Demand-Side Policies

Demand-Side Policies

__Demand-side policies __refer to the ways in which the government can intervene in the economy to achieve its macro-economic objectives by manipulating the level of aggregate demand (AD).

There are two broad sets of demand side policies:

  1. Monetary policy – Controlling the availability of credit (borrowing) in the economy and its price (interest rates)
  2. Fiscal policy – Changes in government spending and taxation.

Monetary Policy

Monetary policy is not under the direct control of the government; it has been delegated to the Bank of England (B of E), the central bank for the UK. This gives the B of E independence from political pressure so it can concentrate on its main task of keeping inflation at the target level set by the government. Other major economies such as the USA and euro zone have also handed control of monetary policy to their central banks. Central banks that are not independent of government may be required to take measures (such as cutting interest rates) to improve the government’s popularity, which may cause problems or the economy later on.

Interest Rates – a Monetary Policy Instrument

In the U.K. the Monetary Policy Committee (MPC) of the B of E meets once a month to set Base Rate_, _which is the most important interest rate in the economy. The MPC comprises nine members, five of whom (including the Governor) are from the B of E. The other 4 are independent economists. It is the rate at which the B of E will lend to the major banks in the U.K. The B of E is the lender of last resort, which means that a bank in difficulty can borrow from the B of E to avoid a collapse that would threaten confidence in the entire banking system.

If the B of E raises Base Rate, the commercial banks will protect themselves from the risk of the higher cost of borrowing by raising their own lending rates to borrowers. If they are charging borrowers more, competition between the banks will force them to offer savers higher rates too. Equally, a fall in Base Rate enables them to lower their lending rates in order to attract more customers. The banks will then also have to lower the rates they pay to savers in order to restore their profit margins. (Essentially, banks make a profit by borrowing from savers at a low rate of interest and lending this money to other customers at a higher rate).

Demand-Side Policies, figure 1

It follows from this that interest rates throughout the economy are influenced by changes in Base Rate. Changes in interest rates will affect the overall level of aggregate demand [C+I+G+(X-M)] as all the components of AD are likely to change:

Consumption_ – _A rise in interest rates is likely to cause consumption to fall and vice versa. Higher interest rates increase the cost of borrowing, which is important for ‘big ticket’ items such as cars and furniture. Higher interest rates also make saving more attractive (and therefore make consumption less attractive). Interest rate changes also affect consumption through ‘wealth effects’; lower rates drive up prices of assets such as houses and shares, encouraging more consumption and vice versa.

Investment_ – _A fall in rates will encourage investment and vice versa.

Net exports (X-M)_ – A fall in interest rates may cause the exchange rate to fall. _This should make exports more competitive and imports less competitive, leading to a rise in net exports.

The Inflation Target

The B of E is set an inflation target by the government. Since 1997 this target has stayed at 2%. If inflation varies by more than 1% from this target (ie below 1% or above 3%) the Governor of the B of E has to write an open letter to the Chancellor explaining why it has happened and what measures the Bank will take to bring the rate back to target.

If inflation is above target, the B of E can raise interest rates in order to reduce AD. This should then result in a fall in equilibrium output and a fall in the price level - ie lower inflation. If inflation is too low, the B of E can lower interest rates to stimulate AD and push inflation up.

Demand-Side Policies, figure 1

The MPC of the B of E looks at economic forecasts to try to predict the likely course of inflation in the period ahead. It does not just react to the current rate of inflation when setting base rate. It may raise base rate in an attempt to head off a possible increase in inflation.

Although meeting the inflation target is the B of E’s major responsibility, it is not always the only consideration when setting interest rates, particularly when the economy is facing exceptional circumstances. After the banking crisis of 2007/8, which plunged the economy into a very severe recession, base rate was cut to 0.5% in 2009 (the lowest in the Bank’s 300 year history). Base rate stayed at 0.5% until 2016, when it was lowered even further to 0.25%. For much of the period, inflation was above target (reaching 5% in 2011), but the Bank took the view that the inflationary pressures were temporary, and caused by cost push factors, such as high oil prices, rather than excess demand.

Fiscal Policy

Fiscal policy (decisions about government spending and taxation) is directly under the control of the government (in the UK, the Chancellor of the Exchequer and The Treasury).

Government spending accounts for around 40% of GDP, so changes in it can have a big impact on AD. Spending on the pensions and benefits, the NHS, education, law & order and defence are the biggest components of government spending.

Demand-Side Policies, figure 1

Tax revenues usually take a slightly lower percentage of GDP, as in most years the government borrows to finance some of its expenditure.

Taxes fall into two categories. Direct taxes __are taxes on income and wealth. The major direct taxes are income tax, national insurance and corporation tax. __Indirect taxes are taxes on spending. The main indirect taxes are VAT and excise duties on alcohol, tobacco and fuel. Taxes on imports from outside the EU (called tariffs) are also indirect taxes.

Direct taxes are collected directly from the person or company that has to pay them. Indirect taxes are collected from the seller, who may be able to pass some, or all of the tax on to the buyer (by including it in the price of the good).

The government can increase or reduce taxes or spending in pursuit of its macroeconomic objectives. It can influence the overall level of AD by running a budget surplus or deficit.

A budget surplus means that government spending (G), is greater than tax revenue (T). This would reduce the overall level of AD, as the withdrawal (T) is greater than the injection (G).

A budget deficit will have the opposite effect.

Measures to increase a budget deficit or reduce a budget surplus are described as expansionary fiscal policy_, _whilst reducing a budget deficit, or increasing a surplus is called a contractionary fiscal policy.

A neutral fiscal policy __means that the overall effect of any changes in spending or taxes leaves the budget balance unchanged, and therefore has no effect on AD. The __fiscal stance can therefore be described as expansionary, contractionary or neutral.

Quantitative Easing

During the banking crisis of 2007/8 and the subsequent deep recession that affected most of the rich countries (especially North America and Europe), central banks all cut interest rates to record lows, close to zero.

The severity of the banking crisis caused a big reduction in banks ability and willingness to lend. This deepened the recession as finance for business investment, mortgages and consumer credit dried up.

The sharp fall in interest rates proved insufficient to stimulate demand, in part because of banks unwillingness to lend. They had become over cautious in lending, whereas previously they had not been cautious enough.

Central banks therefore deployed another policy instrument: - quantitative easing (QE). Central banks have the unique power to ‘print’ money (this means creating deposits, rather than printing bank notes).

The B of E created hundreds of billions of pounds in new money, which it used to buy financial assets from the banks. This injected huge amounts of money into the banking system for the banks to lend out to businesses and households.

Demand-Side Policies, figure 1

The financial assets were mainly bonds. (a form of long term borrowing by the government and large companies). Bonds earn a fixed interest payment. It therefore follows that if the price of the bonds rises, the effective rate of interest, called the yield, goes down. For instance, a fixed interest of £10 on a bond whose market price is £100 gives a yield of 10%. if the price goes up to £200, the yield falls to 5%.

QE therefore also contributed to driving down interest rates in the economy, as well as enabling the banks to lend more.

A third effect of __QE __is on the exchange rate; the big increase in the supply of sterling, and the fall in interest rates makes the currency less attractive to investors, so it falls in value against other currencies. This should also help to stimulate AD. However, if all major economies are pursuing __QE __and the supply of all currencies increases, there is not likely to be much effect on exchange rates.

Note that a programme of QE can be reversed by the central bank; it would have to sell the financial assets back to the banks. This would mean the banks use up some of their cash to buy the assets, and will therefore have to reduce the amount they lend out. It would also cause bond prices to fall, so interest rates would rise.

__Summary: __A fall in base rate or a programme of QE will cause an increase in AD, (a shift of the AD curve to the right), resulting in higher equilibrium output and possibly a rise in the price level (depending on whether a Keynesian or neoclassical LRAS model is used, and whether the economy is already at full employment). This is called __expansionary monetary policy __(also known as a __loosening __of monetary policy.

A rise in base rate or a reversal of QE will have the opposite effect and is called contractionary monetary policy __(sometimes called a __tightening of monetary policy).

Evaluation of Demand-Side Policies

Neoclassical economists are sceptical about the use of demand-side policies to achieve growth and full employment. They argue that the long term health of the economy requires low taxation and the avoidance of government borrowing. The latter adds to the __national debt __(the cumulative total of past and present government borrowing) and means taxes have to rise eventually to pay it back. Fear about high levels of government borrowing and the size of the national debt (which increased from 60% to 90% of GDP after 2009) was behind the Conservative led government’s ‘austerity’ policy, involving big cuts to public expenditure.

They argue that any manipulation of aggregate demand should be via monetary policy, and focused on keeping inflation to the target rate, and not on other macroeconomic objectives. They do not believe that demand side-policies can make any difference to growth or employment in the long run; instead it produces only short term gains in output and employment, but at the cost of higher inflation. They believe economies will return to full employment quickly if the appropriate supply side policies are being followed_._

Keynesian economists do believe that demand-side policies have an important role in maintaining growth and employment.They point out that governments throughout the developed world gave massive fiscal and monetary expansionary boosts to their economies after the banking crisis. Without this, they argue that recovery from the recession could have taken many years longer, with high unemployment and a large negative output gap. They also point out that in the 1930s, the Great Depression ended sooner in the USA and Germany, as a result of big increases in government spending, compared to Britain, where the government was more concerned to keep a balanced budget.

Demand-Side Policies, figure 1

The UK government’s response to the financial crisis in 2007/8 can also be compared to that of the US government. Once again, the US government was prepared to run a bigger budget deficit (nearly 13% of GDP in 2009) compared to the UK (just over 10% in 2009). The US government also used QE on a larger scale than in the UK. Output and growth have recovered faster in the US than the UK, where the government has prioritised reducing borrowing and the national debt rather than short term growth. This approach can be defended on the grounds that reducing debt strengthens the long run position of the economy.

Neoclassical economists point to countries such as Greece which ran up huge government debt before the financial crash. The national debt peaked at more than 200% of GDP. This resulted in a loss of confidence by lenders (especially foreign banks), who refused to lend any more. Greece had to be bailed out by the EU and IMF, on the condition that it imposed big tax increases and reductions in government spending, resulting in a very large fall in GDP and unemployment of over 20%.

There is also concern about the long term consequences of QE. Opponents of it argue that not much of the extra bank lending resulting from it ended up financing business investment; banks were still wary of taking risks. Instead, much of it went into mortgage lending, creating another property price bubble, and possibly sowing the seeds of another financial crash if property prices fall again. Supporters of QE argue that it has played a major role in keeping spending going and avoiding a more prolonged recession.

There is also a problem about the accuracy of information that governments have when using demand-side policy instruments. We don’t know the size of the multiplier, for instance, so we cannot be sure what the effect of an expansionary or contractionary policy will be. Neoclassical economists believe the multiplier is likely to be much smaller than Keynesians claim. This is because they argue that a fiscal boost financed by borrowing will drive up interest rates and ‘crowd out‘(i.e. discourage) private sector investment.

There are also significant __time lags __in the operation of demand side policies. Firstly, governments are reacting to information (such as GDP data) that is already out of date. Secondly, it takes time for a fiscal or monetary measure to impact on the economy. A change in interest rates, for instance, will not result instantly in new factories being built. This creates the risk that demand policies can be inappropriate for the needs of the economy by the time they take effect.

Demand-side policies to stimulate growth and employment may also be criticised for conflicting with the objectives of low inflation and balance of payments equilibrium. An expansionary policy may lea to higher inflation and a worsening current account.