Demand-side policies
(demand management)
 Focus: shift AD in the AD/AS model to achieve the





goals of price stability, FE and economic growth.
Based on the idea that short-term fluctuations of Real
GDP are due to actions of firms and consumers that
affect AD, causing inflationary and recessionary gaps.
They try to counteract the effect of those actions and
bring AD to the FE level of real GDP.
D-side policies can also impact on economic growth,
that is, increase potential GDP (shift LRAS curve to the
right). IB exam question last year!!
Discretionary and non-discretionary policy.
Stabilization policies

Discretionary policy: active and purposeful
government intervention to influence AD (the policy
is at the discretion of the gov). Two types:
Fiscal Policy
2. Monetary Policy
1.

Non-discretionary policy. AD is also influenced by
automatic stabilisers, which work to reduce the size
of economic fluctuations.
 Fiscal and monetary policies intended to reduce the
size of short-run economic fluctuations are called
stabilisation policies.
The government budget
 Sources of government revenue
1. Taxes, both direct and indirect (T).
2. Sales of goods and services (transportation, electricity,
water, …)
3. Sale of state-owned enterprises (privatisation).
 Types of government expenditure
1. Current (day-to-day) expenditures
2. Capital expenditures, including public investments or
the production of physical capital (building roads,
airports, harbours,…)
3. Transfer payments for the purpose of income
redistribution
 Current and capital expenditures are included under
G. Transfer payments do not represent value of new
output produced.
 Government budget: a plan of a country’s tax revenues
and expenditures over a period of time (a year).
 If G=T: balanced budget
 If G>T: budget deficit Gov needs to borrow
 If G<T: budget surplus
 Public/Government Debt is the gov’s accumulation of
deficits minus surpluses.
The role of Fiscal Policy (FP)
 Definition: manipulations by the government of its
own expenditures and taxes in order to influence the
level of AD.
 FP can affect AD through 3 components:
 G. Direct impact on AD
 C. FP, through changes in income taxes, affects the
disposable income of consumers, which affects their
consumption expenditures.
 I. Through changes in business taxes, FP affects the after
tax profits of firms, which has an impact on their level of
investment expenditures.
Expansionary Fiscal Policy


In a recessionary gap (Y<YFE), the gov can increase
AD with expansionary FP, which works to expand
the level of economic activity.
Expansionary FP can consist of:
1.
2.
3.
4.

↑G
↓ personal income taxes
↓ business taxes
a combination of the three.
An increase in G has a direct impact on AD
 A decrease in T affects AD in a 2-step process:
↓T → ↑Disposable income Yd / ↑After-tax businesses
profits → ↑C / ↑I → ↑ AD
 The gov can increase G and lower taxes at the same
time by borrowing to finance the excess of spending
over tax revenues.
 The increase in real GDP will be smaller in the
neoclassical model than in the Keynesian one, because
of the upward sloping neoclassical AS curve.
 The increase in the PL will be smaller in the Keynesian
model, where the increase in AD may result in no
increase in the PL at all if the AD shift occurs entirely
within the horizontal segment of the Keynesian AS
curve.
Contractionary Fiscal Policy
 In an inflationary gap (Y>YFE), the gov can decrease
AD with contractionary FP, which works to contract
AD and the level of economic activity.
 Contractionary FP can consist of:
1. ↓ G
2. ↑ personal income taxes
3. ↑ business taxes
4. a combination of the three.
 A decrease in G has a direct impact on AD
 An increase in T affects AD in a 2-step process:
↑ T → ↓ Disposable income Yd / ↓ After-tax businesses
profits → ↓ C / ↓ I → ↓ AD
 Figures 12.1 (expansionary FP) and 12.2 (contractionary
FP).
 Keynesian model with the ratchet effect (Fig 12.2 c)
The role of automatic stabilisers

Definition: factors that automatically, without any action
by government authorities, work toward stabilising the
economy by reducing the short-term fluctuations of the
business cycle. They represent non-discretionary policy.
1.
2.
Progressive income taxes
Unemployment benefits
 Progressive taxation. As income increases, the
fraction of income paid as taxes increases (increasing
tax rate).
 Proportional taxation. As income increases, the
fraction of income paid as taxes remains constant
(constant tax rate).
Progressive income taxes
 During an expansion, real GDP increases and tax
revenues automatically increase, causing disposable
income to be lower than otherwise. This acts to
dampen AD, counteracting the economic expansion.
In a recession, with real GDP and incomes falling,
government tax revenues decrease, causing disposable
income to be higher than it would otherwise be. This
exerts upward pressure on AD, reducing the severity of
the recession.
 The more progressive an income tax system, the
greater the stabilising effect on economic activity.
Unemployment benefits
 In a recession, as real GDP falls and UE increases, UE
benefits rise. The presence of UE benefits allows
unemployed workers to maintain their consumption to
some extent, as their benefits partially replace their
lost income, lessening the downward pressure on AD.
 In an expansion, UE benefits are reduced as UE falls.
Therefore, consumption increases less than it would in
the absence of UE benefits.
Fiscal policy and long term growth
D-side policies can contribute to ↑ the level of potential
GDP in two ways:
1. Indirectly, by providing a stable macroeconomic
environment in which consumers and firms can
plan and carry out their economic activities.



Firms must make decisions on investment in capital
goods and whether, how and in what areas to pursue
R&D and technological innovations.
Both the formation of capital goods and technological
changes are important factors in increasing potential
GDP.
In order to be able to plan over long periods of time,
firms need economic stability, ie, avoidance of sharp
economic upturns (inflation) and downturns
(recession and UE).
Directly (Figure 9.15):
2.


By encouraging investment through lower business
taxes, thereby contributing to new capital formation
and technological innovations.
By directing a portion of G
a.
b.
to the development of physical capital goods, such as
infrastructure (roads, telecommunications,...), as well as
on R&D, which improves technology and therefore the
quality of capital goods. This improves the productivity of
labour.
to the development of human capital, such as training and
education programmes that increase the quality of the
labor force and improve the productivity of labour.
All these factors work to increase potential output,
thus supporting long-term economic growth.
Evaluating Fiscal Policy
Strengths of Fiscal Policy
Pulling an economy out of a deep recession.
Combating rapid and escalating inflation.
Ability to target sectors of the economy. Changes in
the composition of gov spending depending on gov
priorities can affect specific sectors:
1.
2.
3.




Education
Health care, focusing on particular social groups that may be in
greater need.
Infrastructure and its location, focusing if necessary on
economically depressed regions.
Other merit goods
4. Direct impact of gov spending (G) on AD. Changes in
taxes are less direct, as they work by changing
consumers’ disposable income and firms’ after-tax
profit.
5. Ability to affect potential output. FP can affect Yp
and long-term economic growth indirectly (by
creating a stable economic environment) and
directly through investments in human capital and
physical capital and through offering incentives to
firms to invest.
Weaknesses of Fiscal Policy
Problems of timing. FP is subject to time lags:
1.



A lag until the problem is recognized .
A lag until the appropriate policy is decided upon by
the gov.
A lag until the policy takes effect in the economy.
By the time the policy has taken effect the problem may
have become less or more severe, so that the policy
is no longer the appropriate one.
2.
3.
4.
Political constraints. Gov spending and taxation are
subject to numerous pressures that are unrelated to
fiscal policy considerations. Spending in public and
merit goods is undertaken for its own sake and
cannot easily be cut. Taxes are politically unpopular
and might be avoided even though they might be
necessary.
Crowding-out effect. The increase in interest rate
caused by deficit spending can lead to lower
investment spending by private firms. A greater G is
offset by a lower I.
Inability to deal with supply-side causes of
instability. Ex: FP is unable to deal with stagflation.
5.
6.
In a recession, tax cuts may not be very effective in
increasing AD. Part of the increase in after-tax
income is saved. If this share becomes larger due to
pessimistic future expectations, the impacts of tax
cuts on AD will be even weaker. Increases in G are
more powerful.
Inability to fine tune the economy. FP can lead the
economy in a general direction of smaller or larger
AD, but it cannot be used to reach a precise target
with respect to the level of output, employment and
the price level. It is not possible to use FP to keep
real GDP at or very close to its potential level. There
are many factors affecting AD that the gov cannot
control.
Monetary Policy (MP)
 Carried out by the Central Bank (CB) of each country.
 Commercial banks are financial institutions whose
main functions are to hold deposits for their customers
(consumers and firms), to make loans to their
customers, to transfer funds by cheque and
electronically from one bank to another and to buy
government bonds.
 The Central bank is usually a government financial
institution with a number of important
responsibilities:
1.
2.
3.
4.
Banker to the gov. Among other, the CB manages the
government’s borrowing by selling bonds to
commercial banks and the public, and acts as an
adviser to the gov on financial and banking matters.
Banker to commercial banks, by holding deposits for
them and make loans to them in times of need.
Regulator of commercial banks, making sure they
operate with appropriate levels of cash and according
to rules that ensure the safety of the financial system.
Conduct monetary policy, through changes in the
supply of money or the rate of interest. It usually also
responsible for the determination of exchange rates.
 In the countries which form the European Monetary
Union (EMU), monetary policy is carried out by the
European Central Bank (ECB), located in Frankfurt.
The money market and the rate of interest
 MP impacts AD indirectly through the rate of interest.
 Interest is the payment (per unit of time) for the use
of borrowed money. Usually expressed as % of the
principal to be paid per year. This % is called the rate
of interest.
 Money is anything that is acceptable as payment for
g&s (ie, coins and paper money as well as checking
accounts)
 The money market is a market where the demand for
money and the supply of money determine the
equilibrium rate of interest. The horizontal axis
measures the quantity of money in the economy, and
the vertical axis measures the rate of interest.
 The rate of interest is the price of money services.
 The Demand for money, Dm, shows the relationship
between the rate of interest and the quantity of money
demanded. Dm is downward sloping.
Rate of
interest
Sm
i
Dm
Qe
Quantity
of money
 Why is Dm downward sloping?
 Money allows economic agents to carry out their buying
and selling exchanges.
 Money can be used as a form of saving when used to buy
bonds (a certificate issued by the gov or a firm that
promises to pay interest at various intervals until the
date when the money is repaid to the bond holder).
 So, interest is the opportunity cost of holding money, as
you could have received that interest if you had saved
the money instead of holding it.
 The higher i, the higher the opportunity cost of holding
money and the lower the quantity of money demanded.
 The Supply of money, Sm, is fixed at a level that is
decided upon by the CB, does not depend on i.
 The point of intersection between Dm and Sm
determines the equilibrium rate of interest.
 Monetary policy is carried out by the CB, through
changes in the money supply, which shift the Sm curve.
Rate of
interest
Sm3
Sm1
↑Sm → ↓ie
Sm2
↓Sm → ↑ie
i3
i1
i2
Dm
Q3
Q1
Q2
Quantity
of money
 In practice, the CB can target either the money supply
or the interest rate. Most central banks target the
interest rate: decide upon i and then adjust Sm so that
the actual ie will become equal to the target i.
 In the real world there are many interest rates and it
varies from country to country which one central
banks target.
 In the UK, the CB targets the ‘base rate’, which is the interest
rate at which the Bank of England lends to commercial banks.
 In the US, the Federal Reserve targets the ‘federal funds rate’,
the interest rate at which commercial banks borrow and lend
from each other over a 24-hour period.
 The ECB targets the ‘minimum refinancing rate’, which is the
interest rate paid by commercial banks when they borrow
from their respective national central banks.
The role of Monetary Policy
 Changes in i affect two components of AD:
 C, as some consumption is financed by borrowing.
 I, as firms borrow money in order to finance their
investment expenditures.
 Therefore:
↑ i → ↓ C , ↓ I → ↓ AD and AD shifts left
↓ i → ↑ C , ↑ I → ↑ AD and AD shifts right
Expansionary (easy money) Policy
 In a recessionary gap (Y<YFE), the CB increases Sm,
causing the interest rate to decrease.
 A lower i means a lower cost of borrowing, so
consumers and firms are likely to borrow and spend
more: ↓ i → ↑ C and ↑ I → ↑ AD.
PL
LRAS
K-AS
PL
SRAS
AD1
Yrec
YP
AD2
AD1
Real
GDP
Yrec
YP
AD2
Real
GDP
 The effects of the AD increase are different depending
on the shape of the AS curves:
 In the monetarist model there is a smaller increase in
real GDP and a larger increase in the price level
compared to the Keynesian model.
Contractionay (tight money) Policy
 In an inflationary gap (Y>YFE), the CB decreases Sm,
causing the interest rate to increase.
 A higher i means a higher cost of borrowing, so
consumers and firms are likely to borrow and spend
less: ↑ i → ↓ C and ↓ I → ↓ AD.
PL
LRAS
SRAS
AD1
AD2
YP
Yinf
Real
GDP
 If AD falls within the downward sloping part of the AS
curve in the Keynesian model, the effects on the price
level and real GDP are similar to those in the
monetarist model. But if AD decreases in the
horizontal part of the AS curve, there would be a larger
fall in real GDP and a smaller fall in the price level in
the Keynesian model.
 The ratchet effect also applies here.
Monetary policy and inflation targeting
 As we have seen, MP can be used to achieve the goals
of FE and a low and stable rate of inflation.
 In recent years, more CBs (26 in total) around the
world pursue a kind of MP that aims at maintaining a
particular targeted rate of inflation. Examples: New
Zealand (first one, 20 years ago), Australia, Canada,
UK, EU, Brazil, Mexico, among others.
 Defined by IMF as ‘…the public announcement of
medium-term numerical targets for inflation with an
institutional commitment by the monetary authority
to achieve these targets.’
 Targets range between 1.6% and 2.5%, with one
percentage point as a ‘tolerance’ margin.
 Target set in terms of the consumer price index (CPI)
but usually based on forecasts of future inflation based
on the CPI.
 If predicted inflation is higher (lower) than the target,
they use contractionary (expansionay) policy to
increase (decrease) i and lower (increase) AD, thus
lowering (increasing) the rate of inflation.
Advantages of inflation targeting
1. A lower rate of inflation.
2. A more stable rate of inflation (less fluctuations in
the inflation rate)
3. Improved ability of economic decision-makers to
anticipate the future rate of inflation. Public
knowledge about the CB’s objectives on inflation
reduces uncertainty and facilitates economic
decision making.
4. Greater coordination between MP and FP. Gov can
plan its FP to complement the CB’s monetary policy.
5. Greater CB transparency and accountability.
Disadvantages of inflation targeting
 Reduced ability of the CB to pursue other macroeconomic




objectives. MP can then not be used for other goals, such as
FE level of real GDP or exchange rate stability.
Reduced ability of the CB to respond to S-side shocks. This
might require expansionary MP, which may mean a higher
rate of inflation than the target.
Reduced ability of the CB to deal with unexpected events,
such as financial crises.
Finding an appropriate inflation target. If it is too low, it
may lead to higher UE; if it is too high, it could lead to the
problems resulting from high inflation.
Difficulties of implementation, as it is based on forecasts,
which are often highly unreliable.
Evaluating monetary policy
Strengths of Monetary Policy
Quick implementation. MP can be implemented
more quickly than FP because it does not have to go
through the political process.
No political constraints:
1.
2.


Even if a CB is not independent from the government,
MP is not subject to the same kinds of political
pressures as fiscal policy since it does not involve
changes in gov budget.
CB in many countries is independent of the governing
political party.
3.
4.
5.
No crowding-out.
Ability to adjust interest rates incrementally (in
small steps). This makes monetary policy better
suited to ‘fine tuning’ the economy in comparison
with FP. However, also subject to limitations.
Central bank independence. CB can take decisions
that are in the best longer term interests of the
economy, having greater freedom in pursuing
policies that may be politically unpopular.
Weaknesses of Monetary Policy
Problems of timing. Although MP does not depend
on the political process, it is still subject to time
lags:
1.


A lag until the problem is recognized .
A lag until the policy takes effect in the economy.
Changes in interest rates can take several months to
have an impact on AD, Y and PL. This time lags
becomes longer if there is pessimism in the economy.
2.
Possible ineffectiveness in recession. A tight money
policy can effectively combat inflation. However, an
easy money policy is less effective in a deep
recession. In a recession, lower i would encourage C
and I, increasing AD. This is under the assumption
that banks will be willing to ↑ their lending to
households and firms and that these will be willing
to ↑ their borrowing and their spending. However, in
a severe recession banks may be unwilling to ↑ their
lending and if firms and consumers are pessimistic
about the future they may avoid taking new loans
and may even ↓ their I and C. This situation
occurred in the 1930s during the Great Depression
and in 2008.
3. Conflict between government objectives.
Manipulation of interest rates affects also variables in
the foreign sector of the economy, such as exchange
rates. The pursuit of domestic objectives may conflict
with the pursuit of objectives in the foreign sector.
4. Inability to deal with stagflation. MP is unable to
deal effectively with S-side causes of instability, just
like fiscal policy.
 Inflation requires a contractionary policy
 UE requires an expansionary policy
Supply-side policies


Supply-side policies focus on the production and
supply side of the economy, specifically on factors
aimed at shifting the LRAS or Keynesian AS curves
to the right. The objective is to increase potential
output and achieve long-term economic growth.
They do not attempt to stabilise the economy , but
they focus on increasing the quantity and quality of
factors of production, as well as on institutional
changes intended to improve the productive
capacity of the economy.

Two types:
1.
2.
Market-based policies emphasise the importance of
well functioning competitive markets in achieving
growth in potential output. Favoured by
monetarist/new classical economists.
Interventionist policies attempt to achieve growth in
potential output by relying on gov intervention,
rather than the market. Favoured by Keynesians.
Interventionist S-side policies

They presuppose that the free market economy
cannot by itself achieve the desired results in terms
of increasing potential output. Therefore, gov
intervention is necessary in some areas.
1. Investment in human capital
1.
Training and education. More and better training
& education lead to an improvement in the quality
of labour resources, increasing the productivity of
labour. Public training & education programmes can
help workers to become more employable, reducing
the NRU. Education has positive externalities,
justifying government intervention. Examples:
 Setting up programmes for structurally unemployed





workers
Assistance to young people in the form of grants or low
interest loans
Offering subsidies to firms that hire structurally
unemployed workers
Assisting workers to relocate to areas with more demand
for labour through grants and subsidies (low cost
housing)
Providing information on job availability
Establishing government projects in depressed areas,
resulting in new employment creation
2.
Improved health care services and access to these,
which leads to improvements in the quality of
labour resources, as workers become healthier and
more productive. Health care has positive
externalities, which justifies government
intervention.
2. Investment in new technology


R&D makes technological advances possible, and
these are a very important factor behind increases in
potential output and economic growth. R&D also has
positive externalities, thus satisfying government
intervention. Gov in many countries are involved in
R&D and, in addition, they provide incentives to the
private sector to engage in R&D (tax incentives,
granting of patents).
Gov spending in support of new technology
development leads to increases in AD over the short
term and increases in YP over the longer term,
shifting the LRAS or Keynesian AS curves to the
right.
3. Investment in infrastructure
 Infrastructure is a type of physical capital and
therefore results from investment; it includes power,
telecommunications, roads, dams, urban transport,
airports and ports. Many types of infrastructure
qualify as merit or public goods, thereby justifying gov
intervention.
 More and better infrastructure increases efficiencies in
production as it lowers costs.
 More and better infrastructure improves labour
productivity.
 Investments in infrastructure work to ↑AD over the
short term but also contribute to ↑Yp and ↑ AS over the
longer term.
4. Industrial policies
 They are government policies designed to support
the growth of the industrial sector of an economy.
1. Support for small and medium/sized enterprises
(SMEs) in the form of tax exemptions, grants, low
interest loans and business guidance. This promotes
efficiency, more capital formation, more
employment possibilities and therefore increases in
potential output.
2. Support for ‘infant industries’. These are newly
emerging industries (in developing countries) which
sometimes receive gov support (grants, subsidies, tax
exemptions, export protection). This also provides
support for growth of the private sector and increases
in AD and growth in YP.
Market-based S-side policies
 Early 1980s, some monetarist economists in the UK
and the US emphasize the importance of the supplyside of the economy in the growth of real GDP.
Margaret Thatcher and Ronald Reagan adopted this
view.
 Since real GDP tends automatically (according to the
neoclassicals) towards long-run FE equilibrium, the
focus of gov policies should be less on stabilization and
more on achieving increases in potential GDP.
Theoretical justification


An economy pursuing S-side policies will be able to
achieve rapid growth, price stability and FE at the
same time. The reason is that a stable price level and
FE are expected to follow as a consequence of policies
that promote growth (ie, increasing AS).
In the neoclassical view, inflationary and recessionary
gaps are automatically eliminated. Therefore, as long
as the economy can move from one long-run
equilibirum to another, there will be no UE.



If increases in AS match increases in AD (Fig. 9.4) the
price level does not need to increase. Therefore
economic policy should focus on increasing AS
(shifting both LRAS ans SRAS) so that this will at
least match increases in AD.
Increases in AS may address the problem of
stagflation, which D-side policies cannot correct.
(Page 256, Fig. 9.15).
S-side policies may aim at:
1.
2.
3.
Encouraging competition.
Labour market reforms.
Incentive-related policies.
1. Encouraging competition
A. Privatisation, involving a transfer of ownership of a
firm from the public to the private sector, can
increase efficiency due to improved management
and operation of the privatised firm. Rationale: gov
enterprises are often inefficient (admin costs,
unproductive workers, burocracy), as govs do not
face incentives to maximize profits.
B. Private financing of public sector projects. A
private firm undertakes to build, finance and
operate public services and the gov buys the services
from the private firms. Increases competition,
efficiency and quality.
C. Contracting out to the private sector
(outsourcing). Increased competition, improved
efficiency, lower costs and improved quality.
D. Deregulation. Elimination or reduction of gov
regulation of private sector activities.


Economic regulation: government control of prices
and output, which offers firms protection against
competition. Ex: transport, airlines, tv broadcasting,
electricity,...
Social regulation: protection of consumers against
undesirable impacts of private sector activities in
areas like food, pharmaceuticals, worker protection
agains injuries and pollution control. Some
economists argue that social regulation is excessive.
E.
Restricting monopoly power can result in
increased competition, greater scope for the forces
of S and D, increased efficiency, lower costs and
improved quality. Ways of restricting monopoly
power:



By enforcing anti-monopoly legislation,
By breaking up large firms wngaging in
monopolistic practices into smaller units,
By preventing mergers between firms that
might result in excessive monopoly power.
F. Trade liberalisation. Free/freer trade increases
competition between firms both domestically and
globally, resultingin greater productive and allocative
efficiency.
2. Labour market reforms
Also referred to as ‘increasing labour market
flexibility’. The goal is:
•
•
•
•
•
to make labour markets more competitive,
to make wages respond to D and S forces,
to lower labour costs,
increase employment by lowering the NRU.
Lower costs of production → ↑ profits →
investment by firms → ↑ R&D, ↑ capital goods
production → ↑ YP
1. Abolishing minimum wage legislation, which
would reduce UE by allowing the equilibrium
wage to fall. The benefits would include lower
UE, greater firms profits (labour costs are lower),
more investment and economic growth.
2. Weakening the power of labour trade unions, so
that wages will be more responsive to S and D
and more likely to fall if there is UE. Same
benefits as above.
3. Reducing UE benefits, which are argued to have
the effect of lowering the incentive to search for a
new job. The effect would be lower UE.
4.
Reducing job security (laws that protect workers
against being fired making it costly for firms to
fire workers). It is argued that firms would be
more likely to hire new workers if they know
they can fire them easily and without cost when
they are no longer needed. Also, reducing job
security would decrease firm’s labour costs,
increasing profits.
3. Incentive-related policies
1.
Lowering personal income taxes. The gov can ↑
or ↓ personal income taxes as part of fiscal policy,
thereby ↓ or ↑ AD. S-side economists argue that
changes in income taxes have an even greater impact
on AS. They claim that tax cuts will give rise to
higher after-tax incomes, and this is an incentive for
people to provide more work. This can happen
through




↑ number of hours worked
↑ number of people interested in finding work
↑ number of years worked.
↓ in UE, as unemployed workers choose to shorten
the duration of their UE.
All these factors may work to shift the LRAS curve to the
right.
2.
Lowering taxes on capital gains and interest
income (taxes paid on income received from
interest on savings deposits). This will increase
incentives to save, increasing the funds available for
investment. More investment means a greater
production of capital goods and an increase in
potential output.
3.
Lowering business taxes increases AD by
increasing I. S-side economists argue that this is a Sside measure, since the increase in after-tax profits
increases the financial resources of firms to produce
new and improved capital goods and pursue
technological innovations. Both these effects
increase potential output.
Evaluating S-side policies
1. Time-lags. Most S-side policies work after
significant time lags, making their effects on AS over
the longer term. The reason is that increased
competition, labour market reforms, investments...
need time to materialise and affect YP. However,
interventionist policies also have an effect on AD
over the short term. Therefore,


in a recession they have the advantage that they can help
close a recessionary gap.
If an economy is experiencing inflation, they could add to
inflationary pressures
2. Impact on economic growth
1. Increases in YP. In addition to investments in capital
and new technologies, economic growth is encouraged
by the development of institutions involving
incentives and the promotion of the market system,
allowing the well functioning of the private sector.
There is general agreement among economists on the
role of S-side policies in increasing YP.
2. Arguments favouring interventionist policies.
1.
2.
Major advantages of targeted gov support in areas such as
investment, R&D, training and education… as the market is
unlikely to provide them.
Industrial policies allow the gov to support industries with
the greatest possibilities for growth in the future
(experience of Asian Tigers).
Questionable growth performance of many LDCs that
adopted market-based S-side policies in the 1980s.
3. Arguments favouring market-based policies
 Gov interference in the market may lead to inefficiencies and
resource misallocation, while reliance on the market can achieve
long term growth without these disadvantages.
 Gov interference may result in less efficient arguments because
of the influence of political pressures, lack of necessary
information,… Gov may lack the ability to choose the right
industries to support, leading to a poor allocation of resources.
 Interventionist policies rely heavily on gov spending and use
resources that have opportunity costs. Also , they require high
taxes (disincentives to work) and a large gov sector
(inefficiencies).
3.
Incentive-related policies
 Tax cuts
 D-side effect: ↑disposable income → ↑Consumption → ↑AD
 S-side effect: incentives to work and save more.
 However, some economists think that S-side effects are less
important. First, workers may decide to work less and increase
leisure time, and second, they may decide to consume more and
save less, with no significant effects on saving and investment. In
the Us, savings are at the lowest point in the past 80 years, after a
series of tax cuts.
 Disagreement on whether the growth occured in countries
where tax cuts have been implemented is the result of these.
Growth is the result of both d-side and s-side effects of d-side
and s-side policies and it is very difficult to detect which
particular policy has been responsible for each particular effect.
4.
3. Ability to create employment (reduce NRU)

Interventionist policies involving investments in
education and training can reduce UE by:




Enabling workers to acquire the skills necessary to
meet the needs of employers (structural UE)
Providing assistance to workers to relocate (structural
UE)
Providing information that reduces UE when workers
are between jobs (frictional UE) or between seasons
(seasonal UE)
In addition, better-educated and trained people are
more employable.
 Market-based policies involving labour market reforms
may also contribute to ↓ NRU by making the labour
market more responsive to S nad D.
 On the other hand, market-based policies that focus on
encouraging competition may increase UE over the
short-term. For instance, privatised firms often try to
cut costs by firing workers and deregulation has often
led to increased UE. It is possible that this increase in
UE ia reversed over the longer term as the economy
begins to benefit from the broader effects of S-side
policies.
4. Ability to reduce inflationary pressure.
 S-side policies are likely to reduce inflationary
pressures over the longer term, as they are intended to
shift the LRAS curve to the right. As an economy
grows, if increases in AD are matched by increases in
AS, there will be little or no upward effect on the price
level.
 Increases in efficiency (due to increased competition)
and lower wage costs (increased labour market
flexibility) keep costs of production down, which
reduces inflationary pressures.
5. Impact on the government budget. Interventionist
policies (increased gov spending) and incentiverelated market based policies (tax cuts) have
negative effects on the gov budget.
6. Effects on equity (=greater income equality). S-side
policies have mixed effects:
Interventionist policies focusing on investment in
human capital are likely to have positive effects on
equity over the longer term:



Educated and healthy workers are more likely to be
employed, and income is likely to be relatively more equally
distributed.
A lower NRU means more equality, as previously
unemployed workers receive income.
 Market-based policies tend to have negative effects:


Greater competition may result in some UE, which involves a
loss of income.
Labour market reforms result sometimes in reduced
protection for workers with very low incomes and with income
uncertainties (minimum wage legislation, protection against
being fired, UE benefits), which contributes to increasing
income inequalities.
 Tax cuts may also worsen income distribution.

The argument that high taxes create disincentives to work and
save applies mainly to higher income groups who face higher
tax rates. Therefore, to reverse this problem tax cuts must
affect higher income groups, but this would make the tax
system less progressive and income distribution would be less
equal.

Since it is the wealthy who enjoy capital gains and earn most
of the interest income and profits, tax cuts in these areas will
affect wealthy people by increasing their after-tax incomes
more than they will affect lower income groups.
 Prices of products sold by privatised firms. If private
firms have a degree of market power, they are likely to
increase their prices above gov prices. As their products
become less affordable, this may have negative effects
for lower income groups, particularly if these firms
provide necessities or merit goods.
7. Effects on the environment
 Market-based policies to increase competition
(privatisation, deregulation) may have negative effects
on the environment because of the increased scope for
activities leading to negative externalities affecting the
environment.
8. Concluding comments
 Most economists believe that interventionist and
market-based policies should complement each other,
and that the particular mix of policies will be different
according to each country’s social and economic
conditions.