the manipulation of interest rates and money supply.
Monetary Policy is set by the Bank of England’s Monetary Policy Committee (MPC). The committee has nine members who meet on a monthly basis to discuss whether interest rates should be increased or decreased. The MPC are also responsible for trying to achieve the UK’s inflation target of 1-3%.
Monetary Policy is a demand-side policy that impacts aggregate demand (AD).
Key Terms – Monetary Policy
Expansionary/ Inflationary/Loose – Monetary Policy
This occurs when the MPC decides to reduce interest rates to stimulate growth. This causes a shift to the right of the AD curve.
Contractionary/ Deflationary/Tight – Monetary Policy
This occurs when the MPC decides to increase interest rates to slow down growth. This causes a shift to the left of the AD curve.
Monetary Policy – Impacts of changes in Interest rates
Reduction in interest rates
- A decrease in interest rates will help to stimulate growth in the UK economy.
- A decrease in rates will encourage consumers to borrow rather than save.
- Low rates will encourage borrowing as consumers and businesses will have to pay back less interest on money borrowed.
- This will increase consumption (C) and investment (I) and shift the AD curve to the right.
Increase in interest rates
- An increase in interest rates will slow down growth in the UK economy.
- A decrease in interest rates will encourage consumers to save rather than borrow.
- High rates will encourage saving as consumers and businesses will earn high levels of interest on savings.
- High rates will discourage borrowing as more interest would have to be paid back on money borrowed.
- Therefore higher interest rates would decrease consumption (C) and investment (I) and shift the AD curve to the left.
Monetary Supply – Quantitative Easing
- Increase in Money Supply – the Bank of England buys assets in exchange for money, with the intention of increasing the money supply. One way the Bank of England can buy assets is by increasing the ‘reserves’ that banks hold, encouraging them to lend more money
- Quantitative Easing can help to prevent a Liquidity Trap from occurring
- Asset Prices rise – there is a rise in demand for assets as banks buy more, hence asset prices increase, causing a positive wealth effect. The cost of borrowing will also reduce as there are now lower yields, making it cheaper for households and firms to finance their spending
Problems with the Monetary Policy
- Time Lag – changes in interest rates can up to 2 years to have their full effect
- Balance of Trade Deficit – exchange rate may be heavily affected, causing exports to fall and imports to rise – worsening the Balance of Trade Deficit
- Severely low interest rates – if interest rates are extremely low, they cannot be decreased any further to stimulate aggregate demand
- Hyperinflation – if quantitative easing methods are not controlled properly, it could lead to hyperinflation
- Housing Market – greater aggregate demand leads to rapid price increases, worsening the issues surrounding geographic mobility
- Inequality – the inequality between the rich and poor widens due to higher share prices
- No guarantee that higher asset prices will stimulate higher consumption – if consumer confidence is extremely low, there is no guarantee that higher asset prices will lead to higher consumption
The role of the Bank of England
Monetary Policy Committee (MPC)
- The MPC are in control of decisions regarding the Bank of England base rate and actions over quantitative easing
- Keeping inflation at 2% is the main aim of the MPC
- The MPC consists of nine people
Demand-side Policies in The Great Depression and Global Financial Crisis 2008
- The MPC has kept the bank base rate at 0.5% and has focused on boosting economic growth / employment
- Brexit – bank base rate was reduced to 0.25%, but then rose in November 2017 due to the inflation caused by the weak pound
The Great Depression
- UK Government enforced a rise in income tax from 22.5% to 25% and reduced their public sector wages, in order to help balance their budget – however this worsened the situation due to the deflationary pressures caused and the fall of consumer purchasing power
- UK’s pound depreciated by 25% and made the country more competitive due to the abandonment of the gold standard
- UK Government also reduced interest rates, which improved the state of the economy
- US enforced a Contractionary Monetary Policy, causing the money supply to fall
- Shortly after WW2, the US government used the Expansionary Fiscal Policy as they were spending on the war, which helped to stop The Great Depression
- US increased its expenditure on public infrastructure and employment
- US reduced their interest rates from 6% to 4%
The Global Financial Crisis
- UK used the Expansionary Fiscal Policy to help increase consumer spending – VAT reduced from 17.5% to 15%
- UK Government borrowing increased due less tax revenue being generated
- UK interest rates were at 5% when the crisis started, however reduced to 0.5% shortly after
- The Bank of England enforced a program of Quantitative Easing, where initially £75bn was injected into the economy
Direct and Indirect Taxation
- Direct Taxation – these are paid directly to the government by the taxpayer (e.g income tax)
- Indirect Taxation – the person charged with paying the tax is able to pass it onto someone else; a third party is responsible for paying the tax (e.g VAT)
Quick Fire Quiz – Knowledge Check
1. Define a ‘Demand-side Policy’ (2 marks)
2. State the two Demand-Side Policies (2 marks)
3. Explain what a Fiscal Policy is (4 marks)
4. Explain what a Monetary Policy is (4 marks)
5. Distinguish between what an ‘Expansionary Fiscal Policy’ is, and a ‘Contractionary Fiscal Policy’ is (4 marks)
6. Distinguish between what an ‘Expansionary Monetary Policy’ is, and a ‘Contractionary Monetary Policy’ is (4 marks)
7. Explain the impact of Automatic (Fiscal) Stabilisers (4 marks)
8. Examine the problems surrounding the Fiscal Policy (4 marks)
9. Explain the impacts of changes in the interest rates (8 marks)
10. Explain how Quantitative Easing is used within the Monetary Policy (4 marks)
11. Explain some of the problems with implementing the Monetary Policy (6 marks)
12. Explain the role of the Bank of England (4 marks)
13. Explain some of the UK’s demand-side policies used during The Great Depression (4 marks)
14. Explain some of the US’s demand-side policies used during The Great Depression (4 marks)
15. Explain some of the UK’s demand-side policies used during The Global Financial Crisis (4 marks)
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