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3.4 Demand-side and Supply-side Policies
A. Shifts in the AD curve/demand-side policies
a. Fiscal policy
i. Behavior in gov’t in raising money to fund current spending and
investment for collective social purposes and for transfer payments
to citizens and residents
ii. Automatic fiscal stabilizers are tax revenues that rise and benefits
that fall as national income rises. They have the effect of reducing
the size of the multiplier and thus reducing cyclical upswings and
downswings.
iii. Discretionary fiscal policy is where the government deliberately
changes taxes or government expenditure in order to alter the level
of aggregate demand.
1. Changes in government expenditure on goods and services
will have a full multiplier effect.
2. Changes in taxes and benefits will have a smaller multiplier
effect as some of the tax/benefit changes will merely affect
other withdrawals and thus have a smaller net effect on
consumption of domestic product.
iv. Expansionary policies are used to increase AD to increase the
equilibrium level of output, increasing the amount of labor and
decreasing unemployment
v. Contractionary policies are used to decrease AD to reduce the
inflationary pressure that is caused when PL rises
vi. Weaknesses
1. There are problems in predicting the magnitude of the
effects of discretionary fiscal policy. Expansionary fiscal
policy can act as a pump primer and stimulate increased
private expenditure, or it can crowd out private
expenditure. The extent to which it acts as a pump primer
depends crucially on business confidence – something that
is very difficult to predict beyond a few weeks or months.
The extent of crowding out depends on monetary
conditions and the government’s monetary policy.
2. There are five possible time lags involved with fiscal
policy: the time lag before the problem is diagnosed, the
lag between diagnosis and new measures being announced,
the lag between announcement and implementation, the lag
while the multiplier and accelerator work themselves out,
and the lag before consumption fully responds to new
economic circumstances.
3. Net export effect- occurs under an expansionary fiscal
policy. If gov’t enters the money market to finance the
deficit, interest rate will rise. The higher interest rate causes
the dollar to appreciate, so net exports decline, and AD
decreases.
b. Monetary Policy
i. Federal Reserve controls the quantity of money supply in
economy
ii. The money supply can be reduced directly by using open-market
operations (OMO). This involves selling more government
securities and thereby reducing banks’ reserves when their
customers pay for them from their bank accounts. Or it could use
funding, by increasing the sale of bonds relative to bills, thereby
reducing banks’ liquid assets
iii. In a recession, the decreases in discount rates or reserve rates cause
the money supply to increase. As the Q of money demand
increases this causes the AS to shift to the right. As the interest
rates decrease this will cause more investments.
iv. Weaknesses
1. The money supply is difficult to control precisely, and even
if it is successfully controlled, there then arises the problem
of severe fluctuations in interest rates if the demand for
money fluctuates and is relatively inelastic.
2. The case against discretionary policy is that it involves
unpredictable time lags, which can make the policy
destabilizing. The government may as a result overcorrect.
Also the government may ignore the long-run adverse
consequences of policies designed for short-run political
gain.
B. Shifts in the AS curve/supply-side policies
a. Market oriented supply side policies- markets operate freely with min.
government intervention. Usually increase incentives, another name for
these policies, for labor to work harder and be more productive.
i. Reduction in income taxes
1. If ppl work harder and make more money, it is possible that
they will have to pay higher taxes on the higher levels of
income
ii. Reduction in corporation taxes
1. If businesses and firms make more profit then they will
have more money to invest. Investment increases the
capital stock to the economy, increasing the potential
output. The keeping of profits instead of giving it to the
government through taxes gives firms more incentive to
produce efficiently
iii. Reduction in trade union power
1. Reduction in trade union powers will reduce the ability of
unions to negotiate higher wages and this will cause lower
costs of production to firms, increasing their potential
output
a. The lowering of union powers might lead to
exploitation of workers
iv. Reduction or elimination of minimum wages
1. Min. wage will keep the price of labor above the free
market level. If there was no min. wage then this would
decrease the costs of production and increase AS
a. This will cause a reduction in standard of living
v. Reduction in unemployment benefits
1. Assurance of government benefits gives less incentives to
find jobs.
vi. Deregulation
1. When govt have regulations on the operations of firms,
then this may increase their cost of production, reducing the
AS. A reduction of regulations would lower their costs,
increasing their AS
vii. Privatization- sale of public, government-owned firms, to the
private sector
1. Privately-owned profit maximizing firms will be much
more efficient and productive than government
b. interventionist supply side policies- govt is needed to actively encourage
growth
i. education and training
1. provided the labor force with necessary skills and
knowledge to reach efficient production
ii. Research and development
1. Firms need to be up-to-date with modern developments, to
develop new production techniques and constantly seek
improved methods of production, increasing the potential
output
2. govt gives firms tax incentives known as tax credit for
research and development. Some firms do not use this tax
C. The Multiplier Effect:
a. The multiplier effect is the shift in aggregate demand resulting from
government spending which is greater that would be seen as a direct result
of the expanded money supply. The multiplier effect takes place when
expansionary fiscal policy is enacted. The cycle begins with increased
government spending which in turn increases incomes and therefore
consumer spending. This rise in consumer spending results in more jobs
and higher profits for the corporations that produce such consumer goods.
In essence, the multiplier effect means that a dollar spent by the
government raises the aggregate demand for goods and services by more
than a dollar.
b. The formula for Calculating the Multiplier:
1
1  MPC 
The MPC is the marginal propensity to consume which is the fraction of extra income
that a household consumes rather than saves. If marginal propensity to consume is ¼ then
for every additional dollar a household receives it will spend $0.25
Multiplier 
The larger the MPC the greater the multiplier effect on aggregate demand.
Price Level
AD3
AD2
Quantity of Output
AD1
D. Accelerator
a. The accelerator effect is a positive effect on Gross Domestic Product
resulting from a positive effect on private fixed investment, or the amount
of real capital goods used in production or to replace depreciated capital
goods, of the growth of the market economy. An increase in GDP shows
that businesses are experiencing higher profits and are producing more
efficiently. This should lead to greater business expansion an employment
of more workers. This increase in employment and wages will result in an
increase in aggregate demand in the same manner as the multiplier effect.
b. The accelerator effect also applies to falling GDP. This is because a
recession hurts business profits and consumer confidence. As a result
fixed investment decreases and aggregate demand shifts in exacerbating
the recession.
c. Formula to Calculate the Accelerator:
In = x*(Kd - K-1)
In = net investment
X = the coefficient of adjustment and is between 0 and 1
Kd= the desired stock of capital goods
K1= the existing stock of capital goods left over from the fact
E. Crowding Out Effect:
a. The crowding out effect is the opposition to the multiplier effect. It is the
downward pressure on aggregate demand which results from expansionary
fiscal policy. Crowding out occurs when expansionary fiscal policy raises
interest rates and thereby reduces investment spending. This occurs
because; with higher government spending increases incomes. This
increase in income leads to higher demand for consumer goods. However,
this increase in demand for consumer goods also leads consumers to raise
the demand for money. This increased demand for money, given that the
government has not increased the money supply results in the shift shown
in graph A. This shift causes interest rates to rise which in turn decreases
demand for goods and services. Therefore the crowding out effect partially
negates the positive impact on aggregate demand of the government
investment.
Graph A
Interest
Rate
Money
Supply
MD2
Quantity of Money
MD1
Crowding Out Effect Graph
Price Level
AD2
AD3
AD1
Quantity of Output
$700 billion doesn’t go far in bad times
http://articles.latimes.com/2008/oct/05/business/fi-econ5
On October 17 2008, the $700 billion financial rescue plan was passed by the
Congress to aid the many financial giant companies from bankruptcy and crashing to the
ground. The financial plan is planned to help the United States’ economy from
plummeting into a recession, in which a country's GDP, or gross domestic product,
sustains a negative growth factor for at least 2 consecutive quarters, a fall in real output
for a period of 6 months. The decision of the government to spend 700 billion dollars into
the economy is known as fiscal policy; the behavior of the government in raising money
to fund current spending and investment for collective social purposes and for transfer
payments for citizens for which the government is responsible.
The idea of increasing government spending is to regulate and try to manipulate
the economy. The government can increase aggregated demand, the total amount of
spending on goods and services in the economy during a stated period of time that makes
up the gross domestic product (GDP), the market value of all final goods and services
produced within a country in a given period of time, through cutting tax rates and, or
increasing government spending. Aggregate demand (AD) is the total demand for final
goods and services in the economy at a given time and price level. AD curve can be
shifted by changes in the sum of consumption expenditure, which can be wealth,
expectation, household debts or taxes, investment expenditure, which can be interest rate,
profit expectation, business taxes, or technology excess capacity, government
expenditure, and net exports, which is the income abroad or exchange rates.
Using the Keynesian approach to alleviate a recession, the government should
run an expansionary fiscal policy or a deficit, when government spends more than is
generated in revenue, during recession to stimulate the economy. The government
increases its purchases but keeps taxes constant; it increases demand directly, which
shifts the AD curve to the right. The bailout plan is suppose to help promote fullemployment, price stability, and economic growth. As seen on the graph below. Point A
shows the economy in a recession. AD demand shifts to the right to point B, reaching the
natural rate of output (NO), which causes the decrease in unemployment to its natural
rate (NU). The economy will encounter a slight increase in price levels and inflation.
In the article, however, Peter Gosselin states that the expected outcome of the
financial rescue plan is the direct opposite. Although the fiscal policy has been successful
in the past it is not always dependable and predicable. The effectiveness of fiscal policy
depends on confidence of the consumers and the effectiveness of recognizing the
recession, not allowing the lagging time to be so great. If consumers are pessimistic about
the future, tax cuts or increased household income may not be spent but saved. The fear
of recession causes consumers to purchase less. As demand for the products decrease, the
producers begin to lose revenue and are forced to produce less and cut jobs to save
money. The decrease in consumption causes the AD curve to shift left. The aggregated
supply curve, the total of all goods and services, including exports and imports, supplied
at every price level, within a national economy during a given period, is shifted inward as
well because of the decrease in productivity. This causes a slow economic growth that
Gosselin predicts. From the graphs below, the inward shifts of the AD curve and the AS
curve causes GDP to decrease, preventing the economy to grow. As point A moves to
point B because of the inward shift of AD, the decrease in AD causes the productivity to
decrease. This decrease causes the AS curve to shift inward to point C. Price levels are
undetermined but inflation in decreased. The double shift inward causes GDP to
decrease, and in the long run, economic growth will contract.