AD-AS Analysis

Demand Management Polices

Unit 2-The Exam

90 minutes long 50% AS Total 80 marks- 1 data response from a choice of 2. Each data response exercise contains 1 30 mark essay, which will require definitions, diagram(s), analysis and evaluation.

Fiscal Policy
Fiscal policy is defined as the use of government expenditure and taxation to influence the level of AD in an economy, in an effort to achieve the macro objectives.
In the UK, fiscal policy is mainly targeted at economic growth and employment.

Fiscal Policy
Keynesian economists argue that fiscal policy is a very useful tool for changing AD in an economy, especially when the economy is operating below full capacity (existence of a negative output gap).
Price Level LRASK

P* AD1 Q1 Output gap QF Real Output

Fiscal Policy
There are a number of transmission mechanisms we can look at. Firstly, any increase in government spending will increase the G component in AD, and so as G, AD.

Fiscal Policy
Price Level

G, AD

LRASK

P*

AD1

AD2

Q1

Q2

QF

Real Output

Output gap shrinks

Fiscal Policy UK Government Spending

Source: HM Treasury 2010-2011

Fiscal Policy
Government spending made up of:
1. Transfer payments- e.g. social protection 2. Current govt spending- e.g. defence, wages 3. Capital spending- e.g. education, transport

The Multiplier Effect

Whenever we deal with a change in government expenditure, it is useful to consider the multiplier process.
An increase in any component of AD will lead to an even greater increase in national income overall, via the multiplier process. So for an increase in G, the overall change in AD will be much greater than the initial increase.

Multiplier

G directly adds to AD and triggers multiple rounds of repeat spending (C)

This multiplier effect dampens out over time due to withdrawals (S, T, M)

The overall impact on GDP is greater than the initial injection

The Multiplier Effect

The extent of the multiplier effect will depend greatly upon the size of the initial change in AD, and also on the level of withdrawals in an economy. The greater the withdrawals, the weaker the multiplier effect.
Remember, you can also talk about a negative multiplier effect for any fall in AD. (http://www.ft.com/cms/s/0/985e76ba-4eb411dd-ba7c-000077b07658.html#axzz1NH6txvjo)

Fiscal Policy
We can also examine the fiscal policy transmission mechanisms involved with an alteration in tax rates.
EXPANSIONARY FISCAL POLICY involves a cut in tax rates to stimulate AD and the economy.

Fiscal Policy
Cut in income tax
Cut in indirect taxes

Increased disposable income

Lower pricesincreased real incomes

Cut in corporation tax

Cut in tax on interest from savings

Higher firm profits

Boost to disposable income for those with net savings

Fiscal Policy
Again, we see AD, as either C or I increase.
Price Level

T, AD

LRASK

P*

AD1

AD2

Q1

Q2

QF

Real Output

Output gap shrinks

Fiscal Policy
Remember when using a diagram, you must explain what has happened to price levels and real output/employment levels.

Fiscal Policy
CONTRACTIONARY FISCAL POLICY can be used when an economy is experiencing inflation (over-heating), or when the government needs to tackle a growing budget deficit and/or national debt level. G, T AD

Fiscal Policy
To reduce AD, must either increase tax, or reduce government spending.
Price Level

T or G, AD
P1

LRASK

P*

AD1

AD2

Q2

QF

Real Output

Fiscal Policy Evaluation

Risk of inflation linked to expansionary fiscal policy (can be seen more obviously on the Classical LRAS curve). Fiscal policy can also have some influence on the LRAS in the economy, particularly with regard to education and healthcare expenditure by the government, as well as lower tax rates creating incentives to work and invest.

Fiscal Policy Evaluation

A significant issue with expansionary fiscal policy is the risk of crowding out of private sector investment. As budget deficits require governments to issue debt, national debt stocks rise, potentially leading to a higher interest rate being charged on government bonds.

Fiscal Policy Evaluation

In an effort to remain competitive, banks will offer savers a higher interest rate on their deposits. This will mean that interest charged to lenders will be higher, and investment likely to fall (MEC theory).

Fiscal Policy Evaluation

It might also be useful to consider CROWDING IN as a counter-argument to this (this is more in line with the accelerator theory of investment).

Fiscal Policy Evaluation

Repayments and interest payments on existing national debt also represents an opportunity cost to the government. In the future, government expenditure may need to fall and tax rates rise to tackle a growing budget deficit and national debt. If households are aware of this, they may save more today, reducing the effectiveness of current, expansionary fiscal policy.

Fiscal Policy Evaluation

Other evaluation includes: 1. Time lags (decision, implementation, reaction) 2. Significance (how big is change in G/T?) 3. Consideration of other factors- e.g. current monetary policy in the economy may conflict with the aims of fiscal policy

Monetary Policy
Defined as the manipulation of monetary variables (interest rates, money supply, volume of credit) by the government, in order to achieve their macroeconomic objectives. Since 1997, UK interest rates set by MPC, who have inflation target of 2% +/- 1%, as measured by the CPI.

It is therefore useful when discussing the effects of monetary policy to focus on the price level in the economy.

Monetary Policy
By altering interest rates, the MPC can influence AD and, as a result, inflationary pressures within the economy.
The process of influence can be referred to as the monetary policy transmission mechanism: how changes in the base rate affect the decisions of consumers and firms, and ultimately the rate of inflation.

Monetary Policy
What data do the MPC consider when making interest rate decisions?

Monetary Policy
We will consider an example of expansionary monetary policy (e.g. a cut in interest rates).
It may be easiest to examine the effects of a cut on each of the components of AD in turn.

Monetary Policy
Consumption 1. Lower interest on savings- less inclined to save C 2. Borrowing is cheaper- expenditure on durables may increase C 3. Interest repayments on loans falls-more money available C 4. Mortgage repayments fall on variable mortgages-increase in discretionary income C 5. Mortgages cheaper- more demand for housing, house prices increase-POSITIVE WEALTH EFFECT C

Monetary Policy
Investment 1. Borrowing is cheaper for firms- more willing to borrow to invest-Marginal Efficiency of Capital Theory I 2. Increased demand for goods may force firms to invest to increase outputAccelerator Theory of Investment I

Monetary Policy
Exports-Imports 1. Lower interest rates in UK compared to other economies means that saving in UK banks is unattractive. 2. Fall in demand for , and so depreciates against other currencies, as hot money flows out of economy. 3. Exports increase, because they are now relatively cheaper, and imports, now more expensive because of the weakness of the , fall.

Monetary Policy
i- C, I, X,MAD
Price Level LRASK

We have demand-pull inflation

P1 P* AD2 AD1

With higher real output,Q1 a and smaller output gap

Q2 QF

Real Output

Monetary Policy Evaluation

The effectiveness of monetary policy depends on a range of factors:

Current fiscal policy The size of the interest rate changes The speed at which commercial banks pass on interest rate changes The % of variable mortgage holders in the economy

Monetary Policy Evaluation

Also consider: Time lags (12-18months) Asymmetric impact- a cut will reduce interest on savings for those with net savings- impact on income distribution The Liquidity Trap (e.g. Japan) Supply-side effects