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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.