Demand-side policies is an attempt to increase and decrease AD in order to control the economy. These can be fiscal and monetary.
Monetary policy – used by the Bank of England to control the money flow of the economy. This is done through interest rates and quantitative easing.
The Bank of England which is separate from the Government, holds a meeting of the Monetary Policy Committee (MPC) monthly which sets the base rate. The base rate influences the interest rates across the company. Reducing the base rate would encourage spending and therefore increases AD.
They also use quantitative easing to pump money directly into the economy to stimulate it. It is used when interest rates are already very low. The central bank buys government and corporate bonds to increase money flowing in the economy. They create this money using bank’s electronic reserves. However, this can have inflationary effects and reduce the value of currency. If inflation is high, the Bank can sell off their assets, reducing the supply of money.
Limitations of monetary policy
- Banks may not pass on the base rate to consumers so even if the base rate is adjusted it might not have the desired effect.
- Even if the cost of borrowing is low, banks may be unwilling to lend (risk-averse).
- Interest rates are more effective when consumer confidence is high as if confidence is low then spending will not increase.
Fiscal policy – controlling the economy by changing the level of tax and/or Government expenditure.
The Government can change their spending and taxation to encourage or discourage spending. The general aim is to stimulate economic growth and stabilise the economy. By increasing expenditure e.g. for the NHS, it increases wages for the workers and further stimulates the economy. Tax decreases work in a similar way as consumers will have more disposable income.
EXPANSIONARY POLICY à Anything that increases AD (used when AD is low and there is usually unemployment and recession)
- Decreasing interest rates
- Decrease tax rates
- Increase Government spending
CONTRACTIONARY POLICY à Anything that decreases AD (used when AD is too high and there is inflation, aiming to get consumers to spend less)
- Increasing interest rates
- Increase tax rates (politically undesirable)
- Decrease Government spending (politically undesirable)
Limitations of fiscal policy
- Governments might have imperfect information about the economy. It could
lead to inefficient spending.
- There is a significant time lag involved with employing fiscal policy. It could
take months or years to have an effect.
- If the government borrows from the private sector, there are fewer funds
available for the private sector, which could lead to crowding out.
- The bigger the size of the multiplier, the bigger the effect on AD and the
more effective the policy.
- If interest rates are high, fiscal policy might not be effective for increasing
demand.
- If the government spends too much, there could be difficulties paying back
the debt, which could make it difficult to borrow in the future.
How investment, job creation and economic growth can be encouraged
- A policy package that includes both fiscal and monetary policy (like a two-pronged attack)
- Both AD policies (to increase consumption and investment) and AS policies (to create jobs) must be used to create a stable economy.
Time lags
- People and businesses take time to adjust to policy
- Businesses will need time to consider an investment decision
- Unemployment usually increases 1-2 years after a fall in AD and recovers slowly after a recession as businesses try to keep employees in hopes the economy will pick up in the future.
