Fiscal, Monetary & Supply-Side Policies: Impact on Economic Growth, Inflation & Unemployment
Demand-Side Policies and Their Impact on the Economy
Demand-side policies, including fiscal and monetary measures, aim to influence aggregate demand (AD) to achieve economic objectives like growth, inflation control, and unemployment reduction.
Fiscal Policy
Fiscal policy involves adjusting government spending and taxation to influence the economy.
- Increasing government spending or decreasing taxes can stimulate economic activity, leading to higher AD.
- Decreasing government spending or increasing taxes can curb inflation by reducing AD.
Monetary Policy
Monetary policy, typically managed by central banks, focuses on controlling the money supply and interest rates.
- Lowering interest rates encourages borrowing and spending, boosting AD.
- Raising interest rates discourages borrowing and spending, helping to control inflation.
Fiscal Policy and Economic Growth
Expansionary fiscal policy, such as reducing taxes or increasing government spending, can stimulate economic growth by increasing AD. This leads to higher output, potentially reducing unemployment. However, it can also lead to inflation and may be constrained by factors like crowding out (where government borrowing reduces funds available for private investment) and time lags in implementation.
Monetary Policy and Economic Growth
Reducing interest rates can also promote economic growth by making borrowing cheaper for businesses and consumers. This can lead to increased investment and consumption, boosting AD. However, like fiscal policy, it can also contribute to inflation. Additionally, the effectiveness of monetary policy depends on factors like the responsiveness of businesses and consumers to interest rate changes and the central bank’s ability to manage the money supply effectively.
Addressing Unemployment
Fiscal policies like reducing income tax or increasing government spending on infrastructure can create jobs and reduce unemployment. However, the effectiveness of these policies depends on factors like the level of consumer and business confidence and the type of unemployment (e.g., cyclical vs. structural).
The Impact of Budget Deficits
A budget deficit occurs when government spending exceeds revenue. Switching from a budget surplus to a deficit implies increased government spending or reduced tax revenue, both of which can increase AD.
Crowding Out Effect
may arise when the government increases its spending. [10] It happens when the government has to borrow funds from money market to finance its spending, the interest rate would be driven up and crowd out private sector investment. G increases, G is a component of AD, increasing Ad from AD1 to AD2, but govt does not have enough fund to spend. Need to borrow from money market, Increase MD from MD1 to MD2, R increases from i1 to i2 (diagram interest rate Md and Ms), higher cost of borrowing would deter C & I. Reduction in C & I would decrease AD from AD2 to AD3 (3 AD and 1 LRAS and SRAS). Public sector crowd out private sector.
Supply side policy – increase LRAS 1)Interventionist supply side policy – increase the government’s role in resources allocation. a)Investment in human resources (education / health care). Skilled, Higher productivity. Increase productivity capacity. Shift LRAS to the right. Investment in infrastructure: HK 3rd runway. Increase the commuting facilities. More passengers and freights can be transported. Increase productivity capacity. 2) Market-oriented supply side policy a) Competition – based: Privatization: Transfer the ownership from public sector to private sector. Private sectors firms aim at profit max. Higher incentive to increase efficiency and cut cost. Increase productive capacity -> shifting LRAS to the right. Deregulation: Reduce the entry barriers of a market so that more firms can join the market, increase the competition. Open-skies policy – many airlines join the market . More firms → more labour is needed b) Labour market reform – make the wage more flexible to the interaction of D and S. Reduce unemployment benefit. Reduce minimum wage. Reduce trade union power: Trade union bargain higher wage, better working environment for workers. This increases cost for the firms. Difficult to cut wage even if the demand for labour is reduced (e.g. Recession in 2008 in US). Reduce trade union power → less barriers for firms to hire labour. Increase in FOP increase productive capacity c) Incentive related. Reduce income tax: (e.g. UK reduces income tax rate from 45% to 40%). Workers consider more income earned can be kept. Increase working incentive. High income earners would move into the country. Increase labour supply. Increase productive capacity, shifting LRAS to the right. Reduce corporation tax (business tax)
Discuss the view that market-oriented supply policy to increase economic growth. [15] Limitation (general) – Time lag: Takes time to privatize. Political process, go through the congress. It takes time between the implementation of the policy and the effects to be seen. Limitation (Disadvantage of specific point): Privatisation – profit max – cut cost – cut labour, create unemployment. Reduce trade union power – harm labour – mostly low income workers, being exploited. Reduce income tax – income inequality increases. Limitation (towards the objective that the government wants to achieve: During recession, economy is weak and situated at Y, any increase in LRAS would not increase in real GDP Alternative: monetary policy, By reducing interest rate, lower cost of borrowing would increase the incentive for households and firms to borrow to consume and invest, increasing the AD, increasee the real GDP from Y1 to Y2. (Diagram showing AD increase). (+) Interdepence of central bank allows central bank to adjust interest rate promptly according to the macroecnomic situation, unlike the supply side policy, that has to undergo legislation. (-) AD increases would increase the inflationary pressure, supply side policy can achieve economic growth without causing inflation
Supply policy to reduce inflation. [15] Increase productivity, productive capacity. LRAS will shift to the right from LRAS1 to LRAS2. Price level would decrease from PL1 to PL2. Alternative: Contractionary Monetary policy can be used (interest rate reduce, reduce AD and PL) (+/- above)
Discuss the view that interventionist / market-oriented supply policy to reduce unemployment. [15] (copy above) define, explain, limitation, alternative: Expansionary Monetary policy can be used(decrease interest rate, Increase AD, Increase real GDP, Increase production of goods and services, firms would hire more labour, reducing unemployment (+/-)