DEMAND MANAGEMENT POLICIES
use of govt spending and taxation to influence AD to achieve macroeconomic objectives
Expansionary
↑ AD
Contractionary
↓ AD
Govt spending
Operating Expenditure
Development Expenditure
Taxation
Direct tax (Paid directly to Government)
Indirect tax (Paid indirectly to the government via intermediaries)
Fiscal policies
Discretionary fiscal policies
Limitations
- Accuracy of prediction by government
- Conflict with other macroeconomic goals
- Inflation: if at or near full employment, excessive increases in AD cause demand-pull inflation
- BOP
- Risks of running into a budget deficit
- Gov Exp < Tax Revenue
⇒ Budget Deficit: Persistent → Accumulated debts → Borrowing to finance deficit and debts
- Crowding out effect
G is financed by borrowing → Increase AD → ↑ dd for loans → Upward pressure on i/r → Higher cost of borrowing → ↓I and ↓Cd → Fall in AD
Strengths
Unintended benefits of an increase in AS, even though the policy intent could be an increase in AD only
Direct impact on AD, intended consequence is met
↓ T
↓corporate income tax rate
→ ↑post-tax profit
→ ↑expected returns from investment
→ Volume of investment ↑at every given interest rates
→ MEI shifts to the right
→ I ↑
↓personal income tax rate
→ ↑households’ disposable income
→ ↑purchasing power
→ Consumption of goods will ↑ assuming normal goods
→ Cd ↑
↑ G ⇒ directly ↑AD
Depends on the accuracy of information gathered
Dynamic changes not accounted for → likely intended consequences not achieved and require government to review the fiscal policy decision.
Time lags:
- Decision making process takes time → Decision lag
- Implementation lag → at the time of implementation, policy no longer address the issues in the economy.
- Upon implementation → the effects take time to filter though the economy and agents
Monetary policy
manipulation of monetary valuables to influence AD to achieve macroeconomic objectives
↓ Interest rate
Money supply: The total stock of money in a country at any point in time
Exchange Rate: Price of domestic currency in terms of foreign currency
Interest rates: Cost of borrowing money
Determined by the demand and supply of money
↓ Exchange rate
↓ expected returns will now appear profitable increasing the firms’ incentive to invest
→ I ↑
↓cost of borrowing and ↓returns to savings
Less incentive to save
→ ↑ incentive to spend on credit + ↑ money left for spending after paying loans
→ Cd ↑
⇒ outflow of HOT MONEY
→ ↓dd for domestic currency
⇒ depreciation of currency
→ X-M ↑
Lower rate of return for financial investments
↓ price of exports → ↑dd for export → ↑X → ↑X-M
↑ price of imports → ↓dd for imports → ↓M → ↑X-M and ↑Cd
Limitations
Other factors affect I: gloomy consumer+business outlook
MEI is interest-elastic: The higher the interest elasticity, the more successful the policy
Limitations
Time lags: Marshall-Learner Condition may not hold
Availability of reliable information + Difficulty in predicting impact
Conflicts with other macroeconomic growth
- Imported inflation may offset part of price advantage of export gained
- Lack of spare capacity and resulting demand-pull inflation eliminate price advantage of a devaluation