DEMAND-SIDE

POLICIES
FISCAL
POLICY
FISCAL POLICY
WHAT IS IT?
Fiscal policy is defined as the government's policies relating to its expenditure and taxation rates, used to
influence aggregate demand and control macroeconomic outcomes

CATEGORIES OF GOVT SPENDING

Capital expenditure: refers to the government spending on long-term items (public sector investments)
that help boost he economy’s productive capacity
Example: spending on upgrading the highway
Current expenditure: refers to the government spending on goods and services consumed within a year
Also known as consumption expenditure
FISCAL AND MONETARY POLICY
MACROECONOMIC OBJECTIVES
Governments or central banks employ fiscal and monetary policy to help achieve several macroeconomic
objectives, such as:
Maintenance of low and stable inflation, often achieved through inflation targeting" where the central
bank sets a specific medium-term target inflation rate (e.g., 2%)
A low unemployment rate
A stable economic environment for long-term growth
To reduce fluctuations in the business cycle
To achieve an external balance between export revenue and import expenditure
FISCAL POLICY
SOURCES OF REVENUE FOR THE GOVT
Governments receive their income from different sources
These include the payment of income taxes and social security payments by households and firms,
corporate taxes by firms, indirect taxes paid on expenditure on goods and services, and tariffs paid
on the purchase of imported products
Other than income from taxes, governments also earn money from the profits of government-owned
(nationalized) businesses or privatization. Income is also earned when governments rent out
government-owned buildings or land
EXPANSIONARY FISCAL POLICY
WHAT IS IT?
Expansionary fiscal policy is the use of increased government spending and/or reduced taxation to
stimulate economic activity (shift AD to the right)

If a government would like to encourage greater consumption, it can

lower income taxes to increase disposable income
If a government would like to encourage greater investment, then it can
lower corporate taxes so that firms enjoy higher after-tax profits that
can be used for investment
Governments have major investment projects themselves and may
increase their spending in order to improve public services
This also directly impacts upon AD by shifting it to the right
EXPANSIONARY FISCAL POLICY
EFFECTS
Expansionary fiscal policy is the use of increased government spending and/or reduced taxation to
stimulate economic activity (shift AD to the right)

If the government follows a successful expansionary fiscal policy, then

there will be a shift of aggregate demand from AD₁ to AD₂
There will be inflationary pressure as the average price level rises
from PL₁ to PL₂
However, there will be an increase in national real output, from Y₁
to Y₂, which will mean an increase in national income, an increase in
economic growth, and very probably, a decrease in unemployment
Trade-off between lower unemployment and higher inflation
HOW EFFECTIVE ARE FISCAL POLICIES?
EFFECTIVENESS IN DEEP RECESSIONS
Fiscal policy, especially expansionary measures involving increased government spending, has historically
demonstrated its ability to help economies recover from severe recessions in the long run
The experiences of countries during the Great Depression and the global recession of 2008 highlight this
potential

TARGETED GOVERNMENT EXPENDITURE

A key strength of fiscal policy lies in the government's capacity to direct spending towards specific sectors
of the economy
By strategically allocating funds and implementing targeted tax cuts, policymakers can aim to stimulate
growth in particular areas or provide relief to specific populations deemed most in need
CONSTRAINTS ON FISCAL POLICY
TIME LAGS
Changes in government spending or taxation often take time to have a significant impact on the economy
There can be delays in the political process of implementing policies, and it may take further time for
individuals and businesses to respond to these changes
The full effects of fiscal policy might not be felt for a considerable period

POLITICAL FACTORS
Deflationary policies, such as tax increases or spending cuts, might be politically unpopular, making
governments hesitant to implement them even when economically necessary

FUNDING CONSTRAINTS AND NATIONAL DEBT

Expansionary fiscal policies that increase government spending or cut taxes can lead to larger budget
deficits and an increase in national debt
Persistent deficits may necessitate future austerity measures (policies to manage public debt), potentially
undermining long-term growth. High levels of national debt can also constrain the government's ability to
respond to future economic downturns
CONSTRAINTS ON FISCAL POLICY
CROWDING OUT EFFECTS
Expansionary fiscal policy, if it leads to higher interest rates, can attract foreign investment and cause the
domestic currency to appreciate
A stronger currency makes exports more expensive and imports cheaper, potentially leading to a fall
in net exports and offsetting some of the intended increase in aggregate demand - crowding-out of
net exports
Also, higher interest rates can make it more expensive for private firms to borrow and invest, thus
crowding out private investment and reducing the overall impact of the fiscal stimulus on aggregate
demand. The extent of this crowding-out effect is a subject of ongoing debate

INABILITY TO ACHIEVE SPECIFIC TARGETS

The economy is complex and influenced by numerous factors, making it difficult for governments to
accurately predict the size and timing of the impact of their fiscal measures on variables like inflation and
unemployment
MONETARY
POLICY
MONETARY POLICY
WHAT IS IT?
Monetary policy is defined as the government's use of interest rates, exchange rates and money supply
to influence aggregate demand and control macroeconomic outcomes

KEY INFO
Interest rates and the base rate: while various interest rates exist in an economy, the key interest rate
used as a tool of monetary policy is the base rate (discount rate or prime rate), set by the central bank
Role of the Central Bank: the central bank is the government's bank and the ultimate authority in
controlling the money supply. In most developed countries, the central bank operates as an independent
body with the primary responsibility of maintaining a low and stable rate of inflation
Impact on borrowing and lending: changes in the central bank's base rate have a cascading effect on all
borrowing and lending activities in the economy. It serves as an important signal for the direction of a
country's monetary policy
EXPANSIONARY MONETARY POLICY
Expansionary monetary policy aims to increase aggregate demand in the economy.

LOWERING THE BASE RATE

A reduction in the base rate reduces the cost of borrowing for commercial banks
These banks are likely to lower the interest rates they charge to consumers and businesses for loans
Lower interest rates make borrowing cheaper, encouraging both households to increase consumption
(e.g., through mortgages and personal loans) and firms to increase investment (e.g., in new equipment
and buildings)

INCREASED MONEY SUPPLY

Lower interest rates can also indirectly lead to an increase in the supply of money in the economy, as
borrowing becomes more attractive
When the cost of money (interest rates) is lower, its "price" is reduced, leading to increased demand and
circulation
EXPANSIONARY MONETARY POLICY
MACROECONOMIC OUTCOMES
If the government follows a successful expansionary monetary policy,
then there will be a shift of aggregate demand from AD₁ to AD₂
There will be inflationary pressure as the average price level rises
from PL₁ to PL₂
However, there will be an increase in national real output, from Y₁
to Y₂, which will mean an increase in national income, an increase in
economic growth, and very probably, a decrease in unemployment
Trade-off between lower unemployment and higher inflation
HOW EFFECTIVE IS MONETARY POLICY?
RELATIVELY QUICK TO IMPLEMENT
Unlike fiscal policy, which often requires lengthy political debate and legislative approval, monetary policy
decisions, particularly adjustments to the central bank's interest rate, can typically be implemented swiftly
The central bank has the authority to act independently and make changes as deemed necessary

REDUCED POLITICAL INTERVENTION

In countries where the central bank operates with a significant degree of independence from direct
government control, this allows for decisions to be made based on economic considerations rather than
being swayed by short-term political pressures, such as the unpopularity of raising interest rates
This contrasts with fiscal policy, which is inherently subject to political influences
HOW EFFECTIVE IS MONETARY POLICY?
LIMITED CROWDING OUT EFFECT
Compared to expansionary fiscal policy, expansionary monetary policy operates by directly lowering
interest rates
This encourages borrowing and investment without necessarily increasing government debt or
exerting upward pressure on interest rates

ABILITY TO MAKE SMALL, PRECISE ADJUSTMENTS

Central banks can adjust interest rates in small increments (e.g., by a quarter of a percentage point)
This allows for a more nuanced approach to managing the economy and targeting specific goals, such
as an inflation target of 2%
The speed of implementation and the lack of direct political involvement further enhance this precision
LIMITATIONS OF MONETARY POLICY
TIME LAGS
The effects of interest rate changes on aggregate demand may not be fully realized for several months
By the time the impact is felt, economic conditions may have changed, potentially rendering the policy less
effective or even inappropriate

INEFFECTIVENESS AT VERY LOW INTEREST RATES

When interest rates are already very low, the central bank's ability to further stimulate the economy
through rate cuts becomes limited
Eventually, interest rates will approach zero, a situation known as the zero lower bound, leaving little
room for further monetary easing

LOW CONSUMER AND BUSINESS CONFIDENCE

Even when interest rates are reduced, if consumer and business confidence is low (e.g., during a deep
recession), borrowing and spending may not increase significantly