Demand-Side Policies

Fiscal Policy

Designed by the government and is a part of the budgetary policy. It is initiated by the government of the country and deals with two main areas - taxation and government expenditure.

Fiscal Policy is imposed to stimulate the aggregate demand in an economy while boosting economic growth. This is executed by altering the tax rates in an economy as well as the public expenditure (government spending). This greatly influences the level of economic activity in a country. 

Fiscal policy is the policy designed and initiated by the government with regards to revenue and expenditure to achieve macroeconomic objectives. (Definition)

1. Taxation is a major part of government revenue.

2. Government expenditure is dependent on taxation.

3. The government also earn revenue from fees and fine and profit earned from government enterprises.

Aggregate demand consists of C(consumption expenditure) + I(Investment expenditure) + G(government expenditure) + Net Export(X(export) - M(Imports))

Types of fiscal policy

Expansionary fiscal policy: aims to increase the aggregate demand in the economy. Used to correct the situation of unemployment, to achieve economic growth and is useful in the times of recession. Policy works to increase economic activities. 

Use two instruments: taxation and government expenditure. They reduce tax and increase government spending to avoid unemployment and recession. If the government reduces income tax, consumers will have more disposable income. This means that purchasing power of consumers in the economy increases. They start spending more. As a result, aggregate demand(total spending made by people in a country) rises. This may solve the problem of recession. Businessmen get more optimistic and motivated to produce more, they employ more people and thus unemployment falls, and GDP also rises. When corporate tax reduces, the profit of businesses will increase. Businessmen will be motivated to invest more. More investment leads to a rise in production. Again, employment will fall and GDP rises. When the government reduces indirect tax, the cost of production will reduce. If government spending rises, AD will rise as well.

Negative impact: Inflation rises, increase budget deficit

Contractionary fiscal policy: Used to control inflation. Aims to reduce AD. Increase taxation and reduce government spending. If the government increases income tax, consumers will have less disposable income. This means that purchasing power of consumers in the economy decreases. They start spending less. As a result, aggregate demand(total spending made by people in a country) falls. This can solve the problem of inflation. Businessmen get less optimistic and less motivated to produce, they employ less people and thus unemployment rises, and GDP also falls. When corporate tax increases, the profit of businesses will decrease. Businessmen will be less motivated to invest as well. Less investment leads to a fall in production. Again, employment will rise and GDP falls. When the government increases indirect tax, the cost of production will increase, thus demotivating producers further. If government spending falls, AD will fall as well.

Monetary Policy

A policy designed by the central bank of the country by changing its interest rate and supply of money to influence total demand in an economy and economic activities.

Designed by the central bank

The tools used by the central bank to use monetary policy

1. Interest rates

2. Money supply

It is a demand side policy - tries to influence the aggregate demand in a country

It is also designed to influence different economic activities and achieve macroeconomic goals

• Control inflation

• Ensure price stability, influence prices

• Influence the exchange rate(exchange rate policy)

• Influence employment situation in the country

Types of monetary policy

Tight monetary policy (contractionary): used when inflation levels are high to control the inflation. Central bank increases the interest. The cost of borrowing will be higher thus leading to a fall in consumer borrowing. Consumer spending will fall, thus leading to a fall in the aggregate demand. Cost of production rises, which also leads to businesses borrowing less. Investments will reduce which will lead to a fall in aggregate demand. Central bank will reduce the supply of money, which means there is less money with the people, it decreases the spending power of the people. As a result, aggregate demand will fall. Price of products will also fall.

Loose monetary policy (expansionary): Used in situations where there is a recession, unemployment, or economic growth needed. Central bank decreases the interest. The cost of borrowing will be lower thus leading to a rise in consumer borrowing. Consumer spending will rise, thus leading to a rise in the aggregate demand. Cost of production falls, which also leads to businesses borrowing more. Investments will increase which will lead to a rise in aggregate demand. Central bank will increase the supply of money, which means there is more money with the people. It increases the spending power of the people. As a result, aggregate demand will rise. 

Exchange rate policy 

Exchange rate - The value of one currency in terms of another currency.

How the central bank in a country, by changing interest rates, tries to change the value of the exchange rate.