MR KAYBEE

Demand-side and supply-side policies

It is of paramount importance to know that each country strives to achieve what are called
macroeconomic goals and it is from these objectives that governments crafts some
macroeconomic policy aims which are:
full employment
 price stability
 balance of payments equilibrium
 steady and sustained economic growth
 avoidance of exchange rate fluctuations
 sustainable economic development
 Income redistribution
 Environmental considerations
At any one time, a government may prioritise one objective. For example, if the inflation rate
is at 20% and rising, a government may decide to concentrate on achieving price stability.
We can use AD-AS model as the basis for analyzing and evaluating policy alternatives that can
be used by governments to achieve these objectives highlighted above. These major policies
governments use to achieve such goals or eradicate problems that emanate from failure to
achieve them are called demand- side polices, supply- side policies, income policies etc.

Demand- Side Policies

Demand-side policies, which are also known as demand management, focus on changing aggregate
demand, or shifting the aggregate demand curve, to achieve macroeconomic goals/objectives which are
price stability, full employment and economic growth just mentioning a few. They are based on the idea
that short-term fluctuations in real GDP of the business cycle are due to actions of firms and consumers
affecting aggregate demand and causing inflationary or recessionary (deflationary) gaps.
Demand-side policies try to counteract the effects of these actions and bring aggregate demand to the full
employment level of real GDP, or potential GDP. In addition, demand side policies can also impact on
economic growth by contributing to increases in potential GDP. Active and purposeful government
intervention in the economy to influence aggregate demand is termed discretionary policy, meaning that
the policy is at the discretion (or the choice and will) of the government.
So under demand- side policies you need to know that there are two types of discretionary demand-side
policies which are;
 fiscal policy
 monetary policy.

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In addition, aggregate demand is influenced by automatic stabilisers, which work to reduce the size of
economic fluctuations. Since they operate automatically, they are termed non-discretionary policy.
Automatic stabilisers are forms of government spending and taxation that change, without any deliberate
government action, to offset fluctuations in GDP. Let’s have an example to make it clearer. For example,
during a recession, government spending on unemployment benefits automatically rises because there are
more unemployed people. Tax revenue from corporation tax, income tax and indirect taxes will fall
automatically as profits, incomes and expenditure decline.
Fiscal and monetary policies that attempt to reduce the short-run fluctuations of the business cycle, are
called stabilisation policies, because they try to ‘stabilise’ the economy, or eliminate short run
instabilities caused by increases and decreases of aggregate demand. If stabilisation policies worked as
intended, the business cycle would be flattened out, and the economy’s actual output would be very close
to its potential output.

Fiscal policy
Fiscal policy and aggregate demand
Fiscal policy refers to manipulations by the government of its own expenditures and taxes to influence
the level of aggregate demand. (Since this is purposeful policy, it is ‘discretionary’.) It can also be
defined as the use of taxation and government spending to manage aggregate demand in order to achieve
the government’s macroeconomic aims. So from all these definitions you can see that the term fiscal
policy covers a range of policy measures that affect government expenditures and revenues through the
decisions made by the government on its expenditure, taxation and borrowing.
From the knowledge of the AD/AS model , we can reflect that the components of aggregate demand are
consumption (C), investment (I), government spending (G), and net exports (X − M). Fiscal policy can
affect three of these four components:
 The level of the government’s own spending, G, can be changed.
 The level of consumption spending, C, can be influenced if the government changes taxes on
consumers (personal income taxes), changing their level of disposable income, which is the
income of consumers after income taxes have been paid.
 The level of investment spending, I, can also be influenced if the government changes taxes on
business profits.
We have reflationary and deflationary fiscal policy. Reflationary can also be termed expansionary fiscal
policy and deflationary are also known as recessionary fiscal policy. Reflationary or expansionary fiscal
policy is designed to increase aggregate demand. This can be achieved by a government increasing its
spending and/or cutting tax rates or the tax base. In contrast, deflationary or contractionary fiscal policy
is intended to lower aggregate demand. This time, the government will reduce its spending and/or
increase taxes.
Objectives of Fiscal Policy
i. Boosting employment levels
ii. Maintain or stabilize the economy’s growth rate

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iii. Maintain or stabilize the price levels

iv. Encourage economic development
v. Raising the standard of living
vi. Maintaining equilibrium in Balance of Payments.

Types of fiscal policies

a. Expansionary fiscal policy
Fiscal policy undertaken to eliminate a recessionary gap is called expansionary fiscal policy, because it
works to expand aggregate demand and the level of economic activity. Expansionary fiscal policy may
consist of:
• increasing government spending
• decreasing personal income taxes
• decreasing business/ corporate taxes, or
• a combination of increasing spending and decreasing taxes.

An increase in government spending impacts directly on aggregate demand, which increases. If the
government decreases taxes, aggregate demand is affected in a two-step process. If personal income
taxes are cut, the result is a rise in disposable income, which is then likely to lead to an increase in
consumption spending, causing the AD curve to shift to the right. If business taxes are cut, after-tax
business profits increase, which in turn is likely to lead to higher investment spending and therefore
higher AD. In all three cases, AD is intended to shift to the right from AD1 to AD2, allowing the economy
to achieve full employment or potential output Yp as shown by diagrams below.

So as highlighted above, government use this type of policy to stimulate economic growth by increasing
spending or lowering taxes or both. The objective of this policy is to ensure more money in the hands of
the citizens so that they spend more. More spending, in turn, leads to more income and more job creation
as well.
However, there have been debates over which is more effective – tax cuts or spending. Some say that
spending in the form of public projects ensures that the money reaches the consumers. Those in favor of
the tax argue that tax cuts allow businesses to hire more staff. Though there is no consensus on which of
the two is better, the government uses a combination of both the tools.
b) Contractionary fiscal policy

Fiscal policy undertaken to close an inflationary gap is called contractionary fiscal policy, because it
works to contract aggregate demand and the level of economic activity. Contractionary fiscal policy
consists of:

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 decreasing government spending

 increasing personal income taxes
 increasing business taxes, or
 a combination of decreasing spending and increasing taxes.
A decrease in government spending has a direct influence on the aggregate demand curve, causing it to
shift to the left. An increase in personal income taxes or business taxes is intended to affect aggregate
demand in a two-step process also. As personal income taxes increase, after-tax income falls, causing
consumption spending and aggregate demand to fall. As taxes on profits increase, after-tax profits fall,
leading businesses to spend less on investment and causing aggregate demand to fall. In all three cases,
the aggregate demand curve is meant to shift to the left as shown on diagrams below. The government
can also pursue a combination of decreases in government spending with increases in personal income
and business taxes. Depending on the initial conditions that prevail in the government’s budget, such a
combination of policies would lead to the creation of a budget surplus, or the shrinkage of a budget
deficit, or turning a budget deficit into a surplus

Most governments rarely uses this policy as it aims to slow economic growth of which economic growth
is aimed by many governments in the whole world. You must be thinking why any government will want
to do that, the answer is to curtail inflation. Too much inflation has the potential to damage the economy
in the long-term. So, the government has to step in to control inflation. Here also, the government has the
same tools at its disposal – spending and tax cuts. But, they are used differently – taxes are raised while
the spending is reduced. One can easily imagine how unpopular such measures will be among the voters.

Evaluating fiscal policy

Now we need to discuss on the potential positive effects of fiscal policies as well as the complexities of
the real world that present some difficulties that often prevent these policies from achieving the desired
and expected impacts. The effectiveness of fiscal policy also depends crucially on the whole policy
environment in which it is utilized.
Meanwhile, let us consider some strengths and weaknesses of fiscal policies.

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Advantages of Using Fiscal Tools/ Strengths of fiscal policy

1. Dealing with rapid and escalating inflation. Fiscal policy is known to be one that deals with
rapid and escalating inflation. Inflationary pressures arising when there is an inflationary gap can
sometimes get out of hand, resulting in rapid increases in the price level. Contractionary fiscal
policy may then be used effectively to help bring the problem under control.

2. Ability to target sectors of the economy.

Fiscal policy can target specific sectors by making changes in the composition of government
spending depending on government priorities. For example, it may focus on changing the
amount of spending on education, health care etc.
3. Direct impact of government spending on aggregate demand. Changes in government
spending impact directly on aggregate demand, and this can be helpful to policy-makers who
want to be reasonably certain that changes in spending are likely to change aggregate demand in
the desired direction. Changes in taxes are less direct, as they work by changing consumer
disposable income and firm after-tax profits, and this poses some uncertainties about their effects
on aggregate demand. For example, in a recession if consumers are insecure about the future, tax
cuts may lead to greater saving rather than greater spending.
4. Raising taxes helps in discouraging alcoholism and drug abuse. This is made possible by
increasing taxes on tobacco and alcoholic drinks. Also through taxes, a country can build
infrastructure, thus improving service delivery to citizens; and subsidies in development and
research can aid in a country’s economic growth.
Disadvantages of Using Fiscal Tools/weaknesses of fiscal policy
1. Political constraints. Government spending and taxation face numerous pressures that are
unrelated to fiscal policy. Spending for social services (merit goods such as health care and
education) and public goods is undertaken for its own sake and cannot easily be cut if a
contractionary policy is required. On the other hand, tax increases are politically unpopular and
may be avoided by the government.

2. In a recession, tax cuts may not be very effective in increasing aggregate demand.
Tax cuts are less effective in a recession than increases in government spending because part of
the increase in after-tax income is saved. If the proportion of income saved rises due to
pessimism about the future, the impacts of tax cuts on aggregate demand are even weaker.
Increases in government spending are more powerful because they work in their entirety to
increase aggregate demand.
3. Problems of time lags. Fiscal policy is subject to a number of delays in timing called time lags.
There is a lag until the problem (recessionary or inflationary gap) is recognized by the
government authorities and economists. Also a time lag until the appropriate policy to deal with
the problem is decided upon by the government and that the policy takes effect in the economy.

4. Crowding out. Another problem of fiscal policy is that of crowding out. If the government
pursues an expansionary fiscal policy involving spending increases without an increase in
revenues, it is forced to borrow; this is called deficit spending. Government borrowing involves
an increase in the demand for money, and leads to an increase in the rate of interest. A higher

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interest rate in turn can lead to lower investment spending by private firms, or a ‘crowding out’
of private investment. This means that the government’s expansionary fiscal policy is weakened,
since a greater G (government spending) is counteracted by a lower I (investment spending).

Golden Rule of fiscal policy: is a rule stating that over the economic cycle, net government borrowing
will be for investment only and not for current spending. This means that the government should borrow
only to invest and not to fund current expenditure. This is usually intended to help achieve equity
between present and future generations.

Monetary policy
Monetary policy refers to deliberate attempts to manipulate the rate of interest and money supply in order
to bring about desired changes in the economy. It can also be defined as a policy that involves altering
the supply of money in the economy or manipulation of interest. It entails the use of monetary variables
such as money supply and interest rates to influence aggregate demand.
This policy has become the prime instrument of government macroeconomic policy in many developed
countries, with the interest rate acting as the key control variable.
Aims of the monetary policy
In general terms monetary policy is used to regulate credit conditions and the supply of money in order to
fulfil macroeconomic objectives. The overall objective is to improve the standards of living within the
economy. Alternative objectives can be listed as follows: -
a) To maintain stable prices, that is, control inflation or deflation.
b) To attain a rising level of employment.
c) To achieve real economic growth which is prerequisite to improvement in the standards of
living.
d) To secure a healthy BOP position.
Targets of monetary policy
To achieve the above objectives of economic policy, the authorities through monetary policy will seek to
manipulate:
a) Interest rates.
b) Growth in money supply.
c) Exchange rate and,
d) Growth in the volume of credit
Monetary policy, like fiscal policy, seeks to influence aggregate demand. Again reflationary or
expansionary monetary policy is intended to increase aggregate demand.

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In this case, this may be achieved by a cut in the interest rate, an increase in the money supply and a
reduction in the foreign exchange rate. To reduce aggregate demand, deflationary or contractionary
monetary policy may be adopted. This might include a rise in the interest rate, a decrease in the money
supply and an increase in the foreign exchange rate.
An increase in the money supply by the central bank is referred to as an easy monetary policy. It is also
an expansionary monetary policy, since the objective is to expand aggregate demand and the level of
economic activity.
A decrease in the money supply by the central bank is referred to as a tight monetary policy, or
contractionary monetary policy, as the objective is to contract aggregate demand and therefore the
economy.
Monetary policy measures are usually implemented by the central bank of the country or area. In recent
years, in a number of countries, changes in interest rates have been the main policy measure used to
control inflation and, more recently, to influence economic activity.
A central bank may also target the money supply in the economy as changes in the money supply can
influence aggregate demand. Policy measures to change the money supply include those that seek to
influence lending by commercial banks. This is because such lending is a major cause of changes in the
money supply.
Exchange rate measures include government decisions on what type of exchange rate system to operate
and, in the case of a managed and fixed exchange rate, at what rate to set the exchange rate

Evaluating monetary policy

Advantages of using monetary policy/ Strengths of monetary policy

1. Relatively quick implementation. Monetary policy can be implemented more quickly than
fiscal policy because it does not have to go through the political process, which is very
cumbersome and time consuming (though, as we will see below, monetary policy is also subject
to some time lags).

2. Central bank independence. This is an advantage because independence from the government
means the central bank can take decisions that are in the best longer term interests of the
economy, and therefore exercises greater freedom in pursuing policies that may be politically
unpopular (such as higher interest rates making borrowing more costly).

3. No political constraints. Even if a central bank is not independent of the government, monetary
policy is still not subject to the same kinds of political pressures as fiscal policy, since it does not
involve making changes in the government budget, whether in terms of government spending
that would affect merit and public goods provision, or government revenues (taxes).

4. No crowding out. Monetary policy does not lead to crowding out, which may result from higher
interest rates due to an expansionary fiscal policy (based on deficit financing). The monetary
policy counterpart to an expansionary fiscal policy is an easy monetary policy, which leads to
lower (not higher) interest rates.

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Disadvantages of using monetary policy/ Weaknesses of monetary policy

1. Time lags. Unlike fiscal policy, monetary policy can be implemented and changed according to
perceived needs relatively quickly, because it does not depend on the political process. However,
like fiscal policy, it remains subject to time lags (delays), including a lag until the problem is
recognised, and a lag until the policy takes effect. Changes in interest rates can take several
months to have an impact on aggregate demand, real output and the price level. By then,
economic conditions may have changed so that the policy undertaken is no longer appropriate.

2. Possible ineffectiveness in recession. Whereas monetary policy can work effectively when it
restricts the money supply to fight inflation, it is less certain to be as effective in a deep
recession. Expansionary monetary policy is intended to increase aggregate demand by
encouraging investment and consumption spending through lower interest rates. This process
presupposes that banks will be willing to increase their lending to firms and consumers, and that
firms and consumers will be willing to increase their borrowing and their spending. However, in
a severe recession, banks may be unwilling to increase their lending, because they may fear that
the borrowers might be unable to repay the loans.

3. Conflict between government objectives.

Manipulation of interest rates affects not only variables in the domestic economy (consumption
and investment spending, inflation, unemployment) but also variables in the foreign sector of the
economy, such as exchange rates. The pursuit of domestic objectives may conflict with the
pursuit of objectives in the foreign sector.
4. Inability to deal with stagflation. Monetary policy is a demand-side policy, and is therefore
unable to deal effectively with supply-side causes of instability, just like fiscal policy.

Supply-side policies
The history of supply-side policy
From 1945 until the mid-1970s, Keynesian fiscal policy was the major instrument of government
economic policy in most countries around the world. It was felt that by influencing AD the economy
would remain on target for what the government wanted to achieve. However, in the early 1970s,
stagflation arose in many countries, which was the simultaneous increase in both prices and
unemployment. Many economists had felt that this was not possible. So, monetary policy began to grow
in popularity, especially amongst monetarists. The 'radical right' in America suggested that rather than
concentrate on the demand-side of the economy we should turn our attention to the supply-side and so a
new school of thought entered the economic arena.
Supply-side policies focus on the production and supply side of the economy, and specifically on factors
aimed at shifting the long-run aggregate supply (LRAS) or Keynesian AS curves to the right, to increase
potential output and achieve long-term economic growth. They are measures that are designed to
increase aggregate supply by improving the workings of product and factor markets. They may involve
reducing government intervention or, in some cases, increasing it.
Objectives of Supply side Policies

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i. Removing market imperfections - barriers to the smooth operation of markets

ii. Removing restrictive practices - rules that do not allow the free movement of factors within an
economy
iii. Making work more attractive and workers more efficient
There are two major categories of supply-side policies: interventionist and market-based.
Interventionist policies rely on government intervention to achieve growth in potential output, and are
usually favored by economists influenced by Keynesian economic thinking. Market-based policies
emphasize the importance of well-functioning competitive markets in achieving growth in potential
output, and are usually favored by monetarist/new classical economists.
Interventionist supply-side policies
Interventionist supply-side policies presuppose that the free market economy cannot by itself achieve the
desired results in terms of increasing potential output, and argue that government intervention in specific
areas is required.
Market-based supply-side policies
Many governments throughout the world have pursued policies influenced by market-based supply-side
thinking. In this view, the economy’s real GDP tends automatically towards long run full employment
equilibrium and potential. The focus of government policies should therefore be less on stabilisation, and
more on creating conditions that allow market forces to work well.
The examples of supply side policies or the tools are explained below.
 Investment in human capital i.e. education and health services
For example training and education. More and better training and education lead to an
improvement in the quality of labour resources, increasing the productivity of labour, which is
one of the key causes of economic growth.
 Industrial policies are government policies designed to support the growth of the industrial
sector of an economy. Measures that fall under industrial policy include offering support for
small and medium-sized enterprises or firms (SMEs). Governments can provide support to
small and medium-sized firms, which may take the form of tax exemptions, grants, low-interest
loans and business guidance. This provides support for the private sector, promoting efficiency,
more capital formation, more employment possibilities and therefore increases aggregate
demand as well as potential output.

 Incentives to enter work and work harder, such as lower direct taxation, which widens the
gap between earnings and social security.

 Removing the unemployment trap, where some people earn more on benefits than from
working and so find it economic sense to stay out of work and draw benefit. The unemployment
trap means that the extra income coming from work is insufficient to encourage people to seek a
job.

 Paying benefits to those in work, but drawing low wages. The shadow economy of those
working unofficially whilst still claiming benefits would be made less easy to be a part of.

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 Education and training improvements - we have already seen that the 'quality' of labour as a
factor of production is just as important as the 'quantity'. The aim of supply-side education
policies is to raise the skill level of the population and therefore make people more productive.
This means focusing on both expanding and deepening the skills base of the labour force.
Policies could include encouraging more students into tertiary education, broadening access to
primary and secondary education, improving teacher/student ratios to improve the quality of
education or perhaps providing more teacher training to raise the number of teachers.

 Privatisation - this is the selling of state or publicly owned assets to the private sector. This has
happened in many economies in transition between command and market economies (e.g.
Eastern European economies like Bulgaria, Romania and Hungary). Many developed countries
have also privatised state-owned industries. By doing this it is hoped that firms will become
more efficient, competitive and better able to provide a consistent service of high quality.
Privatising them in theory would expose them to competition and market forces therefore
improving efficiency. Significant privatisation, e.g. of utilities such as gas, water and electricity,
has also taken place in the less developed countries, often as part of IMF structural adjustment
programmes. Once again these polices, it is hoped, would shift the AS curve to the right.

 Deregulation - these policies concentrate on removing barriers to entry to various markets and
forcing participants to be more competitive. The markets then become more contestable and
react to changes, especially global changes, more quickly than they had once done. Once again
the AS curve is supposed to shift to the right, so expanding the economy by removing
bottlenecks and gaps within its capacity to react to changes in national income.

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