POLICIES:

Fiscal policy can be used to alter the level of demand for different products
and also the pattern of demand within the economy. Decisions made by the
government on its expenditure, taxation and borrowing and revenue.
Gov expenditure is a component of AD, thus affects AD, such in time of
recession, expansion of AD = firms increase their production.

 Indirect taxes can be used to raise the price of de-merit goods and
products with negative externalities designed to increase the
opportunity cost of consumption and thereby reduce consumer demand
towards a socially optimal level
 Subsidies to consumers will lower the price of merit goods. They are
designed to boost consumption and output of products with positive
externalities – remember that a subsidy causes an increase in market
supply and leads to a lower equilibrium price
 Tax relief: The government may offer financial assistance such as tax
credits for business investment in research and development. Or a
reduction in corporation tax(a tax on company profits) designed to
promote new capital investment and extra employment. Influence AD
by reducing taxes, encouraging firms and households to increase
expenditure.
 Changes to taxation and welfare payments can be used to influence
the overall distribution of income and wealth – for example higher direct
tax rates on rich households or an increase in the value of welfare
benefits for the poor to make the tax and benefit system more
progressive

Monetary Policy: Decisions made by the government regarding the money

supply or interest rates and the exchange rates.

- Through interest rates it affects aggregate demand – higher interest

rates, firms invest lower, households do less consumption spending,
- Cost of borrowing becomes high, discourages borrowing and spending
- A fall in the rate of interest for example might be used to stimulate the
economy and bring unemployment down.
-

A bold monetary stimulus is designed to:

 Support business and consumer confidence

 Increase the effective disposable incomes of households with debts
such as mortgages
 Increase demand for interest-sensitive products such as household
appliances and new vehicles
 Help to bring about a depreciation in the exchange rate as hot money
flows are reduced
 Lower the cost of businesses borrowing money to fund their survival or
investments
Supply-side policies are mainly micro-economic policies aimed at making markets and industries
operate more efficiently and contribute to a faster underlying-rate of growth of real national
output. Impact on aggregate supply and potential capacity of economy to produce.

 Successful policies have the effect of shifting the LRAS curve to the right leading to a rise in
potential output/capacity to produce, or shift PPC outward. Influence firms and households
confidence in future of economy.
 Most governments believe that improved supply-side performance is the key to
achieving sustained growth without causing a rise in inflation.
 Supply-side reform on its own is not enough to achieve this growth. There must also be a high
enough level of AD so that the productive capacity of an economy is actually brought into play.
 Supply-side policies can be implemented by the public or the private sector

Supply-side objectives
Key concepts to focus on are incentives, enterprise, technology, mobility, flexibility and efficiency.

 1.Improve incentives to look for work and invest in people’s skills

 2.Increase labour and capital productivity, improvements in the productivity of the factors of
production.
 3.Increase occupational and geographical mobility of labour to help reduce the rate of
unemployment
 4.Increase investment and research and development spending
 5.Promoting more competition and stimulate a faster pace of invention and innovation to
improve competitiveness
 6.Provide a platform for sustained non-inflationary growth
 7.Encourage the start-up and expansion of new businesses / enterprises especially those with
export potential
 8.Improve the trend rate of growth of real GDP

Supply side Policies:

- Investment in human capital and physical capital
- Creating a stable macroeconomic environment, which encourages firms to invest
- Raising level of education and training, increases productivity of workers
- Overall productivity can be raised by making markets more flexible and by promoting competition,
Firms have incentive to reduce costs and produce more
- reductions in tax rates to increase the supply of factors of production,

Policies to correct Inflation and Deflation:

Inflation can be reduced by policies that slow down the growth of AD
and/or boost the rate of growth of aggregate supply (AS)

a. Possible use of negative interest rates if an economy is experiencing

price deflation
b. Central bank can move more quickly to change policy interest rates
and vary the scale of quantitative easing
c. A change in interest rates is perhaps more visible to consumers and
businesses

Fiscal policy:

1. Controlling aggregate demand is important if inflation is to be

controlled. If the government believes that AD is too high, it may
choose to ‘tighten fiscal policy’ by reducing its own spending on public
and merit goods or welfare payments
2. It can choose to raise direct taxes, leading to a reduction in real
disposable income
3. The consequence may be that demand and output are lower which has
a negative effect on jobs and real economic growth in the short-term

Monetary policy:

1. A ‘tightening of monetary policy’ involves the central bank

introducing a period of higher interest rates to reduce consumer and
investment spending
2. Higher interest rates may cause the exchange rate to appreciate in
value bringing about a fall in the cost of imported goods and services
and also a fall in demand for exports (X)

Supply side economic policies:

1. Supply side policies seek to increase productivity, competition and

innovation – all of which can maintain lower prices. These are ways of
controlling inflation in the medium term

i.A reduction in company taxes to encourage greater investment

ii.A reduction in taxes which increases risk-taking and incentives to work – a

cut in income taxes can be considered both a fiscal and a supply-side policy

iii.Policies to open a market to more competition to increase supply and lower

prices

Rising productivity will cause an outward shift of aggregate supply

Evaluation points – how best can inflation be controlled?

 The most appropriate way to control inflation in the short term is for the
government and the central bank to keep control of aggregate demand
to a level consistent with our productive capacity
 AD is probably better controlled through the use of monetary policy
rather than an over-reliance on using fiscal policy as an instrument
of demand-management
 Controlling demand to limit inflation is likely to be ineffective in the short
run if the main causes are due to external shocks such as high world
food and energy prices
 The UK is an open economy in which inflation is strongly affected by
events in the rest of the world
 In the long run, it is the growth of a country’s supply-side productive
potential that gives an economy the flexibility to grow without suffering
from acceleration in cost and price inflation.

Fiscal policy can be used but tends to have stronger but less
predictable effects on real output and employment or on prices.

Quantity theory of money states that inflation can only become

persistent if the money stock is increasing more rapidly than real
output.