Policy instruments

Demand-side policies

Demand-side policy is a deliberate manipulation by the government of aggregate demand in order to achieve macroeconomic objectives. There are two demand-side policies: fiscal policy, which is the government’s management of its spending and taxation with the aim of changing the total level of spending in the economy; and monetary policy, which is the decision making using monetary instruments such as the interest rate.

Fiscal policy
If government spending is greater than taxation, the government is operating a fiscal or budget deficit. The net effect is to pump spending power into the economy. The multiplier magnifies the effect of this boost. So, for example, if the government builds a new hospital and does not pay for it all through current taxation, but instead borrows to finance the scheme, there will effectively be more spending power in the future. When the government pays for the workers and building materials for this hospital, the incomes will be re-spent into the economy, creating more incomes – which is the multiplier in operation. If an economy is going through a slowdown or a recession, then according to Keynesian thinking, the government should spend its way out of the recession.

By contrast, if the government is spending less than taxation, there is said to be a fiscal or budget surplus, which take spending power out of the economy with negative multiplier effects. The consensus among economists is that in times of boom or fast growth in the economy, the government should rein in its spending to curb inflationary pressures. This is known as contractionary fiscal policy, and it puts the government accounts in a better position.

Does fiscal policy work?
In the UK fiscal policy can only be implemented in the annual budget, although there is some room for manoeuver in the autumn pre-budget report. This creates a time lag in decision making for fiscal policy, added to which there is an implementation lag because many tax changes cannot being until the start of the new fiscal year in April, sometimes one or two years ahead. This means that if the government tries to respond to current economic problems using fiscal policy, the effect will not become apparent until the economy has started to change tack in the normal course of its economic cycle. Furthermore, when a government deliberately sets out to expand its spending, people will try to cash in on this by expanding their pay demands, and the effect will be increased wages and costs, rather than expected output.

Next, there are crowding-out effects of increased spending by governments, For example, if a government tries to build a new hospital, there is less scope for a private hospital in the vicinity essentially providing the same service. There is also crowding out in a sense that when the government runs a deficit it needs to raise finance, which, in times when credit is less readily available, will stifle private initiative. However, it can be argued that expansionary fiscal policy simply causes inflation because the debt issued to finance the expansion, often Treasury bills, is so liquid that it acts like printing money.

Monetary Policy
The manipulation of monetary variables such as the interest rate has enormous implications across the whole economy. In the UK a group of up to nine economists forming the Bank of England’s Monetary Policy Committee, whose sole purpose is to control the level of inflation, makes the interest rate decision independent of government. They meet at least once a month for a day and a half to examine evidence from across the country relating to inflationary pressures. They have a target set for CPI inflation set for them by the Chancellor of the Exchequer, currently at 2% ± 1%. If inflation falls outside the range of 1-3%, the Governor of the Bank of England must write and open letter to the Chancellor to explain why this has happened. In the first 10 years of operation, this only occurred once when inflation reached 3.1% in MArch 2007, but has risen significantly above since May 2008. The most recent letter was about three weeks ago, when the CPI measured inflation at 3.7%.

Causes of inflation
In order to understand how monetary policy works it is important to consider the causes of inflation. In terms of AS/AS analysis, inflation can be shown as a shift to the right in AD, or a shift to the left in AS. A shift to the right in AS is often called demand pull inflation and it occurs whenever AD shifts to the right, usually exacerbated by the effect of the multiplier. A shift to the left in AS is known as cost-push inflation and occurs whenever costs of production increase in an economy. These might be for short term reasons, such as a fall in the exchange rate making imports more expensive, or for longer term reasons such as higher corporation taxes.

However, according to monetarists such as Milton Friedman, inflation is always and everywhere a monetary phenomenon’, meaning that inflation is caused by increases in the money supply about the rate of the increase in real output of the economy. Inflation can be controlled by controlling the money supply, either directly or perhaps more effectively though the rate of interest.

Costs and benefits of inflation
Monetary policy involves controlling inflation, whether too high or too low. To judge whether the policy is worth pursuing it is helpful to consider the costs of inflation and the possible benefits of a little inflation.

The costs of inflation include:

  • Loss of international competitiveness. Exports become relatively expensive and imports relatively cheap. The balance of payments is likely to worsen.
  • Redistribution of income. Those on fixed incomes will find incomes fall in real terms. Those with index-linked incomes will not loose out, unless linked to a fairly unrepresentative measure such as CPI.
  • Increased uncertainty. If firms think that costs are rising and fear increases in interest rates, they might curb investment.
  • Investment from abroad might decrease. Inflation erodes the value of money,  so why buy into a currency that is falling in value?
  • ‘Shoe-leather’ costs. The opportunity cost of spending more time withdrawing savings and holding less cash because of inflation.
  • ‘Menu’ costs. The money spent replacing signage, price labeling, and menus because of changing prices due to inflation.

Benefits of inflation might include:

  • Inflation reduces the real interest rate, so the cost of borrowing falls. Therefore, those with large debts such as mortgages will find their debt will fall.
  • Increased prices may be a sign that firms can make profits. So in contrast to the above point about uncertainty, it might mean that investment is encouraged.
  • A little inflation provides a cushion against the effects of deflation. When prices are falling in an economy, a vicious cycle of underinvestment and spending can occur.
  • A little inflation means that real wage differentials can be changed without actually cutting money wages. The argument is that people will accept wage rises below inflation, but not wage cuts.

How monetary policy works
When interest rates are raised, the cost of borrowing rises. Consumers who borrow in order to finance their spending might be deterred from doing so and savers will be less keen to spend their savings as there is a greater opportunity cost in doing so. People with mortgages – of whom there are almost 10 million in the UK – will find that their mortgage interest repayments rise, and will therefore be discouraged from spending, although those with fixed rate mortgages will not suffer this immediately.  Hire purchase – the method of buying major durable items, such as cars and white goods, on credit – will incur increasingly expensive monthly repayment installations, which means that consumers might delay further major expenditures.  House prices may fall as mortgages become less affordable, and this can cause negative wealth effects, where lower asset prices mean that people feel less inclined to spend and less able to take out loans based ont he equity of their homes.

Firms will find that investment is less attractive in many cases, and that fewer investments will make a return higher than the increased cost of borrowing. Therefore, firms will be less inclined to invest, which not only reduces current aggregate demand, but also has implications for long-term output prospects. The cost of exports might increase because interest rates are essentially a cost of production, so exports will fall and imports will rise. This is made even more likely when we factor in a very probable increase in the exchange rate, which occurs when ‘hot money’ is attracted to higher interest rates in the UK.

All these changes shift the AD curve to the left with multiplier effects. Depending on the shape of the AS curve, this may decrease both the price level and real output. Increasing interest rates can be an effective way of controlling inflation, but the cost is that economic growth also falls.

How effective is monetary policy?
Monetary policy has a shorter time lag than fiscal policy, although the MPC estimates that interest rate changes can take 18 months to 2 years to have their full impact. There are further delays because many mortgage holders have fixed-rate policies, which may delay the impact on their spending for some years. Furthermore, monetary policy is a very blunt tool that hits the whole economy, affecting both small and large firms, and rises in interest rates usually worsen income distribution. But perhaps the most significant criticism of monetary policy is that raises costs of production in a situation where the cause of inflation may be itself an increase in costs. So the rise in interest rates, rather than curing the problem, exacerbates it. In a time of rising commodity prices, the people who have to bear the brunt of this are those who have debts.

Supply-side policies

Supply-side policies include any action by the government intended to increase the amount that forms are willing to supply at any given price level. In other words, they seek to shift the AS curve to the right.

[diagram on page 51]

There are three basic ways of achieving this:

  • Increasing price flexibility and signalling in a market. If prices are not used to allocate resources effectively, there will be surpluses or deficits on the market. Suppose the government failed to increase the real rate of minimum wage: this means that real wages would fall and there would be less unemployment on the labour market. Firms’ real costs of production would therefore go down, and the AS curve would shift to the right.
  • Increasing competition. Reducing artificial constraints such as legal monopoly rights, as with the UK Post Office, can increase competition. As firms compete, they must either cut costs or become more innovative to survive, which effectively shits the AS curve to the right by reducing costs. Another way to increase competition is to privatise, although there is little scope left for privatisation of publicly owned firms in the UK. Deregulation is another option – this happened in the 1980s in the UK with the freeing up of the bus and coach operations sector.
  • Improving incentives. Incentives function by giving people higher rewards for what they do, and therefore motivating them to work harder. The most obvious way to do this is to vut marginal tax rates. Longer-term solutions involve improving health, education and training and introducing performance-related pay. Again, these will encourage forms to produce more at any given price level.

How effective are supply side policies?

While some supply side policies are clearly very effective – for example, deregulation of the phone industry has resulted in greatly improved standards in terms of price levels, after-care service and the like – there are some industries where there is either no opportunity for increased competition, or where the benefits are outweighed by the increased costs. For example, many people believe that increased competition in the NHS has merely resulted in increased managerial costs rather than improved efficiency.

Another issue with supply-side policies is the time lag. Some policies, most notably in education, can take many years to have any effect on production costs. If anything, in the short run costs may increase as there are less people in the labour market.

In addition, supply-side policies have side-effects on the demand side. For example, cutting taxes will have fiscal policy implications. Perhaps the most important aspect is that cutting minimum real wages and reducing trade union power affects lower-income earners adversely and disproportionally. However, effective supply side policies do have the benign outcome of both lower inflation and higher rates of economic growth.


One thought on “Policy instruments

  1. Pingback: » Was The Great Recession Really So? Five Arguments That Things Aren’t So Bad (And Five That They Are) Platykurtosity

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