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KEY CONCEPTS AND SKILLS:
Unit 2.4 – Demand and Supply Side Policies
Notes:
o This unit is covered in Chapter 12 of the textbook.
o You don’t need to know the Keynesian ratchet effect (pg. 324).
o (HL) The Keynesian multiplier section in the book (pgs. 325 – 326) is way too complicated.
Just remember that the final effect of a government spending program will be the spending
times the multiplier.
Definitions:
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Government Spending:
o Current expenditure: government spending on day-to-day, recurring items and
items that are used up as a good or service is provided (e.g., employee salaries,
medical supplies)
o Capital expenditure: public investments, or the production of physical capital such
as building roads, hospitals, etc.
o Transfer payments: payments made by the government to individuals specifically
for the purpose of redistributing income (e.g., payments to elderly or disabled people
or children)
Government Budget: a balance of a government’s tax revenues and expenditures over a
period of time (usually a year)
o Balanced Budget: if a government’s tax revenues equal its expenditures over a
given time period
o Budget Deficit: if a government’s tax revenues are less than its expenditures over
a given time period
o Budget Surplus: if a government’s tax revenues are greater than its expenditures
over a given time period
o Public (or Government) Debt: the total amount owed by a government to all
creditors; equal to the accumulation of budget deficits less budget surpluses
Fiscal Policy: Manipulations by the government of its own expenditures and taxes to
influence the overall level of aggregate demand.
o Automatic Stabilizers: factors that automatically, without any action by the
government, work towards stabilizing the economy by reducing short-term
fluctuations in the business cycle
o Crowding out: a situation where increased government spending is financed by
new government debt, thereby increasing interest rates and reducing investment
spending by businesses
Monetary Policy: measures undertaken by central banks to influence aggregate demand,
including adjusting interest rates and the money supply
o Interest rate: the price of capital, or the price of borrowed/loaned money (usually
expressed as a percentage)
o Money: anything that can be accepted as payment for goods and services (e.g.,
coins, paper currency, funds in checking accounts)
Supply-Side Policies: policies that focus on improving long-run growth by increasing
long-run aggregate supply
o Interventionist supply-side policies: any policy based on government intervention
in the market intended to affect the supply-side of the economy
o Market-based supply-side policies: any policy based on promoting wellfunctioning, competitive markets in order to affect the supply-side of the economy
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o Industrial Policy: government policies designed to support the growth of the
industrial sector of the economy; for example, support for small companies through
tax cuts, grants, or other measures
o Privatization: a transfer of ownership from the public sector (the government) to the
private sector
o Deregulation: policies to eliminate or reduce government regulation (i.e.,
supervision and/or restriction) of private sector activities
Infrastructure: essential facilities and services such as roads, airports, water,
telecommunications, and other utilities typically provided by the government
Concepts and Applications:
A. Government Budgets (pgs. 320 – 322)
1. Outline the sources of government revenue.
2. Explain how government spending can be classified into current expenditures, capital
expenditures and transfer payments, providing examples of each.
3. Distinguish among a budget deficit, a budget surplus, and a balanced budget.
4. Explain the relationship between budget deficits/surpluses and the public (government)
debt.
5. Explain why taxes are the only revenue source usually reflected in surplus/deficit
calculations.
B. Fiscal Policy (pgs. 322 – 329)
1. Explain how changes in the level of government expenditure and/or taxes can influence the
level of aggregate demand in an economy.
2. Using a diagram, explain how expansionary fiscal policy can help close a deflationary
(recessionary) gap.
3. Explain the cost(s) of expansionary fiscal policy.
4. Using a diagram, explain how contractionary fiscal policy can help close an inflationary
(recessionary) gap.
5. Explain the differences in assumptions regarding fiscal policy in the monetarist / new
classical model versus the Keynesian model.
6. Outline how the shape of the Keynesian aggregate supply curve will affect the market
outcomes (i.e., output and price) resulting from expansionary or contractionary fiscal policy.
7. Explain how the progressive tax system and unemployment benefits automatically help to
stabilize short-term fluctuations.
8. (HL) Explain how the marginal propensity to consume influences the effectiveness of a
fiscal program.
9. Explain how fiscal policy can promote long-term growth both indirectly (by creating an
investment-friendly environment) and directly (via government spending on human and
physical capital).
10. Evaluate the effectiveness of fiscal policy.
11. Using a diagram, explain “crowding out”.
12. Explain why decisions regarding fiscal policy measures depend on more than just shortterm economic considerations.
C. Monetary Policy (pgs. 330 – 338)
1. Describe the usual functions of a central bank.
2. Explain, using a supply and demand diagram, how equilibrium interest rates are
determined.
3. Explain how a central bank can influence the equilibrium interest rate.
4. Using a diagram, explain how an expansionary (easy) monetary policy can help an
economy close a deflationary (recessionary) gap.
5. Using a diagram, explain how a contractionary (tight) monetary policy can help an economy
close an inflationary gap.
6. With reference to the Keynesian AS/AD diagram, explain how the shape of the aggregate
supply curve influences the outcome of monetary policy.
7. Evaluate the effectiveness of fiscal policy.
8. Explain why neither fiscal policy nor monetary policy is well suited for dealing with problems
caused by decreases in short-run aggregate supply.
9. Explain the advantages and disadvantages of inflation targeting.
D. Supply-Side Policies (pgs. 338 – 345)
1. With reference to the long-run AD-AS diagram, outline the intended effects of supply-side
policies on real output, price level and unemployment.
2. Outline the difference between interventionist and market-based supply-side policies.
3. Explain how supply-side policies are related to the long-run effects of fiscal policy.
4. Provide examples of the following types of market-based supply-side policies and explain
how they are intended to improve long-run aggregate supply:
o encouraging competition
o labor market reforms
o tax incentives
5. Outline why supply-side policies might have an advantage over demand-side policies for an
economy experiencing stagflation.
6. Explain the limitations of interventionist supply-side policies.
7. Explain the criticisms and limitations of market-based supply-side policies.
8. When have market-based supply-side policies been tried in the past? Outline the results.
E. Conclusion
1. Evaluate the usefulness of i) fiscal policy, ii) monetary policy, and iii) supply-side policies in
addressing the main goals of government policy:
o Low unemployment
o Low and stable inflation
o Growth of real output
o Equity in the distribution of income
2. Evaluate the effectiveness of these three policies for addressing stagflation.