S5 Economics 5.

1 Demand and supply-side policy

Governments want to influence the national economy so that it would achieve their objectives. They have a lot of
power over business activity and can pass laws to try to achieve their goals. The main ways in which governments
can influence business activity are called economic policies. They are:
Fiscal Policy: taxes and public spending.
Monetary policy: controlling the amount of money in the economy through interest rates.
Supply side policies: aimed at increasing efficiency.
Monetary Policy
Monetary policy is the process by which the government, central bank, or monetary authority of a country controls
the supply of money, availability of money, and cost of money or rate of interest in order to attain growth and stability
of the economy.
Monetary policy is generally referred to as either being an expansionary policy, or a contractionary policy.
An expansionary policy increases the total supply of money in the economy and is traditionally used to combat
unemployment in a recession by lowering interest rates.
Contractionary policy decreases the total money supply and involves raising interest rates in order to combat inflation.
Monetary policy is concerned with controlling the supply of money and the interest rates in the economy. The
government cannot control both the supply of money and interest rates at the same time.

Monetary policy and interest rates

Governments usually have the power to change interest rates through the central bank. Interest rates affect people
who borrow from the bank. When interest rates rise:
Businesses who owe to bank will have to pay more, resulting in less retained profit.
People are more reluctant to start new businesses or expand.
Consumers who took out loans such as mortgages will now have less disposable income. They will spend less
on other goods.
Demand will fall for businesses who produces luxury or expensive goods such as cars because people are less
willing to borrow.
Higher interest rates will encourage other countries to deposit money into local banks and earn higher profits.
They will change their money into the local currency, increasing its demand and causing exchange rate
appreciation.

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Fiscal Policy
Fiscal policy refers to government policy that attempts to influence the direction of the economy through changes in
government taxes or through some spending.
The two main instruments of fiscal policy are government spending and taxation.
Changes in the level and composition of taxation and government spending can impact on the following variables in
the economy:
Aggregate demand and the level of economic activity.
The pattern of resource allocation.
The distribution of income.
How Fiscal Policy works?
Scenario one: High rate of Inflation
High rate of inflation is caused by too much aggregated demand in the economy. Government will use deflationary
fiscal policy. Government will try to influence aggregate demand by reducing its public spending. The government
will spend less on construction of roads, bridges and other public spending and thus aggregate demand will fall. On
the other hand, Government may increase the tax rates. An increase in tax rates will take away the extra disposable
income out peoples pocket resulting in a lower demand.

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Scenario two: Low rate of Inflation

In an economic recession, aggregated demand, output and employment all tend to fall. Now the Government wants
to increase employment in the economy, it can attempt to do so by increasing aggregate demand. The Government
will increase the public spending resulting in a rise in aggregate demand. Government may reduce the tax rates so
that people have more disposable income to spend and instigate demand in the economy.

Watch a Video https://www.youtube.com/watch?v=1qhJPqyJRo8

Problems with Fiscal Policy

Reduce incentive to work
Raising taxes on income and profits reduce work incentives, employment and economic growth. An effort to
reduce aggregate demand may cause disincentives to work, if this occurs there will be a fall in productivity
and Aggregate supply could fall.
Adverse effect of lowering Public Spending
Reduced govt spending to Increase Aggregate demand could adversely affect public services such as public
transport and education causing market failure and social inefficiency.
Crowding out effect
With an increase in government expenditure, there will be greater competition for limited resources. This
will offset private investments resulting in shrinking of the private sector.
Inaccurate forecasting
If the Governments estimate or forecasting is wrong or inaccurate the Fiscal policy will suffer. For example,
if a recession is expected and the government practices deficit budget, and yet the recession turns out to be
a boom, this will cause inflation.
Implementation of the Policy
Planning for the spending is done once by most of the governments. If there is a delay in the implementation of
the fiscal policy, it might reduce the effectiveness of the policy. Thus the time lag is important.

Supply side Policies

Most supply side policies aim to enable the free market to work more efficiently and attempt to promote employment,
low inflation and economic growth. The main idea behind Supply side policies is to reduce Government interference.
Supply side policies include
Privatisation
Privatisation is the selling of state owned businesses to private individuals and groups. This increases the
efficiency of these organisations as they face more competition. Profit motive increases the incentive to
utilise the resources in the best possible way.
Deregulation
Deregulation involves reducing barriers to entry in order to make the market more competitive. It does away
with unnecessary rules and regulations on business which results in reduced cost, increased output and
lower prices. Moreover, it increases the competition in the economy, leading to higher efficiency for
businesses.
Increased education and training
Improving the level of education, training and skills of the workforce will raise the labour productivity and
increase the aggregate supply. Governments usually give a lot of importance to education and encourage
more and more people to attend universities and colleges and enhance the skills of the workforce.
Labour Markets reforms
By controlling the actions of the trade unions the Government can ensure that there is least disruption in the
business activities.

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Supply Side Main tools of Supply Side

Policies Less taxation on income for more incentives
Aim to increase the capacity of the economy to work
to produce Increase transfer payments
Boost output, employment, GDP Reduce taxation on firms for more incentive
Reduce inflation to produce
Increase exports Remove barriers to increase competition
Surplus in balance of payment Improve productivity through innovations and
Strong effect on exchange rate education
Privatization and public ownership
Direct controls and unions

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http://www.i-study.co.uk/Economics/Role_of_Government.html

1-Explain what is meant by fiscal policy.

Fiscal policy refers to all measures that relate to a government raising revenue and all measures that relate to the
spending of money by a government, i.e. it is concerned with public revenue and public expenditure.
The revenue can come from various sources, but in most economies the majority of it will come from different
types of taxations. The expenditures will be on various activities, including expenditure on defence, police,
education and health care. Fiscal policy involves a particular fiscal stance in terms of the balance between revenue
and expenditure. If public revenue is greater than public expenditure, there is a budget surplus which is regarded
as contractionary. If public expenditure is greater than public revenue, there is a budget deficit which is regarded
as expansionary. If public revenue is equal to public expenditure, there is a balanced budget which is regarded as
neutral.

2-Explain what is meant by monetary policy.

Monetary policy refers to all measures that relate to the price of money and the supply of money in an economy.
The price of money involves the interest rate and monetary policy is concerned with a government, or a central
bank, changing the main interest rate in an economy, which is usually known as the bank rate or base rate.
Monetary policy also involves changes in the supply, or stock, of money in an economy. A countrys money supply
can be made up of many different elements, although a distinction is usually made between narrow money and
broad money. Narrow money is mainly cash or balances that can easily be turned into money, i.e. it is relatively
liquid. Broad money tends to be less liquid, i.e. it would usually take longer to turn balance into cash.

3-Analyse the use of fiscal policies in influencing the level of aggregate demand in an economy.
Fiscal policies can be used to influence the level of aggregate demand in an economy. For example, if
unemployment is high, an expansionary policy could be followed where taxes could be cut and/or public spending
could be increased to increase the level of demand. Alternatively, if inflation is high, a contractionary policy could
be followed where taxes could be increased and/or public spending could be decreased to increase the level of
demand.
However, there are potentially some disadvantages and limitations of fiscal policies. For example, it may be
difficult for a government to accurately calculate by how much the level of aggregate demand in an economy
needs to be increased or decreased to achieve the desired objective. Also, increasing in public expenditure in an
expansionary policy may crowd out private spending because a government may need to raise funds for the extra
spending, leaving less money for the sector to borrow. If a government raises taxes to high in a contractionary
policy, such as income tax, there can be a disincentive effect and there may even be a brain drain where many
skilled, well-paid workers leave the country. If the policy is an expansionary one, it is possible that aggregate
demand is in excess of aggregate supply and this would cause the general level of prices in an economy to rise.

4-Analyse how monetary policy instruments can be used to influence aggregate demand in an economy.
Monetary policy instruments can be used to influence the level of aggregate demand in an economy. For example,
if unemployment is high, an expansionary policy could be followed where the interest rate could be cut and/ or
the supply of money could be increased to increase the level of demand. Alternatively, if inflation is high, a
contractionary policy could be followed where the interest rate could be increased and/or the supply of money
could be decreased to decrease the level of demand.
However, there are potentially some disadvantages and limitations of fiscal policies. For example, if there is a
change in the interest rate, it is assumed that this will have a significant effect on the level of aggregate demand
in an economy, but this may not necessarily be the case, i.e. demand may not be responsive to changes in interest

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rate meaning that the interest elasticity of demand is inelastic. An increase in the supply of money, such as through
the process of quantitative easing could increase the level of demand, reducing unemployment, but there is a
danger that if aggregate demand is greater than aggregate supply, that the rate of inflation in an economy will
increase.

5-Explain, using examples, what are meant by supply-side policies.

Supply-side policies aim to expand the productive potential of resources; for example, by increasing education and
training and removing barriers to increased trade and productivity ( for example, by curbing the power of trade
unions to strike).

6-Analyse how different supply-side policies could influence an economys ability to supply goods and
services.
Supply-side policies can be used to influence the level of aggregate supply in an economy. For example, training
and retraining schemes would increase the skill level of workers and made them more employable. Competition
could be increased in an industry, such as through a privatization initiative, and this would be likely to lead to
higher levels of efficiency and productivity. Disincentives to work could reduce, such as substantially reducing the
benefits patio to unemployed workers. However, there are potentially some disadvantages of supply-side policies.
For example, privatization could lead to great efficiency and productivity, but if a firm moves from the public sector
for the private sector, there is no guarantee that it will survive and if it goes bankrupt, many jobs be lost, leading
to an increase in the level of unemployment. Even with firms that survive in the private sector, it may become
necessary to make people redundant if the firm is to survive, again contributing to an increase in the level of
unemployment.

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Answer Key
(a) Governments use policy instruments when controlling the economy. They are like tools. Policy instruments are
economic variables such as the rate of interest, rates of taxation and levels of government expenditure. They can be
adjusted either directly or indirectly by the government.

(b) Monetary policy involves using policy instruments such as the interest rate to influence aggregate demand in the
economy. Many firms and consumers use borrowed money to pay for goods and services. Consequently, changes in
the interest rate will influence the amount borrowed and therefore the amount of demand in the economy. In this
case, India has cut the interest rates but says it has more scope to reduce them further.

(c) Fiscal policy can be used to influence aggregate demand in the economy. If, for example, a government wanted to
increase demand, it could increase government expenditure and lower taxes. This is a fiscal stimulus. The economy is
being stimulated using fiscal policy instruments.

(d) B is the correct answer. If interest rates are reduced, firms and consumers will borrow more to invest and spend.
This will create extra demand in the economy and more people will have to be employed to help meet this increase.

(e) The government in India is concerned about the fall in economic growth. Figure 2 shows that growth rates have
fallen from around 9 and 10 per cent to just 5.3 per cent in January 2009. The government has chosen both monetary
policy and fiscal policy to increase growth rates again. For example, since last October, Indias central bank has cut
interest rates to 5 per cent to raise the pace of growth. One of the advantages that India has over many other countries
in the world at the time is that...they have a lot of room in the area of monetary policy, said Planning Commission
Deputy Chairman Montek Singh Ahluwalia. He also said that, Many other countries dont have that headroom as they

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have lowered their interest rates to near zero. This suggests that further cuts are likely. India is also likely to use fiscal
policy. Ahluwalia says I would still argue that in spite of the high fiscal deficit there is a case for an additional fiscal
stimulus in the present circumstances for the next year.

(f) Supply side policies are designed to increase the productive potential of the economy. Their purpose is to promote
economic growth and they are aimed at the whole economy. Although sometimes supply side measures may be
targeted at a specific part of the economy that is holding up economic growth. One reason for the fast pace of growth
in India is down to the use of supply side policies. They have helped to increase competitiveness and productivity in
India. For example, financial markets have become more deregulated, allowing more flexible loans. These have helped
to increase investment which has led to increased capacity and competitiveness. There has also been more training
and education of at least part of the population. This can be shown using production possibility curves (PPCs). In the
diagram below, the PPC has shifted from PPC1 to PPC2. This shows that the productive potential of the Indian economy
has increased enabling more production of both consumer and capital goods.

Worksheet Monetary policy

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 S5 Economics 5.1 Demand and supply-side policy

Worksheet Monetary policy Answer Key

Getting started:

(a) In common with many other countries in the world, interest rates in the US have fallen since 2007. In 2007, the interest rate
was 5.25 per cent. Since then it has fallen quite steadily to just 0.25 per cent at the end of 2008 and remained there into 2009.

(b) Firms will benefit when interest rates fall. Firms which currently have loans, like Toledo Brakes, find that their interest payments
fall which reduces production costs. When interest rates are lower, firms are also more likely to borrow money to invest. For
example, as a result of the lower interest rates in the US, Toledo Brakes has decided to invest in new tooling technology and
upgrade its computer system.

(c) There is an inverse relationship between interest rates and consumer spending. This means that when interest rates rise,
consumer spending falls. This is because a significant proportion of spending is funded by borrowing. When the cost of borrowing
rises, there will be less borrowing, and therefore less spending. In this case, Emma Durham plans to reduce her spending because
the interest rate charged on her credit card has increased.

Economics in practice Monetary policy in Brazil:

(a) A government can influence aggregate demand by adjusting interest rates or the money supply in the economy. This approach
to demand management is called monetary policy. For example, in Brazil interest rates have been high. This has resulted in lower
levels of aggregate demand and lower inflation levels as a result.

(b) In 2001, the inflation target was 4 per cent. According to Figure 4 inflation was actually 6 per cent. However, it could be
concluded that the target was reached because a variation of up to 2 percentage points around the target is allowed.

(c) Brazils approach to monetary policy is similar to that of the UK. For example, interest rates are set by the Monetary Policy
Committee. COPOM is the committee responsible for decisions on interest rates in Brazil. Members, such as the governor of the
Central Bank and other officials, that sit on the COPOM have voting rights. In Brazil, as in the UK, the government sets targets for
inflation and the Central Bank publishes an inflation report on a quarterly basis which serves as a basis for decision making on
interest rates.

(d) A is the correct answer. If the money supply is allowed to grow too quickly inflation will rise.

(f) When interest rates are high, as they have been in Brazil (up to 25 per cent at times), eventually there will be a decrease in
aggregate demand. This is likely to result in a rise in unemployment. For example, higher interest rates will discourage consumers
from borrowing money to fund spending on items such as houses and consumer durables. As a result, the construction industry
and those firms producing goods such as cars, electronic goods, furniture and non-essential items, will lose sales and lay off staff.
Also, higher interest rates will result in higher mortgage payments for many households. This will reduce their spending power
and lead to a fall in demand. Again, firms will react by reducing capacity and laying off staff.

Higher interest rates will also discourage firms from borrowing to invest in new technology and expansion. This will hamper their
long term development. They may also lose their competitive edge in foreign markets. Also, if interest rates result in higher
exchange rates it may be difficult for firms to sell abroad. Exporters are likely to react by laying off staff. Generally, tight monetary
policy will result in higher unemployment, lower investment and lower economic growth.

(g) Brazils monetary policy is tight. Brazil is aiming to get inflation under control. It held interest rates high for a period of time.
For example, for several years up until 2006, interest rates were between 15 and 20 per cent. Indeed, for a while they were around
25 per cent. Such high interest rates in the economy suggest a tight monetary posture.

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Worksheet Fiscal policy

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 S5 Economics 5.1 Demand and supply-side policy

Worksheet Fiscal policy Answer Key

Getting started:

(a) Government expenditure is the money spent by the government to provide public sector services. Examples of government
expenditure in New Zealand include education, health, defence, law and order and social security payments. The New Zealand
government plan to spend $61.9 billion in 2008/09.

(b) The most expensive item of government expenditure in New Zealand is health care at $12.6 bn.

(c) The most important source of government revenue in New Zealand is individuals income taxes at $27.2 bn.

Economics in practice US fiscal policy:

(a) Figure 38.5 shows US government spending in 2008. Three categories of spending account for over 60% of the total. The
highest category is spending on health care which accounts for 23%. Social security and defence both account for 21% of the total.
These are the three main spending priorities for the US government.

(b) Fiscal policy is used to regulate aggregate demand in the economy. Governments can use changes in the tax system or changes
in the level of government spending to influence the level of aggregate demand in the economy. For example, if the government
wants to cut aggregate demand in the economy to help reduce inflation, it could cut government expenditure or raise taxes. Both
of these measures would dampen demand.

(c) Government spending on defence in the US is the highest in the world. In 2008, defence spending was about $613 bn. One of
the reasons why it was so high in 2008 was because of the nations military commitments in Iraq and Afghanistan.

(d) A is the correct answer. A sales tax is an indirect tax because it is a tax on spending.

(e) Expansionary fiscal policy involves providing a financial stimulus to the economy. This can be done by raising government
expenditure or reducing taxes or a combination of the two. In 2008, the US government took action to help boost the US economy
and avoid going into recession. About $170 billion in tax rebates was used to stimulate the economy. It was estimated that the
extra spending would increase budget deficits (or reduce future surpluses) by $152 billion in 2008 and by a net amount of $124
billion over the 2008-2018 period. Tax rebates were paid to individual U.S. taxpayers during 2008. Most taxpayers received a
rebate of at least $300 per person ($600 for married couples) plus an extra $300 per dependent child under the age of 17. This is
an example of expansionary fiscal policy. In 2009, as a result of the credit crunch the government found another $800 billion to
fund increased spending and further tax cuts. This is a further example.

(f) The amounts of money pumped into the US economy in 2008 and 2009 appear quite large. The extra money is designed to
boost the US economy and avoid recession. It is hoped that the extra money will increase aggregate demand resulting in economic
growth and a fall in unemployment. However, unfortunately, expansionary fiscal policy designed to promote economic growth
may cause inflation if demand rises too quickly. If people in the US spend the tax rebates quickly and at the same time other
government expenditure creates further demand, there may not be enough supply to meet demand. As a result prices will rise.
The increase in aggregate demand may also cause increased spending on imports and a worsening of the current deficit. Also,
expenditure on imports does little to help the US economy.

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Worksheet Supply side policies

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 S5 Economics 5.1 Demand and supply-side policy

Worksheet Supply side policy Answer Key Getting started:

(a) In 2003, Andrei received some financial support to help buy a new machine. The old machine was almost useless and he
couldnt really afford a new one. With the new machine, Andrei was able to produce more efficiently and lower his prices. This
led to more business and higher sales.

(b) Privatisation helped Andrei to get more business. After privatisation, Andrei was given the opportunity to supply parts to the
newly privatised AutoCo. Before privatisation, the company would not have considered Andreis business as a supplier. They just
stuck with their old suppliers. They had no incentive to look around for cheaper and better quality parts. This is because any losses
made by a nationalised industry are covered by the government.

(c) Lower taxes on business profits should provide an incentive for entrepreneurs to expand and develop their businesses. This is
because they get to keep more of the profit they make. Also, as in this case, if businesses can keep more of their profit, they have
more to invest. If more entrepreneurs set up businesses and expand them, and if there is more investment, aggregate supply will
increase.

Economics in practice Supply side policies in Ireland:

(a) Supply side policies are designed to help the economy increase its productive potential. They aim to promote competition,
improve labour market flexibility and encourage the flow of capital into the private sector for investment. In this case, the Irish
government has privatised certain industries to help promote competition. It has reformed training and education to improve the
quality of labour and given tax holidays to foreign businesses that invest in the country.

(b) (i) If the quality of labour can be improved, labour productivity will increase and it will be possible to increase aggregate supply.
Ireland has reformed training and education in an effort to equip the workforce with the skills needed by businesses. As a result,
firms will have access to a pool of skilled and qualified people which will enable them to produce more and contribute to the
increase in aggregate supply.

(ii) It has often been argued that state owned businesses are inefficient. They have no incentive to minimise costs and offer high
quality products because their losses are covered by taxpayers money. However, in the private sector such businesses are exposed
to competition. They have to give value for money and make a profit for their shareholders. As a result, they become more efficient
and therefore help to increase aggregate supply.

(iii) Extra government investment will increase aggregate supply because investment of any sort will help to increase the
productive potential of the economy. In this case, the government has invested heavily in communications technology and also
spent money reforming training and the education system.

(c) Some economists have argued that if taxes are too high, the incentive to work and set up and develop businesses is reduced.
If marginal tax rates are too high, people choose not to work extra hours and entrepreneurs are not prepared to take further risks.
The Irish government agreed with this view and as a result cut taxes. For example, they cut taxes on company profits to just 10
per cent. They also offered tax holidays to foreign firms setting up in Ireland. These lower taxes should act as an incentive for
businesses to set up and expand.

(d) B is the correct answer. Tax breaks should encourage them to invest in businesses and therefore provide them with valuable
capital to develop and expand.

(e) In 1985, unemployment in Ireland was 17 per cent, government debt was over 100 per cent of GDP and its tax rates were
some of the highest in Europe. Ireland was considered one of the most backward economies in Europe at this time. As a result,
the government decided to slash government spending and introduce a range of supply side polices designed to promote export
led economic growth. It could be argued that the governments strategy has worked because by 2003 unemployment had fallen
to around 5 per cent and economic growth was so high that Ireland was branded the Celtic Tiger. Figure 2 shows that economic
growth over the period was very high. For example, in 2001 growth reached 16 per cent. Even after 2002, when it dropped for a
short time, it averaged around 6 per cent. This is an excellent economic performance considering that growth of around 2.5 per
cent is the average for developed countries. However, there may be other factors that have contributed to Irelands good
economic performance. Fiscal policy and monetary policy may have played an important role. For example, interest rates may
have been very low during the period encouraging consumption and investment.

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