Demand-side Policies

There are two main types of demand side policies – monetary and fiscal policy. They both act on factors which affect AD.
Monetary policy is used to keep inflation levels at roughly optimal whereas fiscal policy is used as a way to change the levels of spending in the economy.
Demand-side policies can be used to deal with cyclical unemployment.

Monetary policy instruments – interest rates

In the UK, the Monetary Policy Committee (MPC) uses interest rates and quantitative easing in order to keep a stable level of inflation.
By changing the base rates in the UK, the MPC is able to control the interest rates across the economy.
When interest rates are low, consumption and investment increases because there is less of an incentive to save money due to lower reward for doing so. Consumption and investment make up a large proportion of AD and therefore by increasing both of them, the AD curve will shift outward which has a secondary effect of inflation (due to increasing price levels increasing as shown on the graph below).
The level of inflation depends on the level of spare capacity the economy previously had, if the shift is from AD to AD₁ on the curve then the price levels across the economy don’t increase drastically so inflation isn’t too high. However, if the shift is between AD₁ and AD₂ the price levels increase substantially across an economy and so the inflation may be greater than anticipated. Therefore, the size of the multiplier must be taken into account when making any changes to interest rates.

Monetary policy instruments - quantitative easing

This demand side policy is used when the base rate can’t be reduced further and a further reduction would cause no significant shift in AD. Thus, lowering interest rates in this scenario wouldn’t cause inflation.
Quantitative easing is where bonds or assets are purchased to create new money and increase the money supply in an economy. This new money causes increased output and so causes the shift in AD leading to inflation as price levels rise in the economy.

Fiscal policy instruments – government spending and taxation

Fiscal policy is where the government changes the amount of spending and taxation in order cause shifts in the AD curve.
When the government wants to increase AD, they use expansionary fiscal policy. This is where the government increases spending and decreases taxes. As a result, there are higher levels of employment (increase spending in the public sector creates jobs) and when in tandem with decreased taxes, disposable income levels increase. When this happens, consumption increases in the economy and the AD curve shifts outward (e.g. AD to AD₁).
If the government wants to decrease AD they use deflationary fiscal policy which is where the government increases taxes and decreases spending. As a result, the levels of disposable income across the economy goes down and thus AD decreases (AD₁ to AD).
It can be used in order to balance the government budget but would result in falling price levels and cause a recession.

Distinction between government budget (fiscal) deficit and surplus

A budget or fiscal deficit is when government spending exceeds government revenue. The UK currently runs a budget deficit (as of 2017) and has done since 2001.
A budget or fiscal surplus is when the government revenue exceeds spending. Germany currently runs a budget surplus.

Distinction between, and examples of, direct and indirect taxation

Direct taxes have an impact on AD. As direct taxes are levied on income, people can feel the effect of it directly. Examples include corporation tax, income tax and inheritance tax.
Indirect taxes are imposed on expenditure on goods and services so they affect AS. They are costs levied on the producers and the most common example is VAT.

Demand-side policies in the Great Depression

Fiscal policy

In the US, the fiscal response was to increase government spending and there were taxes placed on goods from other countries due to protectionist policies such as the Smoot – Hawley Tariff Act which almost has the same effect as reducing taxes on American goods.
The UK on the other hand wanted to keep a balanced government budget and therefore their fiscal response was to actually cut public sector wages and unemployment benefits by 10% in 1931. Furthermore, the government raised income taxes from 22.5% to 25% in the same year.

Monetary policy

The US federal reserve reduced interest rates from 6% to 4% in February 1930 but later raised them again to preserve the value of the currency.
In September 1931, the UK government finally abandoned the Gold Standard and as a result the exchange rate of the pound fell by 25%, increasing the international competitiveness of exports. Afterwards, interest rates were reduced from 6% to 2% in order to aid economic recovery.

Demand-side policies in the Global Financial Crisis

Fiscal policy

In 2008 the US government evoked the Economic Stimulus Act which was a $152 billion fiscal stimulus package used to increase spending. Then, the American Recovery and Reinvestment Act of 2009 was invoked which was a $787 billion bill which consisted of increased government spending over a period of many years.

The UK also used a number of fiscal policies. There was a tax cut on basic rate tax which was a temporary 2.5 percentage point cut, there was also a £3 billion worth of investment spending in 2010. However, later on the focus moved to reduce the budget deficit.

Monetary policy

In the US, the Federal Reserve cut the interest rate from 5.25% to 4.25% towards the end of 2007. Furthermore, there will was three rounds of quantitative easing (2008/2009, 2010 and 2012) in order to boost the depleted money supply.

In the UK, the Monetary Policy Committee (MPC) cut the bank interest rate from 5.75% to 5.5% in December 2007.

Strengths and weaknesses of demand-side policies

Strengths

Monetary policy has a smaller time lag than fiscal policy, typically it takes between 18 months to 2 years.
It is very effective in dealing with cyclical unemployment as you can reduce the size of the negative output gap.
Deflationary fiscal policy helps balance the government budget as there would be increases in tax revenues while spending decreases.

Weaknesses

Fiscal policy as I previously stated has a large time lag which is a massive drawback as governments which may want to respond to current economic problems cannot.
Furthermore, the governments’ spending increase may not go to good use. People may just demand pay rises and the effect will just be increased wages as well as costs, this will not expand output and so doesn’t achieve the aim of the government.
Expansionary fiscal policy causes an unbalanced government budget because government spending increases while tax revenues decrease.
Monetary policy hits the entire economy which may worsen income equality. It also increases costs of production due to the inflation it causes and therefore can actually reduce international competitiveness.
Furthermore, monetary policy also tends to be ineffective because if consumer and business confidence is low then the low interest rates or increased money supply may not be enough of an incentive to increase consumption and investment.
Banks may also be unwilling to lend during periods of low confidence so again low interest rates would have no effect.