Demand-side and
Supply-side Policies
Different policies used by government to
achieve macroeconomic stability
Demand-side Policies
Focus
on changing AD to achieve price
stability, full employment and economic
growth. These policies are put into effect
to counter the short-term fluctuations in
real GDP due to the actions of…….
The Animal Spirits!
Behavior of
consumers and
businesses are
responsible for the
ups and downs of
the business cycle.
Goals of Demand-side policies
To bring AD to
potential GDP or
create economic
growth by
increasing
potential GDP
Discretionary Fiscal Policy
 Fiscal
Policy
 Monetary
Policy
Stabilization Policies
Fiscal and monetary policies are designed to stabilize the
fluctuations of the business cycle. Remember, economists (but
not economics) are boring and like predictability!

Government Finance
Balanced
budget, Budget deficit,
Budget surplus and debt………
What’s
the difference?
Fiscal Policy
Fiscal
policy are the decisions made by
government concerning its taxes and
expenditures in order to influence the
level of AD. Fiscal policy can affect three
of the four components of AD, those three
are……..
Components of AD influenced by fiscal
Policy
Right you are!
Fiscal policy can
influence the level
of spending by
consumers,
businesses and the
government itself
How can fiscal policy be so powerful?
 The
government can increase or decrease the
tax rate on consumers
 The
government can increase or decrease the
tax rate on businesses
 The
government can increase or decrease its
own spending levels
Suffering from a recessionary
gap?
Fiscal policy remedy!
 Expansionary
fiscal policy to the rescue…….Uhmmmm,
what’s that again?
Expansionary Fiscal Policy

If we are experiencing a recessionary gap due to insufficient AD,
the following will help!

Increase government spending


Reduce taxes on consumers
Reduce taxes on businesses or

A combination of the above
Expansionary fiscal policy = more AD!
Different results at Different Stages
 If
we are in a deep recession (at the horizontal part of
the Keynesian AS curve) expansionary fiscal policy will
increase GDP without increasing the average price
level
 At
other points of the Keynesian AS curve
expansionary fiscal policy may or may not increase
GDP but will increase the average price level
Suffering from an inflationary
gap?
Fiscal policy remedy!
 Contractionary
fiscal policy to the
rescue…….Uhmmmm, what’s that again?
Contractionary Fiscal Policy

If we are experiencing an inflationary gap due to excessive AD,
the following will help!

Decrease government spending


Increase taxes on consumers
Increase taxes on businesses or

A combination of the above
Contractionary fiscal policy = less AD!
Halftime! Time for some review questions
Questions

What’s the difference between budget deficit and government debt?


What are the objectives of fiscal policy?
What’s the difference between expansionary and contractionary fiscal
policy?

What will fix an inflationary gap?

What will fix a recessionary gap?
Monetary Policy
Monetary
policy is carried out by the
central bank of each country. Central
banks also control the money supply,
determine interest rates and oversee the
banking system
Interest Rates
 So
what’s the relationship between interest
rates and the demand for money?
When interest rates are high, people hold less cash,
when interest rates are low, people hold more cash.
Comprende? Or is it Entiende?
Changes to the money supply
So what happens to interest rates if the central bank increase
the money supply? Interest rates increase, decrease or stay the
same?


And if the central bank decreases the money supply? Interest
rates increase, decrease or stay the same?
Interest Rates and AD
Why change the money supply?
As
you have already seen, when the
central bank increases the money supply,
interest rates fall, and when interest rates
fall, what happens to AD?
Easy Money!
Expansionary Monetary Policy
 When
the central bank increases the money
supply, interest rates fall, and consumers and
businesses are more likely to borrow. Increased
borrowing means increased spending, which
means increased AD which is the perfect
medicine to fight a recessionary gap!
Tight Money!
Contractionary Monetary Policy
 When
the central bank decreases the money
supply, interest rates rise, and consumers and
businesses are less likely to borrow. Decreased
borrowing means decreased spending, which
means decreased AD which is the perfect
medicine to fight an inflationary gap!
So to summarize…..
 During
a deflationary gap, to increase AD the government
may choose to increase spending or cut taxes (fiscal policy)
or increase the money supply/lower interest rates
(monetary policy)
 During
inflationary gap, to decrease AD the government
may choose to decrease spending or raise taxes (fiscal
policy) or decrease the money supply/raise interest rates
(monetary policy)
So which is better?
Fiscal or Monetary?
Strengths of fiscal policy
In case of emergency…
Fiscal
policy can be extremely effective
during times of economic emergency,
whether that is during a deep
recessionary gap (see 1930s) or times of
escalating inflation
Fiscal Policy and long-term economic
growth
 Expansionary
fiscal policy leads to investment and
gains in research and development/new technology as
well as infrastructure improvement and
training/education. All of these can have the effect of
shifting the AS curve to the right and create economic
growth in the future.
The many weaknesses of fiscal policy
Timing
 Fiscal
policy comes with delays. Delays in
recognizing the problem, delays in making the
appropriate decision and delays until the policy
has taken effect. By the time these “lags” are
overcome, the problem could be worse, maybe
been solved already…..
The many weaknesses of fiscal policy
Information
Fiscal
policy decisions are based on
statistical information compiled by
government workers. Can these workers
be trusted? Your teacher used to be one,
so what do you think?
The many weaknesses of fiscal policy
Politics
 Taxes
are unpopular. Government might want to raise
taxes to slow AD, but that is not going to be a popular
move with voters
 Government
might want to cut spending, but many
programs are protected by law, so this may not be
easy to do either
The many weaknesses of fiscal policy
Crowding Out?
If
the government begins to borrow more
money, what will happen to interest
rates? What effect will that have on
private investment? Might that be a
problem?
The many weaknesses of fiscal policy
Tax cuts don’t always lead to increased AD
Government
may think reducing taxes will
lead to increased spending, but if
consumer confidence is low, people may
just take that money and put it in the
bank, rather than spend it…..government
spending is more effective…
The many weaknesses of fiscal policy
Inability to “fine-tune” the economy
Fiscal
policy can guide the economy to a
certain point, but it is not very effective in
reaching precise targets in terms of
output, employment, or price levels.
Strengths of Monetary Policy
Strengths of Monetary Policy
Quick
implementation
No
political constraints
No
crowding out effect
Better
able to fine-tune the economy
Weaknesses of Monetary Policy
Lags can exist due to problem recognition, and time for policy
to take effect


Reliance on statistics compiled by government bureaucrats
May not be effective during severe recession (banks may not
want to lend money, consumers and businesses may not want
to take loans)

What about stagflation?
 Fiscal
and monetary policy can correct
economic problems that arise from a problem
with AD, but what about a negative supply
shock? Fiscal policy is unable to deal with
instability arising from a leftward shift of the
aggregate supply curve 
Pick one!!!
 Keynesians
believe most strongly in fiscal policy
while other economists are wishy-washy and
prefer a combination of fiscal and monetary
policy. Utilizing the strengths of each policy
together is probably the wisest strategy.
Opponents of Fiscal and Monetary Policy
 Monetarists
argue that demand-side policies only
make matters worse. They believe government should
focus on social priorities and change the money supply
to match the rate at which economic growth is
occurring. They also argue for policies that increase
wage and price flexibility to allow the markets to more
easily adapt to changing conditions.