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 .

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

AD↑ LRASK P* AD1 AD2 Q1 Q2 QF Real Output Output gap shrinks .Fiscal Policy Price Level G↑.

Fiscal Policy UK Government Spending Source: HM Treasury 2010-2011 .

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

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

M) The overall impact on GDP is greater than the initial injection .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.

• Remember.ft. the weaker the multiplier . and also on the level of withdrawals in an economy. (http://www. you can also talk about a negative multiplier effect for any fall in AD. The greater the withdrawals.The Multiplier Effect • The extent of the multiplier effect will depend greatly upon the size of the initial change in AD.

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

Fiscal Policy Cut in income tax Cut in indirect taxes Increased disposable income Lower pricesincreased real incomes C↑ C↑ Cut in corporation tax Cut in tax on interest from savings Higher firm profits Boost to disposable income for those with net savings I↑ C↑ .

as either C or I increase.Fiscal Policy • Again. we see AD↑. 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.

T↑ → AD ↓ .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↓.

must either increase tax.Fiscal Policy • To reduce AD. Price Level T ↑ or G↓. or reduce government spending. AD↓ P1 LRASK P* AD1 AD2 Q2 QF Real Output .

. particularly with regard to education and healthcare expenditure by the government.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. as well as lower tax rates creating incentives to work and invest.

• 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 • A significant issue with expansionary fiscal policy is the risk of crowding out of private sector investment.

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

.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).

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

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

in order to achieve their macroeconomic objectives.Monetary Policy • Defined as the manipulation of monetary variables (interest rates. • It is therefore useful when discussing the effects of monetary policy to focus on the price level in the economy. who have inflation target of 2% +/. money supply. as measured by the CPI. . • Since 1997. UK interest rates set by MPC. volume of credit) by the government.1%.

• 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.Monetary Policy • By altering interest rates. the MPC can influence AD and. as a result. . inflationary pressures within the economy. and ultimately the rate of inflation.

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

. 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.g.Monetary Policy • We will consider an example of expansionary monetary policy (e.

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

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

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

Monetary Policy i↓.Q and a smaller output gap Q2 QF Real Output .M↓»AD↑ Price Level LRASK We have demand-pull inflation P1 P* AD2 AD1 1 With higher real output.C↑. I↑. X↑.

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.g.a cut will reduce interest on savings for those with net savings. Japan) • Supply-side effects .impact on income distribution • The Liquidity Trap (e.