Demand side policies can shift the AD curve but what about the
AS curve?
Fiscal policy
and
monetary
policy
HL
May
2010, P1
2(b) Evaluate the likely
effects on the economy of
relying on demand-side
policies to reduce the
unemployment rate. [15
marks]
Answers may include:
an explanation of the use of interest rates to
reduce the unemployment rate
an explanation of the use of increased
government spending/lower taxation levels to
reduce the unemployment rate
an explanation of the linkage between lower
interest rates and AD
an explanation of the “crowding out” effect
resulting from government borrowing to increase
government spending
an explanation of the linkage between increased
government spending and lower taxation and AD
a consideration of the suitability of demand-side
policies for different types of unemployment
the impact on output, growth, inflation and the
balance of payments
use of AD/AS diagrams
AD moving to the right causes inflation on the
vertical part of the AS curve
the inappropriateness of lower interest
rates/higher government spending/ lower
taxation in dealing with real-wage or natural
unemployment
demand-side measures effective against
demand-deficient unemployment
supply-side measures to deal with
unemployment
the problems associated with increased
government spending (running a budget deficit)
the problem of inelastic response of consumption
and investment to lower interest rates
the problem of time lags.
Examiners should be aware that candidates may
take a different approach which if appropriate,
should be rewarded.
Effective evaluation may be to:
consider short-term versus long-term
consequences
examine the impact on different stakeholders
discuss advantages and disadvantages
prioritize the arguments.
Planning this essay:
Definitions of demand side policies, fiscal and monetary policy, and unemployment
Analysis – how fiscal and monetary expansion can lead to reduced unemployment –
related to AS / AD diagram.
Evaluation – effectiveness – crowding out, depends on type of unemployment, neoclassical arguments regarding the tendency for the economy to return to the
‘natural rate of (full) employment’. Time lags and accuracy of forecasts on which to
base ‘correct’ policy response. Need for supply-side policies also.
Demand side policies are policies adopted by the government to manipulate the level of
aggregate demand in the economy. There are two types of demand side policy. Fiscal policy
relates to government spending, taxation and borrowing. Monetary policy relates to the
setting of interest rates or the control of the money supply in an economy.
In order to reduce unemployment (which includes members of the workforce who are out of
work and actively seeking employment) fiscal and / or monetary policy needs to be loosened.
This will entail raising government spending and / or cutting taxes, or cutting interest rates
respectively.
Raising government spending increases AD directly as AD = C + I + G + (X-M). The extra
spending in the economy will go through multiplier rounds as the recipients of the extra
government spending buy goods and services and the recipients of this expenditure go on to
buy extra goods and services. At each round the amount remaining in the circular flow of the
economy will be reduced by withdrawals – income saved, taxed or spent on imports.
Nevertheless, the final change in national income will be higher than the original boost in G
that brought it about. Like a stone falling in a pond the initial action causes several
diminishing ripples. The final change in national income is the summation of all those incomes
/ expenditures.
Cutting taxes will ensure that households have a higher level of take home income which can
lead to an increase in consumption spending. However, this may depend crucially on the level
of confidence. If households are worried about job security they may save any additional take
home pay leading to no increase in AD/ consumption spending.
Interest rates are the reward for saving and the cost of borrowing. Interest rates may be
lowered to encourage borrowing and spending. Low interest rates also weaken the incentive
to save. The result is more borrowing, less saving and more consumption spending in the
economy. Firms may also borrow to invest in new capital equipment, further boosting
aggregate demand and setting off further rounds of multiplier income and expenditure.
Lowering interest rates also discourages speculative demand for the currency as traders look
for higher returns elsewhere. Consequently, the value of the currency may fall. This would
make exports cheaper in foreign currencies and imports more expensive. Export demand will
increase and import demand will fall, eventually this will improve the current account if
combined elasticities of X and M are greater than one.
In the below diagram the impact of fiscal and / or monetary expansion is to shift the AD
curve from AD1 to AD2, real output increases from Y1 to Y2 and as a result employment
increases and unemployment decreases. (Simple diagram here, full labelled)
However, there is much controversy regarding whether this impact on unemployment is likely
to be sustainable. Neo-classical economists argue that the economy will naturally return to
full employment at the ‘natural rate’ of unemployment if wage rates fall, bringing about
equilibrium in the labour market. At this natural rate, workers may still be frictionally and
structurally unemployed. With this latter type of unemployment, workers have lost jobs in
declining industries as changing patterns of demand or technology render their industry in
long term decline. These are jobs that are not coming back and require those effected to be
retrained and, perhaps, relocated. Simply boosting aggregate demand may be of little use to
these unemployed if they do not have the appropriate mix of skills and experience for the
jobs that are created. Instead, supply-side policies, which aim to improve the quality and
quantity of factors of production, such as labour, may be more appropriate. Hence, training
schemes and incentives to set up businesses can lead the structurally unemployed back to
employment. Supply side policies shift the LRAS to the right and the LRPC to the left, raising
the capacity of the economy and, by enabling workers to be more responsive to the needs of
the economy, reducing the level of structural unemployment. Supply-side polices are largely
focused on the labour market, include restricting the power of trade unions, removing or
reducing minimum wages or unemployment benefits and reducing income tax rates. These
are designed to make the labour market work like any other market – so surpluses can be
cleared through falling prices, or in this case, wage rates.
Furthermore, neo-classical economists argue, any attempt to reduce unemployment below
the natural rate will only lead to inflation in the long run. Any short run increase in
employment and output (Y1 to Y2) is due to workers not realising that inflation PL1 to PL2 (a
consequence of demand management expansion) is about to occur and so confuse a nominal
pay rise for a real pay rise. When workers realise their pay cheque does not buy what it used
to they bid up their wages causing AS to shift from AS1 to AS2, causing a further rise in the
price level – PL2 – PL3. The economy has simply returned to its long run equilibrium on the
LRAS curve.
Draw diagram here.
However, Keynesian economists argue that the main cause of unemployment is due to a lack
of aggregate demand in the economy and thus strongly support the use of expansionary
fiscal and monetary policy. They argue that wages are sticky downwards so that the
existence of unemployment does not lead to wage rate falls and an equilibrium being
established at full employment. Therefore, with a high level of unemployment, for example
during a recession, it is the moral responsibility of the government to provide the necessary
boost to aggregate demand in order to reduce unemployment. In such times, trade unions
will not bid up wage rates as they will not have the power to insist on them when there is still
a large pool of unemployed workers who may be happy to work at the prevailing wage rate.
Boosting AD (AD1 to AD2) lead to a rise in real output (Y1 to Y2) and hence lower
unemployment but with no or marginal impact upon the price level. Keynes argued that
governments could not wait around for wage rates to fall as it would take several years for
this long run to be reached, by which time we might be dead. (Draw diagram here.)
Most economists agree that fiscal and monetary expansion can help an economy grow, and
unemployment fall, when there is a recession and a negative output gap exists (the difference
between current output and the level needed to bring about full employment). Moreover, they
may argue that the SRPC is relatively flat when there is an output gap, meaning that fiscal
expansion and a corresponding fall in unemployment may not lead to higher inflation. This is
the argument put forward by the Keynesian / Neo-classical synthesis. This view suggests that
there will be a level of unemployment at which capacity constraints mean that further fiscal
expansion will eventually lead to high rises in inflation (and the SRPC becomes relatively
steep). Hence, this level of unemployment is often referred to as the Non-Accelerating
Inflation Rate of Unemployment NAIRU. Nevertheless, without tending to the capacity of the
economy through successful supply-side policies the capacity of the economy to create jobs
will be limited, and high levels of unemployment can persist. Hence, demand management
policies can be used to alleviate unemployment in the short run, but they will need to be
combined with supply-side policies if unemployment is to be kept low in the long run.