| Demand Side Policies
There are two categories which demand side policies can fall under; Fiscal Policy and Monetary Policy (which includes Quantitative Easing and Credit Easing).
Fiscal policy is the manipulation of government expenditure, taxation and borrowing in order to control the economy. It can take the form of an expansionary fiscal policy; whereby the government attempts to expand the economy, or contractionary fiscal policy; whereby the government tries to control an overheating economy.
Note: When talking about government spending or expenditure in regards to Fiscal Policy, we include benefit payments in this category.
Discretionary fiscal policy is the amount of money that a government chooses to inject into the economy in order to boost aggregate demand. When talking about expansionary and contractionary fiscal policy we are referring to the discretionary part of government spending (as oppose to automatic stabilisers).
Expansionary fiscal policy usually entails tax reductions and/or increases in government spending and generally happens during an economic downturn, as advised by Keynes, in order to kick-start the economy, or at least not make it worse. Increases in government spending has the effect of providing an immediate boost to aggregate demand as G is a component of AD. Tax reductions mean that households have more disposable income which they may choose to spend, thus boosting C in aggregate demand. Even if they choose to save it, the increase in savings should - theoretically - reduce the interest rates for borrowing and thus encourage firms to invest; although, in practice firms are unlikely to invest if household consumption is low and the economic outlook is bleak. This is because firms base their investment decisions more on expected profitability (usually as a result of high demand) compared to the level of the interest rate.
Budget Surplus/Deficit
If the government spends more than it receives in taxation it will have a budget deficit. If it receives more tax than it spends then it will be running a budget surplus.
A budget deficit can be financed by depleting savings ran up from a previous budget surplus, or through borrowing on the financial markets with the expectation of increasing taxes and/or reducing spending in the future in order to pay off the debt. Alternatively the government may decide to roll-over debt (re-issue it) or pay for its debt by printing money.
A government is likely to be running a budget deficit during a recession (when it is using Keynesian measures to boost the economy) and a budget surplus during an economic boom in order to finance expansionary measures during the inevitable recession. This policy of smoothing out the business cycle was advised by Keynes, whom only believed in government spending as a measure to boost the economy when it was in the doldrums and their was a deficiency of demand.
Governments should always budget their balances in the long run. Some choose to do this on a cyclical basis and others choose to do it on an annual basis. By requiring yourself to budget a balance annually you may have to make painful cuts during a recession, even if this is counter-productive and may worsen economic pain. By balancing a budget over the economic cycle(from boom to bust) a government can use a contrast of expansionary and contractionary fiscal policies to boost the economy.
A structural budget deficit, is a deficit which would persist even if the economy was doing well; so thus ignoring the cyclical effects of automatic stabilisers. A government is running a structural budget deficit if it is running a deficit even when the economy is at its full potential.
 The graph to the left demonstrates how a budget deficit or a surplus would arise. The two curves are T for tax receipts, and G for government expenditure. G is downward sloping; as the economy produces more output (and hence there will be higher employment) benefit payments will fall. T is upward sloping as if the economy is doing well then tax receipts will increase. There is only one point where the government could be 'breaking even' on its budget which is the point where the T and G curve intersect. If the economy is to the right of this point then the government will be running a budget surplus, to the left and there will be a budget deficit.
Along with the value of the increase in government spending or the fall in taxation, there will be an associated multiplier. We have already seen that the multiplier is likely to be higher for government spending than for tax reductions.
To the left is a graph showing the macroeconomic equilibrium attained by an expansionary fiscal policy. The economy is initially at PL1Y1, which as we can see means it isn't operating at the full-employment level. This means that resources are idle, and on a PPF graph the economy would be operating at a point within, but not on the curve. The government intervenes in the economy to try and increase employment levels and output, by increasing government spending and thus leading to a rightward shift in aggregate demand from AD1 to AD2. The new equilibrium point is PL2Y2; which, as we can see, means there is less unemployment than before, more output but also more inflation. The same thing would happen if the government had reduced taxes - AD would rise as a result of an increase in the C component (although, probably to a lesser extent than increases in G due to people saving some of this tax break and other withdrawals).
The government would be advised to conduct an expansionary policy so long as aggregate demand isn't at full-employment. The further to the left aggregate demand is (i.e. the greater unemployment and the larger the size of idle resource) then the greater effect an increase in aggregate demand will have. Remember though that for the government to increase G it would have to reduce its budget surplus or borrow more. See Ricardian Equivalence for an evaluation of this point.If the government were to conduct expansionary fiscal policy whilst the economy is at or close to full-employment output, then it would only serve to increase inflation whilst doing little to reduce unemployment or increase the amount of output.
Government expenditure is treated as an injection into the circular flow, and will be expanded by the multiplier effect. The higher the multiplier the more effect that government spending will have, this is dependent on the size of withdrawals from an economy. See more about the multiplier. When undertaking fiscal policy the balance of payments needs to be taken into account. Part of an increase in AD is likely to be withdrawn into spending on imports whereas in the short run there isn’t likely to be an increase in exports. Therefore in the short run there is likely to be an increase in the current account deficit on the balance of payments.
 Contractionary fiscal policy usually means tax increases and/or government spending decreases. It is also known as austerity and is advised for when the economy is overheating (when the economy is at full-employment output and growth is just resulting in inflation), although some governments have conducted austerity measures during a recession or economic slump in order to receive fiscal packages from international organisations like the IMF, or to reassure bond markets that the government won't default. Contractionary fiscal policy can either directly reduce aggregate demand by a reduction in the G component, or indirectly through a fall in consumption as a result of lower disposable income through a rise in taxation, or because of higher prices through indirect taxation. This will cause a leftward shift of the AD curve, which as we can see, would cool the economy down a bit. If the economy is operating at the full-employment output level and inflation is high, then the leftward shift of AD will benefit the economy by reducing the rate of price increases (note: inflation is still occurring, just at a slower rate than before) whilst unemployment is still relatively low (but may rise as a result of the measures). On the other hand, if austerity measures are used when the economy isn't at full-employment output levels then it is likely to result in even greater unemployment. In this case we are likely to see cumulative causation occurring, whereby the government’s actions in order to reduce a budget deficit (a government is only likely to use austerity during an economic slump in order to reduce its budget deficit) actually increase it. This is because the greater unemployment which will ensue will mean the government has to pay more in benefits as well as seeing less tax revenue (automatic stabilisers are in effect). Furthermore, households will have less or no disposable income and so may cut down on consumption, further exacerbating the downturn and creating even more unemployment. Don't forget, there is also a negative multiplier associated with contractionary fiscal policy. The only (potential) benefit is that the private sector may step in to take the slack from the government. Deflation may occur which could mean that people spend more. Depending on the stickiness of wages, the high unemployment may mean a fall in wages which will restore market equilibrium eliminating unemployment; however in reality wages are sticky downwards.
Expansionary Fiscal
Contraction Hypothesis
This hypothesis states that deficit reduction (i.e. fiscal
contraction) can be expansionary, i.e. cause the economy to grow, because it
may lead consumers to believe that a permanent tax reduction in the future will
take place, resulting in a positive wealth effect causing an increase in
consumption. It follows on from the theory of Ricardian
Equivalence. If the positive ΔC is greater than the negative ΔG then the fiscal contraction has been expansionary.
Others propose that fiscal contraction can be expansionary because government crowds out private investment. A fall in government borrowing should lower interest rates which would make private investment and consumption of expensive goods cheaper, and may therefore boost these two components of aggregate demand, offsetting government spending. However, this channel assumes that lower interest rates are passed on to businesses; in periods of low confidence and banking crises this may not be guaranteed.
Finally, it may be the case that the government's fiscal stance affects market sentiment, and that fiscal retrenchment would increase market confidence - perhaps because there is a reduced fear of government default (despite the ability to print money). We can use the following investment function – I = a + b(T-G)
– where b is the sensitivity to confidence channels linking fiscal solvency of
the government to investor confidence. If T-G falls (fiscal contraction) then
this investment function will show that I will rise. If b is greater than 1
then fiscal contraction will have a positive multiplier effect. a in this investment function is autonomous investment which would occur regardless of other factors, it may be due to the level of investment necessary for firms to replace depreciated capital.
However this
model doesn’t take into account the fact that government spending heavily
effects the demand for private sector goods and services, so a reduction in
government spending is likely to lead to a fall in demand which will reduce
profits which may be linked (in reality) to investor confidence and the
willingness to finance investment. More importantly, fiscal contraction would only be expansionary if ΔI > ΔG, where our investment function means that ΔI should be positive and ΔG should be negative.
We have assumed that the government intervening in the economy to prop up aggregate demand would actually work. However there are some reasons why it may not work, or at least not work as well as intended. Firstly, government expenditure may replace private expenditure and thus won't boost aggregate demand, it will just keep it constant (but will at least keep unemployment levels steady to), but change the composition of the economy (private sector: public sector). For example the government may increase spending on health, and as a result fewer people don't go to private clinics resulting in a fall in private investment matched by an increase in government spending/investment. Ergo, the size of the economy stays the same.
There are large time-lags associated with fiscal policy; it takes time for the government to take action and increase/decrease discretionary spending, by the time it does take action the economy may be in a different place so the action taken may hurt the economy in its new state. For example the government might choose to increase spending by investing in transport and infrastructure because the economy is in a bad state and unemployment is high. However, it might be the case that by the time all the preparation (e.g. legislation being enacted, money being found and plans being created) has been done that the economy is now booming and so the government investment in infrastructure actually leads to crowding out and inflation. The different time lags are:
- Recognition: it may take the government a little while to recognise where the economy is, and be sure that the current position isn't just a blip.
- Planning: the government has to work out how it is going to fund certain expenditure (e.g. re-balance its budget or sell bonds).
- Action: it may also take time to hire the workers and prepare the work that needs to be done.
Crowding out is the theory that government action will only replace private expenditure and won't actually boost output, just shift the burden of expenditure from the private sector to the public sector. There are two types of crowding out; resource and financial.
Resource crowding out is when the government uses factors of production such as labour and raw materials, thus pushing their price up (due to a micro leftward shift of demand).This then reduces the amount of resources that the private sector can use, they will now be making less profit due to higher prices, thus potentially deterring them from supplying to the market. This argument may certainly be true when the economy is at full capacity, however, if there is slack in the economy (i.e. it is not working at full capacity) then the government will only be utilising spare resources that the private sector aren't using. This may be beneficial because it may reduce the effects of hysteresis on the unemployed who aren’t being utilised by the private sector. Prices and wages are unlikely to rise by much when there is slack in the economy, because there is excess supply. Financial Crowding out occurs when government spending financed through borrowing reduces the size of funds that the private sector can borrow. This drives up interest rates which may deter the private sector from borrowing and thus investing. But if the government prints money in order to finance its spending then interest rates are unlikely to rise (in the short term) and this may prevent financial crowding out.
The automatic stabilisers are taxation and unemployment benefit payments. These help to smooth out national income over the economic cycle, this is because during a recession tax receipts fall whilst benefit payments rise, leading to a fall in the government surplus (or a bigger deficit), but giving more income to the unemployed so they can still afford to consume to an extent, and help prop up the economy. On the other hand, during a boom tax receipts rise and unemployment benefits fall, allowing the government to pay off its debts incurred during the recession, and cooling the economy down due to higher tax receipts. This is all done without any direct intervention by the government or any agencies, and is the reason why they are called automatic stabilisers.
Automatic stabilisers are useful because they come in to operation instantaneously with fluctuations in aggregate demand and hence don't require the government to take action. It can usually take some time for the government to enact discretionary spending and hence automatic stabilisers are more advantageous as they can reduce fluctuations immediately. However there are some pitfalls to them.
Firstly, the higher the marginal tax rates (also known as ad valorem taxes - i.e. taxes which are only in place for every additional good that is produced, as oppose to fixed taxes which have to be paid regardless of output) the stronger the automatic stabiliser as it reduces fluctuations in the economy by suppressing too much output. However higher tax rates may affect aggregate supply, by shifting the AS curve leftwards causing price inflation and reducing overall output. This is because high tax rates may cause a disincentive to work (see Laffer Curve below).
Similarly, high unemployment benefits would mean that even during a recession (when people are being made redundant and are thus unemployed) consumption wouldn't fall too drastically as people would use the government benefits to continue to consume as oppose to their wages which they previously used. This is useful because it may prevent further unemployment by reducing the deficiency of demand. However, high unemployment benefits may encourage people to remain unemployed and live on benefits, or instead take longer to look for a job rather than take the first immediate post that arises. This shifts the Phillips curve to the right and creates - or at least, perpetuates - unemployment. High unemployment benefits would also shift the supply of labour curve leftwards.
Fiscal drag is an issue where inflation (or increased wages as a result of higher inflation) causes incomes to rise, thus pushing households into higher tax brackets. For example the government might say that the rate of tax for people on an income of between £20,000-£30,000 is 25%, but for those on an income of between £30,000 and £50,000 is 30%. Someone who is on a real wage of £25,000 may see their nominal income rise to £30,000 as a result of inflation, and hence they now have to pay 30% in tax rates. This means they have less disposable income than before, and because their income has been reduced by inflation and not productivity gains, it means that prices for goods and services in the overall economy would have risen ergo resulting in people being able to buy fewer goods/services than before. Hence fiscal drag can cause a fall in consumption as people have less disposable income.
Simply put the twin deficit hypothesis is the view that an economy running a fiscal budget deficit will also run a current account deficit. It stems from a national accounting equation which says that NX = S-I. We arrive at this point because Classical economists take S = Y-C-G, so we can arrange our national accounting equation of Y = C + I + G + NX to get the above NX = S - I.
If the government is running a large budget deficit such that S<I then NX would be negative and the budget deficit means - by definition - a current account deficit. To explain the mechanism for how this could occur we need to assume that we are in a small open economy which perfect capital mobility. This means that our economy, being small, can't affect world interest rates through changes in domestic savings or investment. Having perfect capital mobility means that domestic interest rates are equal to the world interest rate: if there is downward pressure on domestic rates (because S>I) then capital flows abroad and if there is upward pressure on domestic rates (because S<I) then capital flows into the economy. This means that at all times the domestic interest rate equals the world interest rate - rd = rw. Hence, we say upward/downward pressure on interest rates, but this doesn't mean that interest rates have risen/fallen unless explicitly mentioned.
We can now proceed making using of the above assumptions. An increase in government spending with taxes being held constant would weaken the government fiscal balance and it would also lower savings. Remember, S = Y-C-G. If there are lower savings then S<I and there is upward pressure on domestic interest rates, hence capital flows in from abroad. These inward capital flows causes the domestic currency to appreciate. This is because foreigners have to purchase Sterling to be able to save their money in a British bank/asset to relieve the upward pressure on interest rates. An appreciated currency makes British exports more expensive for foreigners and imports cheaper for domestic citizens. Thus, assuming the Marshall-Lerner condition holds, we would expect the appreciated exchange rate to cause a deterioration in net exports. It is this mechanism which can explain how we move from a situation of fiscal weakening to current account weakening which underlies the twin deficit hypothesis.
When talking about taxation with regards to fiscal policy we can evaluate how much a government can tax people using the Laffer Curve, named after Arthur Laffer who developed it.
 The Laffer curve is a diagram illustrating the effects of the level of taxation and the revenue gained from this taxation. From the graph we can see that at a tax level of 0% and 100% no revenue is attained. This is because at 0% the government wouldn’t collect any money and at a 100% there would be absolutely no incentive to work as an individual wouldn't gain anything out of it. Theoretically there is a point, m, at which an optimal amount of revenue would be collected. This means that raising the tax rate above m would be counterproductive and would result in earning less tax revenue. The same applies for decreasing the tax rate. Although m appears to be at a rate of 50% this isn’t necessarily true and could be elsewhere.
High tax rates could prohibit growth if individuals don’t have an incentive to work hard or to innovate and create products, for firms it could mean not investing in the economy and expanding operations. This means that little money is generated and hence the government don’t receive a large revenue return from it. At high tax rates people may also try to evade paying, this can be done through loopholes or illegally. On the other hand low taxes might encourage growth, investment and spending thus increasing GDP but the government would have a smaller percentage of this. However they might receive more money than if the tax rate is higher. Therefore lower tax rates may generate more tax revenue than lower tax rates. The area above m is known as the prohibitive range where you limit output and lose revenue.
The effect of high tax rates prohibiting growth is particularly the case for marginal tax rates - tax rates which are applied for every additional unit produced or hour worked - as oppose to fixed tax rates. Fixed tax rates include the TV license and council tax. Firms have to pay council tax regardless of the amount they produce, and any household that owns a TV has to pay the TV license regardless of how much TV they watch. Marginal tax rates (MTR) on the other hand are levied on additional consumption, production or earnings; for example value added tax (VAT) is an MTR as it is applied for every additional good or service purchased (that is liable for VAT). This may deter consumption as the price of every good is taxed, thus holding back economic growth. The same applies for the supply of labour, workers may decide to reduce the amount they work if it means that they stay within a certain tax bracket or below a threshold - e.g. they may refuse work so they earn less than £10,000 and thus don't have to pay tax. Again this is detrimental to the economy in the sense that it may prevent economic growth. But the only alternative (except to remove taxes completely, which would have many calamitous effects) is to rely more on fixed taxes, which although don't prevent marginal output, may increase the price level generally (especially for firms which don't produce much) and may increase poverty.
Monetary policy is the use of monetary variables such as the money supply and interest rates to influence aggregate demand (and in the long run aggregate supply). The prime instrument of monetary policy is the interest rate.
At higher interest rates firms are likely to undertake less investment, because the expected profit of investment would be lower due to the higher cost as a result of high interest rates, and households are likely to reduce consumption, as they find it more costly to borrow in order to purchase expensive goods such as cars, homes and white goods. Therefore, the overall effect of higher interest rates is to shift the aggregate demand curve leftwards. We can see the effect of this on the graph which shows the link between interest rates and inflation.
Higher interest rates reduce AD, which in turn reduces the rate of inflation.
The central bank (who is usually in charge of setting interest rates and money supply) would be likely to take the measure of increasing interest rates if it believes that the economy is overheating (i.e. growing faster than aggregate supply and hence causing high inflation). Many central banks are independent from the government (the Bank of England, Federal Bank and the European Central Bank to name a few) in order to prevent politicians meddling with the economy. Instead, bankers are given a target, generally to keep inflation within a certain band, in the UK the central bank is tasked with keeping inflation at 2% with a margin of exception of plus or minus 1%. If inflation gets too high then the central bank may decide to increase interest rates to taper off growth. However, it also has to consider the overall effect that this may have on the economy, as it will have a greater effect than simply reducing inflation (i.e. less output and higher unemployment).
Asset Bubbles
Similarly, a central bank may increase interest rates if they see an asset bubble growing, in order to deflate it. An asset bubble is where the prices in an asset market (housing market, stock market, bond market) are rising without any increase in underlying factors. The rising prices cause rising prices as people speculate in order to accumulate. By raising interest rates the central bank would hope that people would choose to save their money in an interest bearing account as oppose to speculate in a risky asset market, if enough people do this then the bubble may be able to deflate without imploding avoiding a demand shock which could lead to a recession.
 Conversely, lower interest rates are likely to boost aggregate demand as households will find it cheaper to borrow to purchase expensive items like cars and jewellery as well as finance a mortgage. Investors will have larger expected rates of profit from investments so are likely to invest more. Both effects will increase aggregate demand and reduce unemployment, but as we can see is likely to lead to a rise in inflation. The amount of inflation is dependent on how much slack there is in the economy. The increase in spending will shift the aggregate demand curve from AD1 to AD2 and will cause an increase in the price level from P1 to P2 whilst increasing output from Y1 to Y2.
We can conclude that interest rates and inflation are negatively correlated - higher interest rates should mean lower inflation and lower interest rates should mean higher inflation.
The transmission mechanism is a model showing the effect on the economy of a change in interest rates. We can use this to see what happens to demand and how this affects inflation. If aggregate demand falls then we would expect inflation to fall (note: there is a difference between lower inflation and deflation. Deflation is when inflation is negative; prices are actually falling. When we say inflation is falling, or lower inflation this means that we are still experiencing rising prices, but at a slower pace than previously).
Market Rates
The official rate (set by the central bank) determines market rates, these are interest rates that operate in the economy from the rate of interest on government bonds to mortgage rates. Banks generally set their interest rates similar to the central banks rate because that is where banks store there money and earn their interest. Therefore commercial bank rates are similar to the central bank rate, and thus if an entity offers a lower interest rate than the commercial rate, they will have no takers (demand and supply) and will be forced to increase their rate, anyone who offers a higher rate would be loosing money.
Asset Prices
Similarly, if interest rates are high people would rather save their money rather than speculate on asset prices which would reduce demand for asset prices and thus drive the price down. It would also be more expensive to borrow in order to purchase assets (e.g. homes) and again this would reduce the demand and hence the price. If interest rates are low then people might be able to make better returns by speculating in asset markets, and it is also cheaper for people to purchase assets. Hence low interest rates can cause asset bubbles to inflate and may cause positive wealth effects which increase aggregate demand. Conversely, high interest rates may deflate asset bubbles and would lower aggregate demand as people would rather save with banks than purchase assets, reducing wealth effects.
Expectations and Confidence
Low interest rates means it is easier/cheaper for people and firms to borrow and so aggregate demand is likely to be buoyant (although not always, interest rates are currently the lowest they have ever been, yet aggregate demand is still depressed) which may make people more confident that the future is bright. If people and firms have high confidence in the ability of the economy - that is they still believe they will have a job, and make a profit in the future - then they may reduce their savings and spend; creating a self-fulfilling prophecy.
Higher confidence in firms and households will lead to more investment and greater consumption. If people believe that the economy will grow then they will be less fearful of loosing their jobs and they may also believe that they will receive wage increases higher than inflation which should lead them to consume more. If firms believe that consumption will increase then they may make more investments by hiring more workers to meet the expected future demand, and building more factories. Creating jobs is likely to reinforce the view that the economy is back on track and will lead to even more confidence.
Low confidence on the other hand can mean that households and firms reduce investment and spending plans to the future. If prices are falling then firms and households may defer spending and investment until the future because they expect the price of goods and services to be lower. If workers are worried that they may loose their job (and if their are few opportunities for re-employment) then they may reduce their consumption and begin to save, just in case. This fall in consumption will send a signal to firms that they need to reduce their output, and as a result they may make job cuts, again this will create a self-fulfilling prophecy, whereby consumers merely believing that they may loose their jobs and the action which they take (reducing spending) actually leads to them being made unemployed because firms make them redundant due to a deficiency of demand.
Exchange Rates
If domestic interest rates are greater than foreign interest rates then foreigners would wish to save with domestic banks, to do so they would need to purchase units of domestic currency increasing demand and thus causing an appreciation of the currency. This appreciation makes imports cheaper for domestic citizens and exports more expensive for foreigners. Cheaper imports should mean an increase in volume, thereby reducing inflationary effects (prices are falling, not rising). Moreover, if imports are rising and exports are falling (assuming that the Marshall-Lerner condition holds) then net exports (X-M) will also fall, meaning aggregate demand falls, ceteris paribus. Note, that for this element of the transmission mechanism to work we are implicitly assuming that we don't have perfect capital mobility, otherwise domestic interest rates would have to equal world interest rates for a small economy.
Effect on Demand
High market rates make it expensive to borrow so investment will fall because the expected rate of profit from investment undertaken by firms will fall, also consumption will fall because it becomes more expensive for households to borrow to consume. This will reduce aggregate demand and also inflation.
Low market rates make it cheaper to borrow so investment should rise (but this is dependent on confidence and expectations) as will consumption as borrowing to consume becomes cheaper, which shifts the aggregate demand curve rightwards. This will lead to increased inflation.
In short, when the economy is at/or near to full-employment (so not the current situation, but in "normal" times), low interest rates increase aggregate demand and put upward pressure on inflation. High interest rates lower aggregate demand and puts downward pressure on inflation. Therefore a central bank - with a mandated target of 2% inflation - would be expected to raise interest rates when inflation exceeds 2% and lower interest rates when inflation falls below this level.
Interest Rates explained Graphically
The diagram to the left shows how the market determines the interest rate based on demand and supply. Supply is formally known as the supply of loanable funds and is the pool of savings. Demand is known as the demand of loanable funds and is the amount that consumers, firms and government want to borrow. The point where demand and supply intersect is the rate of interest. Although, we speak of the central bank 'setting' interest rates, they don't actually dictate them, but instead use bank liquidity ratios and government bonds, amongst other instruments, to influence the interest rate. The interest rate as set by the central bank is also the rate at which commercial banks can save or borrow with the central bank, and therefore which helps to influence market rates.
An increase in the savings rate will result in a greater pool of loanable funds and would therefore cause a rightward shift of supply, the larger the savings pool, the lower the interest rate consumers expect, ceteris paribus.
Factors that might determine a higher savings rate are:
- Job insecurity - if people believe they might loose their jobs in the near future, then they may switch from consumption to saving in order to have some money to fall back on if they are made redundant. Higher welfare payments and protection may prevent this substitution.
- High interest rates - obviously the higher the interest rate, the more people that want to save. High interest rates would arise due to a deficit of savings, or due to very high demand for funds to invest. Money (cash) is available for spending, whereas savings are not. The opportunity cost of holding money (i.e. cash in your wallet) is the interest you could have earned had the money been saved. The lower the interest rate, the higher the demand for money (cash), and vice versa.
***Quantitative Easing is a money stimulus used as the traditional tool of a central bank, interest rates, are no longer effective. Essentially the central bank prints money and buys assets with it such as government bonds from private sector holders, thus injecting money into the economy. It is then believed that the bond sellers – households, firms or banks – will buy other assets such as shares or corporate bonds. This will cause the price of the asset to increase, a higher price of assets means a lower yield (remember - [(Interest/Bond Price) * 100]). This lower yield may mean (if it is lower than other asset yields) demand for other assets like bonds and government debt will increase. Therefore there price will rise and the yield will fall meaning the government (and firms) will be able to borrow for less.
They can therefore invest more or spend the money elsewhere. This also increases confidence which should further boost investment and thus AD. Alternatively the bond sellers will increase their consumption which will boost AD and thus encourage growth.
If the recipient (the owner of the bond who the BoE is buying it off of) lives overseas then they may use the money they receive to buy overseas assets in another currency (not Sterling). To do this they would have to convert the sterling to their respective currency. The greater supply of Sterling on the markets would cause the value of it to depreciate which would help UK exports and UK based businesses (as the price of imports would rise).
Quantitative easing should influence expectations about how long the BoE will keep interest rates at their current levels. By undertaking quantitative easing the BoE is signalling that they aren’t going to raise interest rates in the near future. This should lead to private sector banks reducing their interest rates. This is important when the base rate cannot be cut any further.
Fundamentally though, no-one really knows the effects of quantitative easing. It is expected that quantitative easing doesn’t have its optimal effect until 2 years after the programme is initiated. This means its short term effects are minimal (although it does provide a confidence boost). Also it might have a negative effect on the economy as it is effectively printing money and so might lead to inflation. ***
*** Credit Easing is also known as the national Loan Guarantee Scheme and is intended to create investment amongst small firms (turnover up to £50m). The Treasury is initially making £5bn of loans available which is expected to be used up in 6 months; another £18bn will be made available for a further 18 months. The way the scheme works is the Treasury will guarantee borrowing by banks for these small firms. This will allow the banks to borrow more cheaply than they normally do (expected 1 percentage point lower rate). It is believed that these cheaper loans to businesses will encourage them to borrow and thus invest and take on more staff which will benefit the economy. However it is believed that the effect of this won’t be very large and most large firms have a lot of accumulated cash but are apprehensive to spend it.***
So far we have assumed that by governments reducing taxation through increased borrowing (due to a budget deficit, meaning there is a shortfall in that the government spends more than it receives in income) consumers will spend more. Ricardian Equivalence, named after the British economist David Ricardo, argues against this assumption. It evaluates this point by taking the assumption that consumers base their spending decisions, not only on there current disposable income, but what they predict their future disposable income to be. This is contrary to conventional economic thinking which dictates that consumers base their spending decisions on current disposable income (amongst other things).
This idea, follows through, that if government reduces taxes funded through the issuing of debt, then forward thinking consumers will save some money as they know that taxes will have to rise in the future to pay back the debt. By reducing their spending (hence increasing their saving) they are smoothing out their income for when the 'inevitable' tax increase occurs. Obviously, not all consumers are this forward thinking, and some will spend money as the government intended, but those forward thinkers realise that the tax-cut today, can be only be afforded through tax rises in the future, and therefore they keep their consumption unchanged.
The overall implication of this theory, is that tax cuts financed through debt, don't result in an increase in spending (assuming that all people were forward thinkers), or wouldn't increase spending by much (if we assumed that some people were myopic - see below). Also, the increase in private saving would offset the fall in public saving meaning that national saving would remain the same.
We can see Ricardian Equivalence with a little example: assume that the interest rate = inflation rate, and that the government decides to give its citizens a tax break of £500, in the population there are 100 people. The government has to issue debt in order to pay for the tax break, and hence sells £50,000 worth of bonds. Some consumers will go off and spend their £500, whilst others (the forward-thinkers) will realise that they will have to pay back the debt in the future and so may save their £500. When the debt has to be repayed (assuming the government doesn't roll it over) they increase taxes by £500. Those forward-thinkers who saved their £500 tax break, merely spend the £500 in the bank to ensure that their consumption is constant. Those who spent the £500 tax break will now have to forgo £500 worth of consumption, and so their consumption/living standards will now fall.
This small example ignores those who may spend a proportion and save the rest, but you get the jist! Our assumption that the interest rate equals inflation also simplifies matters. If the interest rate was higher than in inflation, then the government may have needed to increases taxes more than the tax rate. This wouldn't have affected the forward thinkers, as by saving their money they will receive interest and so will remain at a break even point, but the myopic consumers would end up seeing a greater fall in living standards, and would have actually lost out in real terms from the whole affair. Conversely, if inflation had been greater than interest rates then the government wouldn't have needed to increase taxes by very much in order to pay off the debt, those myopic consumers would have benefited, whilst the forward-thinkers would end up losing money from the affair as the real value of them saving the tax break would fall.
An argument against Ricardian Equivalence is myopia. Myopia means short-sightedness, and this term is used in economics to argue that consumers don't think that far ahead into the future to realise that tax cuts now (funded through debt) will mean tax rises in the future. This may be because the majority of people don't have a great enough grasp of economics, they might not know how the tax cut is funded (they may be mistaken in believing that it is afforded through a reduction in the budget surplus), or they may just not think that far into the future when making decisions. David Ricardo himself signed up to the view that consumers were myopic (although they didn't use that term in those days), he thought consumers were so short-sighted that they wouldn't adopt the equivalence of which is named after him!
Tax-cuts financed by debt don't always result in Ricardian equivalence if the government instead reduces government spending in the future, as oppose to raising taxes. As long as consumers know that the government is paying for the tax cut by reducing government spending in the future, then they will spend the money as there won't be an associated tax increase (at least not with that policy). Here though, it isn't the tax cut that stimulates spending but the prospect of a fall in government spending in the future.
Another argument against Ricardian equivalence is that the tax increase in the future may be payable by the future generation and not the current. If this is the case then consumers are more likely to spend. This is because, they won't have to pay for the tax cut, this will be payed by the next generation who see a tax hike, therefore current consumers may decide to spend. However, the current generation may take this into account, and know that the burden will fall on their children, they may decide to put the money away into a savings account for their child in order to smooth out their off-springs income.
Further reading can be found here.
Page last updated on 09/06/16
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