DEMAND-SIDE AND SUPPLY-SIDE POLICIES [1]

IB Economics SL Demand-side and supply-side policies

12.1 Introduction to demand-side policies
OBJECTIVES OF DEMAND-SIDE POLICIES
Demand-side policies focus on changing AD (shift of AD curve) to achieve price stability, full
employment, and economic growth. It is based on the idea that short-term fluctuations in real GDP
are results of actions that affect AD and cause inflationary/recessionary gaps.
Demand-side policies try to bring AD to potential GDP and can also contribute to potential GDP
increases.
Government intervention in economy to influence AD is called discretionary policy, because the
policy is at the discretion of the government. (Two types: fiscal policy and monetary policy)
AD is influenced by automatic stabilizers which reduce size of economic fluctuations; these are non-
discretionary.
Fiscal and monetary policies attempt to reduce short-run fluctuations are called stabilization policies.

12.2 Fiscal policy
THE GOVERNMENT BUDGET
Sources of government revenue:
o Taxes
o Sales of goods and services
o Sales of government-owned property (privatization)
Types of government expenditure:
o Current expenditures
Includes government spending on day-to-day recurring items, consumable items.
Examples include wages, salaries for government employees, school supplies, etc.
o Capital expenditures
Includes public investments and production of physical capital
o Transfer payments
Transfer payments are not included in the measurement of GDP
Government budget type of plan of a countrys tax revenues and expenditures.
o Balanced budget tax revenues = government expenditures
o Budget deficit tax revenues < government expenditures
o Budget surplus tax revenues > government expenditures
The government pays for excess expenditures by borrowing when there is a deficit.
Government accumulation of deficits referred as public debt or government debt.
Note that revenues from the sale of g/s and government-owned enterprise arent counted in the
budget because they are one-off sources of revenue; the government cant keep selling enterprises
to pay for their debt.
Revenues from the sale of state-owned enterprises can be used to pay off a debt that accumulated
over a period of deficits. This reduces interest on past loans, which allows those funds to be spent on
other expenditures.

ROLE OF FISCAL POLICY
Fiscal policy a discretionary policy that refers to government changes of expenditures and taxes to
influence AD. Of the four components of AD (C, I, G, X-M), fiscal policy can affect the level of
government spending, the level of consumption spending (done by taxes), and the level of
investment spending.

DEMAND-SIDE AND SUPPLY-SIDE POLICIES [2]
IB Economics SL Demand-side and supply-side policies
EXPANSIONARY FISCAL POLICY
Expansionary fiscal policy is fiscal policy that aims to eliminate a recessionary gap by increasing
aggregate demand.
o Can consist of: increasing government spending, decreasing personal income taxes,
decreasing business taxes, or a combination of the above.
Governments spending increase directly causes AD to increase.
Tax decreases will increase disposable income which will increase
consumption to increase AD.
Business tax decreases increase profits which increases investment spending
and increases AD.
If the government increases spending and lowers taxes, it will shrink a
surplus into a deficit.
Both models (Keynesian and monetarist) show that an increase in AD will
increase real GDP, but the size of the increase will be different. Generally, the
GDP increase will be smaller in the monetarist model because of the upward
sloping SRAS curve and an increase in price level.

CONTRACTIONARY FISCAL POLICY
Contractionary fiscal policy is fiscal policy that aims to close an inflationary gap by decreasing AD.
o Consists of: decreasing government spending, increasing personal income taxes, increasing
business taxes, or a combination of the above
Government spending decrease directly decreases AD.
Increases in tax will decrease consumption and decrease AD.
If the government decreases spending and increases taxes, it may turn a deficit into a surplus.
The effects of the AD decrease can be different depending on the model.
o If AD falls in downward sloping part of the AS curve in
the Keynesian model, the effects on the price level and
real GDP are similar.
o If AD falls into horizontal part of the curve, the price level
fall will be smaller but the real GDP decrease will be
larger.
In the Keynesian model, the price level can increase with AD, but
doesnt fall easily with AD.
o Ratchet effect price level moves up when theres an
increase in AD and remains at that level until a further
increase in AD.

AUTOMATIC STABILIZERS
Automatic stabilizers - factors that work toward stabilizing the economy by reducing fluctuations of
the business cycle automatically. There are two important types: progressive income taxes and
unemployment benefits.
Progressive income taxes: As real GDP and income rises, tax revenues increase so disposable income
is lower which acts against expansion. In a recession, tax revenues decline so disposable income
increases, reducing recession severity. The more progressive an income tax system, the greater the
stabilizing effect.
monetarist model

DEMAND-SIDE AND SUPPLY-SIDE POLICIES [3]
IB Economics SL Demand-side and supply-side policies
Unemployment benefits: As real GDP falls and unemployment increases, benefits rise and are offered
to more workers. Without benefits, these workers spending will decrease, causing AD to fall. During
expansion, benefits are reduced, so consumption increases at a slower rate.
Automatic stabilizers cannot stabilize economy on its own and eliminate gaps. They can only reduce
severity of fluctuations.

IMPACT ON POTENTIAL OUTPUT
Fiscal policy focuses on short-term stabilization but can impact long-term growth of potential GDP.
o Indirect effects: economic stabilization can create a macroeconomic environment that
encourages growth impacting activities. Firms can plan better if there is economic stability.
o Direct effects: Fiscal policies can allocate government spending on different types of capital.

EVALUATION: FISCAL POLICY
+ Pulling economy out of deep recession
+ Dealing with rapid and escalating inflation
o Contractionary fiscal policy can control the rapid price level increases.
+ Ability to target sectors of the economy
o Can change government spending priorities, i.e. education, health care, infrastructure, etc.
+ Direct impact of government spending on AD
o Government spending changes directly impact AD (taxes, not so much).
+ Ability to affect potential output
o Affects output indirectly and directly (see above).
Time lag (number of delays in timing)
o There is a lag until the problem (gap) is recognized. There is a lag until the appropriate policy
is decided upon. There is a lag until the policy takes effect. By the time the policy takes effect,
the problem may have changed.
Political constraints
o Some spending, such as for merit goods, cannot be cut if a contractionary policy is needed.
Tax increases are unpopular and tax decreases are popular, and this may cause unsuitable
policies being enacted.
Crowding out
o If the government increases spending without revenue increases, it needs to borrow (deficit
spending). This increases demand for money and increases the interest rate. Higher interest
rate lowers private investment spending, weakening the fiscal policy.
Partial crowding out: where the investment spending decrease is less than government
spending increases
Complete crowding out: where the fall in I is equal to the increase in G.
o Controversial, and some Keynesians believe
that the government spending can improve
expectations and raise output during a
recession.
Inability to deal with supply-side causes of instability.
o Fiscal policy cannot deal with stagflation, as
inflation needs a contractionary policy but the
recession requires an expansionary policy.

DEMAND-SIDE AND SUPPLY-SIDE POLICIES [4]
IB Economics SL Demand-side and supply-side policies
Tax cuts may not be effective
o In a recession, part of the increase in after-tax income is saved. Government spending
increases can be more powerful.
Inability to fine tune the economy
o Fiscal policy cant reach a precise target w/ respect to output level, employment, and price
level. Many factors affect AD simultaneously so the government cant control it all.

12.3 Monetary policy
CENTRAL BANKS AND INTEREST RATES
Monetary policy is carried out by the central bank of each country.
o Commercial banks financial institutions that hold deposits, make loans, transfer funds by
check, and buy government bonds.
o Central banks government financial institution with several responsibilities
Central bank responsibilities include:
o Banker to the government the bank holds the governments cash, receives payments, writes
checks, and manages the governments borrowing.
o Banker to commercial banks the bank acts as a banker to commercial banks and can hold
deposits for them.
o Regulator of commercial banks central bank makes sure commercial banks operate
according to the rules.
o Conduct monetary policy central bank responsible for monetary policy, based on changes in
money supply or interest rates
Every country has a central bank. In the Eurozone countries, the responsibility of monetary policy is
given to the European Central Bank.
Monetary policy impacts AD indirectly through the rate of interest.
o Borrowing money: payment for the loan (interest) and a principal. Different rates of interest
depending on: risk of loan, period of time over which loan must be paid (maturity), size of the
loan, degree of monopoly power, etc.
o Money anything that is acceptable as payment for goods and services, incl. currency and
checking accounts.
o Money market: horizontal axis measures quantity of money, and vertical axis measures rate of
interest. Rate of interest acts as the price of money. The supply of money is fixed, and the
level is decided by the central bank. It is usually a vertical line.
o The point where the demand and supply meet determines the
equilibrium rate of interest (i).
o An increase in the supply of money leads to fall in rate of interest
rate, and vice versa.
The central bank can focus on controlling the money supply or the rate of
interest. The money supply is harder to control, so most of the time they
focus on the interest rate.
o If a central bank wants to increase the interest rate, they will reduce
the supply of money. This allows the interest rates to be determined
by the market.
o The interest rate targeted varies by country: UK base rate, US federal funds rate, Eurozone
minimum refinancing rate

DEMAND-SIDE AND SUPPLY-SIDE POLICIES [5]
IB Economics SL Demand-side and supply-side policies
ROLE OF MONETARY POLICY
The ultimate goal is to influence AD by changing interest rates. The components of AD influenced
are: I, investment and C, consumption.
If interest rates increase, AD will decrease as borrowing is lowered and spending decreases.

TYPES OF MONETARY POLICY
Easy (expansionary) monetary policy is the policy that increases the money supply to expand AD.
o By increasing the money supply, interest rate falls, which makes consumers and firms more
likely to consume and invest, which will increase AD.
Tight (contractionary) monetary policy is the policy that decreases the money supply to lower AD.
o By decreasing the money supply, interest rates increase which causes consumers and firms to
consume and invest less, which decreases AD.

COMPARISONS
EXPANSIONARY CONTRACTIONARY
FISCAL
Govt spending increase
AD
increase
Govt spending decrease
AD
decrease
Decrease taxes (increase
consumption and investment)
Increase taxes (decrease
consumption and investment)
MONETARY
Increase supply of money (Lower
interest rate)
Decrease supply of money
(Increased interest rates)
Increase consumption and
investment
Decrease consumption and
investment

INFLATION TARGETING
Recently several central banks are trying monetary policy that maintains a particular rate of inflation.
Inflation targeting monetary policy that focuses on achieving a particular inflation target
o The target is usually between 1.5% and 2.5% with a tolerance margin of a percentage point
o Inflation target is set in terms of the CPI, but is usually based on predictions of future inflation
+ Lower and more stable rate of inflation
+ Improved ability to anticipate future rate of inflation
+ Coordination between monetary and fiscal policy
o Inflation targets allow governments to plan fiscal policy to work with monetary policy
+ Greater transparency and accountability
o Central bank becomes more open to the public
Reduced ability to pursue other objectives
o If bank focuses only on inflation, it cant pursue other goals like real GDP stability or full
employment levels
Reduced ability to respond to supply-side shocks
o If a supply-side shock leads to stagflation, the central bank may need expansionary monetary
policy, but it could cause inflation
Reduced ability to deal with unexpected events
Finding an appropriate inflation target
o Too low: unemployment, too high: problems regarding unemployment
Difficulties of implementation
o Forecasts can be unreliable

DEMAND-SIDE AND SUPPLY-SIDE POLICIES [6]
IB Economics SL Demand-side and supply-side policies
EVALUATION: MONETARY POLICY
+ Relatively quick implementation
o doesnt go through political process
+ Central bank independence
o independence from government means they can make decisions that are politically unpopular
+ No political constraints
+ No crowding out
+ Ability to adjust interest rates incrementally
Time lags
o There is still a lag until the problem is recognized and a lag until the policy takes effect
Possible ineffectiveness in recession
o During a recession, banks may not want to increase their lending because borrowers might
not be able to pay back.
Conflict between government objectives
Inability to deal with stagflation

12.4 Supply-side policies
SUPPLY-SIDE OBJECTIVES
Supply-side policies focus on production and supply side of the economy, especially on shifting the
LRAS or Keynesian AS curve rightwards.
These policies dont focus on reducing business cycle severity but increase quality and quantity of
factors of productions
Two types:
o Interventionist policies rely on government intervention and are favored by Keynesian
economists.
o Market-based policies focus on importance of competitive markets
INTERVENTIONIST SUPPLY-SIDE POLICIES
These policies presuppose that the free market cannot achieve the results of increasing potential
output and government intervention is required.
Investment in human capital
o Training and education better training/education can improve quality of labor resources to
increase productivity. Education has positive externalities that justify intervention. Measures
include: training, assisting young people with grants, etc.
o Improved health care services and access healthier workers are more productive, and can
have an effect in increasing the economys potential output. Health care also has positive
externalities.
o Human capital investments increase AD over the short term and increases potential output in
the long term.
Investment in new technology
o R&D results in new/improved capital goods, which can cause potential output increase. It has
positive externalities. Governments can provide patent protection or tax incentives.

DEMAND-SIDE AND SUPPLY-SIDE POLICIES [7]
IB Economics SL Demand-side and supply-side policies
Investment in infrastructure
o Good infrastructure can save time and effort. Good roads can make transportation costs and
times lower.
Industrial policies
o Industrial policies are government policies that support the growth of the industrial sector.
Policies above (investments in human capital, tech, and infra) count.
o Support for small/medium-sized enterprises/firms (SMEs) governments can support small
and medium-sized firms with tax exemptions, grants, and low-interest loans. This supports the
private sector.
o Support for infant industries infant industries are newly emerging industries in developing
countries
MARKET-BASED SUPPLY-SIDE POLICIES
In this view, real GDP tends to the long run equilibrium, so the government doesnt have to focus on
stabilization as much as creating conditions that let the market forces work well.
There are three main types:
o Encouraging competition
o Labor market reforms
o Incentive-related policies
Encouraging competition: competition forces firms to reduce costs, which results in greater efficiency,
improved allocation of resources, and possibly quality improvement. This makes the unproductively
used resources used productively.
o Privatization transfer of ownership of a firm from the public to the private sector. This can
increase efficiency because the improved management. Government enterprises are often
inefficient because they have unproductive workers, high costs, and other procedures.
o Deregulation elimination/reduction of government regulation of private sector activities.
Government regulation slows growth and increases efficiency.
Economic regulation government control of prices and outputs, offering them
protection against competition. Deregulation of this allows firms to enter monopolistic
industries to force competition.
Social regulation protecting consumers from undesirable effects (some w/ negative
externalities). This is actually being strengthened due to public safety, but some argue
that it is costly and inefficient.
o Private financing of public sector projects private sector firms will compete with others to
take on public sector projects.
o Contracting out to the private sector/outsourcing public services provided by private firms
based on contract
o Restricting monopoly power increased competition can result from enforcing anti-monopoly
legislation
o Trade liberalization (see in future notes)
Labor market reforms: increasing labor market flexibility/reducing labor market rigidities which make
labor markets more competitive, make wages respond to supply and demand, and lower labor costs.

DEMAND-SIDE AND SUPPLY-SIDE POLICIES [8]
IB Economics SL Demand-side and supply-side policies
o Abolishing minimum wage legislation this can reduce unemployment by letting equilibrium
wage fall. Increased flexibility can cause more investment and growth.
o Weakening power of labor and trade unions unionized labor groups usually succeed in
getting wage increases
o Reducing unemployment benefits unemployment benefits can reduce incentive for looking
for a new job
o Reducing job security This makes it easier and cheaper for firms to lay off workers, which can
increase profits.
Incentive-related policies: this involves cutting types of taxes
o Lowering personal income taxes in addition to tax decrease in fiscal policy, tax cuts can lead
to higher after-tax incomes which incentivizes people to provide more work and increases the
number of people looking for jobs; these can shift LRAS curve outwards
o Lowering taxes on capital gains and interest income capital gains tax is a tax on profits from
financial investments. Reducing this will make people more motivated to save, which increases
the amount available for investment.
o Lowering business taxes lowering business taxes increase AD, but also increases the after-tax
profits that can be used for investment
EVALUATION: SUPPLY-SIDE POLICIES
Time lags these policies work after time lags because all the policies need time to take action
+ Interventionist
o The market is unlikely to provide investment, R&D, training, education, etc. Interventionist
policies allow the government to target industries for possible growth.
+ Market-based
o Government interference may cause inefficiency and misallocation.
o Government interference may be less efficient due to political pressure and result in
government failure.
o Government interference requires spending, which has opportunity costs.
Debate over incentive-related policies
o Tax cuts have both supply-side and demand-side effects. However, increases in disposable
income can mean that people work less and have more leisure time.
Creating employment
o Supply-side policies can create employment by reducing the natural rate of unemployment.
o Interventionist policies reduce unemployment because the increased training and skills can
help with structural unemployment, and providing information that reduces frictional or
seasonal unemployment.
o Market-based policies can reduce unemployment by making the labor market more
responsive to supply and demand.
o Market-based policies that encourage competition can increase unemployment. Privatized
firms may want to maximize efficiency and cut costs by firing workers. However, these may
only be a short term increase, until the effects become more beneficial.


DEMAND-SIDE AND SUPPLY-SIDE POLICIES [9]
IB Economics SL Demand-side and supply-side policies
Reduce inflationary pressure
o Supply-side policies can shift the LRAS curve to the right, so it can reduce inflationary pressure
when an AD increase is matched by a LRAS increase.
Govt budget impact
o Interventionist and incentive-related policies affect the government budget negatively
Interventionist: based on government spending
Incentive-related: tax cuts
Equity
o Mixed effects.
o Interventionist (human capital): more positive, especially if distributed, because of increased
productivity. Interventionist policies that lower unemployment (natural) can lower inequality.
o Market-based: usually negative, because competition can result in unemployment.
o Incentive-related: may worsen income distribution
o Privatization: private firms with more market power can raise prices which hurts low income
groups.
Environment effects
o Market-based policies that increase competition may harm the environment as there may be
negative externalities in the methods used by private firms. Can be limited by the government.
12.5 Evaluating government policies to deal with unemployment and inflation
UNEMPLOYMENT POLICIES CYCLICAL UNEMPLOYMENT
Cyclical unemployment caused by low/falling AD. Expansionary policies can weaken the recessionary
gap and eliminate the unemployment.
o Expansionary fiscal policy
+ Pulling economy out of recession
+ Impact of govt spending on AD
Time lags
Political constraints
Crowding out
Tax cuts ineffective as spending
Inability to fine-tune
o If automatic stabilizers were present, the recession would not be as severe.
o Expansionary monetary policy
+ Quick implementation; incremental adjustment
+ No constraints; independence
+ No crowding out
Time lags
Ineffective in deep recession
Conflict among govt objectives


DEMAND-SIDE AND SUPPLY-SIDE POLICIES [10]
IB Economics SL Demand-side and supply-side policies
UNEMPLOYMENT POLICIES NATURAL UNEMPLOYMENT
Structural unemployment is the most serious part of natural unemployment.
Supply-side policies can address this usually.
Monetary policy and fiscal policy can be ineffective.
o Imagine economy at the level of potential output, and unemployment = natural rate. Increase
in AD will drop the natural rate temporarily, but result in inflation. The reduction of AD to
counter the inflation will return the natural rate to original.
o Fiscal policy, however, has some supply-side effects.
Interventionist supply-side policies
o Methods to reduce structural unemployment
Retraining programs
Grants and low interest loans for retraining
Direct govt hiring and training
Subsidies to firms hiring structurally unemployed workers
Subsidies/grants for relocation
o Methods to reduce frictional unemployment try to improve information flow, so that a job
seeker spends less time searching for a job.
o Methods to reduce seasonal unemployment include the increase in information to workers
about other jobs available during off-peak seasons
o These have direct positive impacts on job creation, but impact the government budget
negatively.
Market-based supply-side policies
o Increase labor market flexibility
Reduced minimum wage can reduce unemployment
Weaker labor unions reduce the pressure and make it easier to hire
Reducing job security makes it easier for firms to hire
o Can reduce rate of unemployment without negative effects on budget, but increase income
inequality and cause loss of low-income worker protection
INFLATION POLICIES: DEMAND-PULL
Demand-pull inflation caused by AD increase that makes inflationary gap. Contractionary policies can
decrease AD to bring the economy back to potential output.
o Contractionary fiscal policy
+ Dealing with rapid inflation
+ Direct impact on government spending
Time lags
Political constraints
Inability to fine-tune the economy
o Contractionary monetary policy
+ Quick implementation
+ Independence; no political constraints
Time lags and conflict with objectives

DEMAND-SIDE AND SUPPLY-SIDE POLICIES [11]
IB Economics SL Demand-side and supply-side policies
o Supply-side policies cant be used because demand-pull inflation has demand-side causes,
and supply-side policies have a lag. However, over long times, these policies can reduce
inflation by shifting the LRAS curve rightwards.
INFLATION POLICIES: COST-PUSH
Cost-push inflation caused by increase in costs of production or supply-side shocks which causes the
SRAS curve to move left (higher price level, decreased output, rise in unemployment).
Demand-side policies arent appropriate and there is no general solution to the problem.
o Some governments use contractionary monetary policy to lower AD but it will cause recession.
The policy used is usually based on the cause. If inflation is caused by a wage increase, efforts may be
taken to reverse the wage increase.
If the inflation is caused by an increase in the price of an imported input, the solution is harder to
find. In the case of oil, countries tried to reduce the demand for oil by using other forms of energy.
If inflation is caused by firms with monopolistic powers raising prices, policies that encourage
competition or break monopolistic powers can be used.
If inflation occurs due to a decrease in a countrys currency, policies that decrease dependence may
be used.
INFLATION POLICIES: INFLATION TARGETING
Inflation targeting is a type of monetary policy that keeps inflation at a targeted rate and does not
care about the type of inflation.
Though successful at maintaining low and stable rates of inflation, it loses the ability to pursue other
objectives.