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Demand-side Policy
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Detailed notes on Demand-side Economic Policy
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Demand-side PolicyFiscal policy
Fiscal policy involves the government manipulating the level of government expenditure and
or rates of tax so as to affect the level of aggregate demand. An expansionary fiscal policy
will involve raising government expenditure and or reducing taxes. A
deflationary/contractionary fiscal policy will involve cutting government expenditure and or
raising taxes.
Why might a government use fiscal policy?
• Try to remove any severe deflationary or inflationary gaps
• Try to smooth out the fluctuations on the economy associated with the business cycle
by fine tuning (the use of demand management policy (fiscal or monetary) to smooth
out cyclical fluctuations in the economy
• Try to influence aggregate supply e.g. increasing spending on infrastructure, tax
breaks etc.
Deficits and surpluses
➢ Central government deficit and surpluses
A budget deficit in any one year is where central government’s expenditure exceeds its
revenue from taxation. A budget surplus is where tax revenues exceed central government
expenditure.
➢ General government
General government includes central and local government.
➢ The whole public sector
• Total public expenditure
o Current expenditure is recurrent spending on goods and factor payments e.g.
wages and salaries of public-sector staff, administration and the payments of
welfare benefits.
o Capital expenditure is investment expenditure; expenditure on assets e.g.
expenditure on roads, hospitals and schools.
o Final expenditure is expenditure on goods and services. This is included in
GDP and is part of aggregate demand, and includes the wages of public sector
workers.
o Transfers are transfers of money from taxpayers to recipients of benefits and
subsidies. They are not an injection into the circular flow but are the
equivalent of a negative tax i.e. a negative withdrawal.
• Public sector deficits
o Public-sector net borrowing is the difference between the expenditures of the
public sector and its receipts from taxation and the revenues from public
, corporations. If expenditures exceed receipts (a deficit), then the government
has to borrow to make up the difference.
o Public-sector net cash requirement (PSNCR) is the (annual) deficit of the
public sector, and thus the amount that the public sector must borrow. It
differs slightly from the PSNB (public-sector net borrowing) because of time
lags in the flows of public-sector incomes and expenditure.
If the public sector runs a surplus it will be able to repay some of the public-sector debts that
have accumulated from previous years.
The use of fiscal policy
➢ Automatic fiscal stabilisers
To some extent, government expenditure and taxation will have the effect of automatically
stabilising the economy e.g. as national income rises, the amount of tax people pay
automatically rises. This rise in withdrawals from the circular flow of income will help to
damp down the rise in national income. Also, the total paid in unemployment benefits will
fall, if rises in national income cause a fall in unemployment. This again will have the effect
of dampening the rise in national income.
➢ Discretionary fiscal policy
Automatic stabilisers cannot prevent fluctuations; they merely reduce their magnitude. They
government may thus choose to enact discretionary fiscal policy (deliberate changes in tax
rates or the level of government expenditure in order to influence the level of aggregate
demand.
The effectiveness of fiscal policy
There are various problems with using fiscal policy to manage the economy. These can be
grouped under two broad headings: problems of magnitude and problems of timing.
Problems of magnitude
Before changing government expenditure or taxation, the government will need to calculate
the effect of any such change on national income, employment and inflation. Prediction these
effects, however, is often very unreliable for a number of reasons.
➢ Predicting the effect of changes in government expenditure
A rise in government expenditure of £x may lead to a rise in total injections (relative to
withdrawals) that is smaller than £x. This will occur if the rise in government expenditure
replaces a certain amount of private expenditure e.g. a rise in expenditure on public schools
or the national health service may lead to fewer people going private.
Crowding out (where increased public expenditure diverts money or resources away from the
private sector) is another reason why the total rise in injections may be smaller than the rise
in government expenditure. If the government relies of pure fiscal policy (fiscal policy which
does not involve any changes in money supply) it will have to borrow money from the non-
bank private sector. It will thus be competing with the private sector for finance and will have
to offer higher interest rates. This will force the private sector also to offer higher interest
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