Introduction

In the last few articles, we discussed aggregate demand (“AD”), aggregate supply (“AS”), and how gross domestic product (“GDP”) is determined through an interaction between them. Of particular importance is the shape of the long run AS (“LRAS”) curve.

Economists disagree about the shape of the LRAS curve, and whether economies can grow GDP through increasing AD.

Classical economists think that the LRAS curve is vertical due to market forces – see article on Classical AS. They think that economies can only grow GDP in the long-run through increasing AS, whereas increasing AD will only result in price increases (inflation), making citizens worse off. Accordingly, if AD increases too much, economies may need to take steps to control this.

However, other economists believe that the shape of the LRAS curve may vary depending on factors including (amongst others) spare capacity, diminishing returns, and investment – see articles on Keynesian AS and Conclusion of AD and AS.

If AD intersects the LRAS curve where it is flatter – i.e. where there is spare capacity – then an increase in AD may result in GDP growth without a disproportionate increase in prices. Indicators of spare capacity within an economy could include low inflation and high unemployment (amongst others).

Alternatively, if AD intersects the LRAS curve where it is steeper – i.e. the economy is operating at close to full capacity and experiencing diminishing returns – then an increase in AD may result in a disproportionate increase in prices compared to GDP (meaning people within an economy are worse off). In these circumstances, an economy will need to increase AS to achieve GDP growth and may need to take steps to control AD growth. Indicators that an economy has no spare capacity include high inflation and low unemployment (high employment), amongst others.

Accordingly, governments and central banks need to calibrate their policies according to the economic data available, what they think the economy’s LRAS curve looks like, and where AD is intersecting it.

In the next two articles, we discuss demand-side policies which are aimed at controlling AD.

Controlling aggregate demand

As the names suggest, demand side policies are aimed at controlling AD – whether to increase or decrease it, depending on various economic indicators.

You will recall from our article on AD that the formula for AD at a given price level within an economy is – consumer spending (C), plus investment (I), plus government spending (G), plus exports minus imports (X – M). Together: AD = C + I + G + (X – M)

Review our article on AD to remind yourself of the definitions of each of these components of AD.

Demand-side policies seek to increase or decrease one of the components of AD. Some demand-side policies may also have supply-side effects, which we discuss in later articles.

Fiscal policies

Broadly speaking, economic policies can be split into fiscal and monetary policies.

Fiscal policies relate to the levels of taxation and government spending, and monetary policies relate to control of money supply and interest rates.

Government spending

Government spending is a direct component of AD. Increasing government spending should therefore result in AD growth. Reducing government spending will have the opposite effect.

Governments can spend on a variety of things, such as infrastructure (roads, public transport) and public services (healthcare, social housing), and the welfare state (although, as noted in our article on AD, welfare payments don't count towards the G in the AD formula because they are transfer payments; although increasing welfare may increase C because people may have more money to spend).

However, governments cannot spend indiscriminately for a number of reasons.

Firstly, the rate of return (the benefits obtained versus costs) that governments get on their spending will vary according to the type of expenditure. For example, spending on new infrastructure may have a greater benefit to the economy than repairing potholes...

The efficiency of a project will also impact rate of return. If there are delays, errors, misuse of public money etc, the government may not get a good rate of return.

Secondly, many governments’ incomes derive predominantly from taxation, although there are other sources - such as the sale of natural resources (for example, sale of oil by the United Arab Emirates), returns on investments etc. Accordingly, governments have a finite amount of money to spend (without having to borrow more) and will want to ensure it is used effectively.

Thirdly, where a governments’ income is not sufficient to meet its expenditure plans, it will be required to borrow, increase taxation, or find some other source of income (for resource rich countries, this could include the sale of additional resources).

Money borrowed will need to be paid back and will bear interest at the prevailing market rate (taking into account the creditworthiness of a country). The higher the interest rate, the higher the cost of borrowing and the more that a government will have to pay back.

This will impact the rate of return for government spending (cost will include the amount borrowed, plus interest), and the amount of money that is available for future spending (money spent on interest payments could be used for something else). The level of deficit – how much government spending exceeds income, and how much a government has to borrow – is therefore a hotly debated topic.

Taxation

The level of taxation can affect various components of AD.

Consumer spending – If governments lower income tax, consumers will have more disposable income, which may cause an increase in consumer spending and therefore a rise in AD.

The same will apply if governments lower Value Added Tax (“VAT”), since goods and services will become comparably cheaper, and consumers can spend more on them.

However, the opposite will apply if governments increase tax.

Government spending – Governments also need to consider the impact of increasing or decreasing taxation on government income and spending (which will also have an impact on AD). Governments will need to consider the net impact of any change on AD. Is the money better in consumers' / firms' hands, or does the government need a certain amount of money to fund its activities?

Imports and exports – Governments can also control levels of imports and exports using taxation. If import tariffs are increased, foreign goods or services may be relatively more expensive than domestic ones. This may therefore result in reduced imports. The opposite will apply if governments reduce import tariffs.

However, governments do not legislate in a vacuum. Imposing tariffs could cause other countries to retaliate, which may affect the level of exports. This is a sensitive topic, and countries often enter into trade negotiations and agree trade deals, rather than acting unilaterally. The sensitivity of this topic can be demonstrated by the difficulty and speed (or lack therefore) at which the EU-UK Brexit trade negotiations progressed, and ongoing negotiations.

Monetary Policy

Monetary policy relates to the control of money supply and interest rates.

The monetary policy of a country is often controlled by its central bank, albeit with economic targets set by the government and, in cases, with some level of government control.

In the UK, the central bank is the Bank of England and in the USA it is the Federal Reserve.

The position is somewhat different in the Eurozone. Monetary policy for all countries that have adopted the euro is set by the European Central Bank (“ECB”). National central banks do retain some responsibilities for the financial system e.g. regulating financial services firms, but other powers are ceded to the ECB.

To increase AD, central banks can:

1. Increase the supply of money using various methods - Individuals, firms and potentially governments will have more money to spend, which increases AD. Increasing money supply too much may cause uncontrolled inflation, however, and central banks need to proceed with caution; and
2. Decrease the central bank interest rate - Various financial products, such as savings accounts and mortgages, are linked (or at least correlate for market reasons) with the central bank interest rate. Lowering the central bank interest rate will make saving less attractive because accounts will bear less interest, and people will therefore spend more. Further, mortgage repayments will (generally speaking) become cheaper and people will have more disposable income, thereby increasing consumer spending.

To decrease AD, central banks can reduce the supply of money or increase interest rates.

We discuss central banks and monetary policy in further detail in the next article.

Conclusion

You should now have an understanding demand-side policies, and how they can be used by governments to control AD.

In summary:

• AD = C + I + G + (X – M);
• Changing any of those components will have an impact on AD. There may also be supply-side effects, which we discuss in future articles;
• Increasing government expenditure will increase AD. Lowering government expenditure decreases AD;
• Governments can spend on a variety of things, including infrastructure, public services, and the welfare state;
• Governments cannot spend indiscriminately, because government income is finite, and borrowing can be expensive. Governments also need to think about the rate of return for their spending;
• Varying taxation can impact different components of AD. Governments need to carefully consider the net benefit from any such variation;
• Monetary policy is often set by central banks. To increase AD, central banks can increase money supply and lower interest rates. To decrease AD, central banks can decrease money supply and increase interest rates. We discuss this in further detail in the next article.