Demand-side and
Supply-side Policies
Macroeconomics Section 3.4
1
Automatic stabilizers when economy
overheats
2
 Social benefits and taxes can act as automatic stabilizers
Unemployment
Falls
Social
payments
decline
Government
spending
declines
AD falls
Higher
income:
higher taxes
Less
disposable
income
Reduction in
Consumption
AD falls
Automatic stabilizers in recession
3
 Social benefits and taxes can act as automatic stabilizers
Unemployment
increase
Social benefits
increase
Government
spending
increases
AD rises
Lower
incomes:
lower taxes
More
disposable
income
Increase in
Consumption
AD rises
Fiscal and Monetary Policies
Demand-side & Supply-side
Policies
4
Discretionary Stabilization Policies
5
Discretionary
Policies aim to
Stabilize the
Economy
Fiscal
Demand-side
Policies
Monetary
Supply-side
Policies
Demand-side Policies
6
Fiscal
Policy
Focus on taxes
and/or
government
spending
Monetary
Policy
Focus on
interest rates
Expansionary Fiscal Policies (in recession)
7
Fiscal
Policy
Increase
government
spending
Decrease
personal and/or
business taxes
Combination of
both policies
8
The Government Budget and the
National Debt (Public Debt)




Government Budget = annual government spending
Budget Surplus = Tax Receipts > Spending
Budget Deficit = Tax Receipts < Spending
National Debt = Money borrowed domestically and/or
internationally (foreign debt) to balance the budget
 National Debt often expressed as % of GDP
9
10
Contractionary Policies (in inflation)
11
Fiscal
Policy
Decrease
government
spending
Increase
personal and/or
business taxes
Combination of
both policies
Strengths of Fiscal Policy
12
Combats rapid and
escalating inflation
Government
spending directed
at redistribution of
income
Government
spending on the
provision of public
goods and services
Combats a deep
recession
Weaknesses of Fiscal Policy
13
Time lags in
recognizing the
problem, determining
and implementing
policies
Inadequate
information
Political constraints
Crowding-out i.e.
Government
borrowing raises
interest rates
Tax cuts may be
ineffective
Unable to fine tune
economy
14
The Neoclassical/Monetarist
Challenge

Argument that discretionary fiscal polices that try to stabilize
the economy are so flawed that they actually cause
instability
Monetarist argue that governments should:
1. Take a long-term view about spending and taxation to
achieve social priorities
2. Ensure steady supply of money
3. Ensure price and wage flexibility
4. Focus on supply-side policies to achieve economic growth
Supply-side Policies
Market-orientated/
Interventionistorientated
15
Growth Policies
16
Discretionary Fiscal
Policies that aim to
increase potential
output
Market-orientated
Policies
Interventionistorientated Policies
Supply-side Policies
Market-orientated
17
Market-orientated Policies
18
Economic
Growth through
supply-side
policies
Price Stability
Full
Employment
19
Market-orientated Supply-side Policies:
Objectives
Reduce
Government
Sector
Improve
incentives for
private initiative
Ensure the Labor
market responds
to supply and
demand
Free Trade
(Discussed in
Section 4)
20
Reduce Government Sector
Deregulation
to encourage
competition
and efficiency
Restrict
Monopolies
Privatization
to increase
incentives and
reduce costs
Reduce
Government
Sector
Private
Financing of
Public
Services
Outsourcing
to Private
Sector
21
Reduce Government Sector: Pros and
Cons
More competition
Greater efficiency
Lower costs
Improved services
Public monopoly becomes private monopoles
Private financing expensive
Loss of flexibility
Job losses
Dangers of deregulation
22
Improve incentives by lowering taxes
Lowering taxes
on interest
income to
stimulate saving
and investment
Lowering
business taxes to
increase
investment, R&D
and innovation
Reduce personal
taxes to
encourage more
work
Improve
incentives
for private
initiative
23
Improving incentives : Pros and Cons
Increase quantity of labor and
capital
Reduce unemployment
Increase saving and investment
Increase R&D
Reducing taxes impacts AD
People work less & spend more
Inflation
Worsen income distribution
Increase government budget deficit
24
Make labor more responsive to supply
and demand
Weaken unions to
provide greater
flexibility, increase
profits and spur
economic growth
Abolish minimum
wage to provide
greater flexibility
increase profits
and spur economic
growth
Reduce
unemployment
benefits to lower
unemployment
rates
Make labor
more
responsive
to supply
and demand
Reduce job
security so firms
can fire at will
25
Make labor more responsive to supply
and demand : Pros and Cons
Labor markets more competitive
Wages respond to supply and
demand
Lower costs and higher profits
Increased employment
Increase income inequality
Unemployment benefits help to
maintain consumption
Supply-side Policies
Interventionist-orientated
26
27
Government policies to improve industry
Fund and
provide
incentives for
R&D
Provide
education and
health to
improve quality
of labor
Support SMEs
(small to
medium sized
firms)
Support
industry
Support infant
industries
through grants,
subsidies tax
exemptions &
tariffs
Invest in
infrastructure
28
Government policies to improve industry:
Pros and Cons
Provide an underpinning for
economic growth
Inefficiencies and resources
misallocation
Opportunity costs
Increased taxes
29
Shifting the SRAS and the LRAS in the
AS-AD Model
SR
LR
• Focus on the price of
labor, inputs and taxation
and legislation
• Focus on new technology,
new production methods,
quality and/or quantity of
FOPs
The Multiplier,
accelerator and
crowding effect
HL Topics
30
31
The Multiplier Effect
• Any change in
Consumption,
Investment,
Government
Spending and Net
Exports
Change
components of AD
Change in real
GDP
• Induced
expenditures, a
change reaction of
further expenditures
Marginal Propensity
MPS
• Marginal
Propensity to
Consume
MPC
•Marginal
Propensity
to Save
MPI
•Marginal
Propensity
to Tax
MPT
•Marginal
Propensity
to Import
1
32
33
Example of the Multiplier in Effect
Initial Spending by government
$100m
2nd Round of Spending
$60m
3rd Round of Spending
$36m
4th Round of Spending
$21.6m
5th Round of Spending
$12.96m
And So On
Last Round
Total Spending, including initial
spending by government
$0.01m
$249.99m
Assumption 60%
of additional
income spent on
Consumption
(MPC = 0.6)
The Multiplier
= 1/1-MPC
The Multiplier Effect
35
The Accelerator Theory & the Combined
multiplier/accelerator effect
 Argues that small changes in GDP produces larger
changes in investment spending.
 These fluctuations interact with the Multiplier effect to
increase the momentum of business cycle.
36
Crowding-out Effect
Governments
borrow to
finance fiscal
polity
Interest rates
rise
Private
investment falls
Crowding-out Effect
Crowding-out Effect