10.1 Demand-Side Policies

© 1999-2020, Douglas A.Ruby (06-16-2020)

Demand-side policies may be expansionary or contractionary in nature. Expansionary policies are intended to stimulate spending in a recessionary economy. Contractionary policies intended to reduce spending in an inflationary economy. On the demand-side these policies would be implemented through one of the four expenditure categories (Consumption Expenditure, Investment Expenditure, Government Expenditure, or Net Export Expenditure) that make up GDP.

10.1.1 Fiscal Policy

A tax cut is a tool of expansionary Fiscal policy designed to increase disposable income thus leading to greater consumption expenditure. In addition, this tax cut may make certain investment project more profitable thus leading to more investment expenditure. Increases in government spending are designed to affect the government expenditure category directly. These increases may be the result of legislative action responding to the desires of the electorate or deliberate spending as an economic response to recessionary pressure emerging in the economy. A fiscal expansion might be designed in this case to offset a decline in one of the other expenditure categories.

10.1.2 Monetary Policy

Monetary policy, as an expansionary policy, is designed to affect investment expenditure through lower interest rates that accompany increases in the money supply or to effect net export expenditure. In this latter case, we might observe that a monetary expansion could lead to more dollars being available on Foreign Exchange markets. This surplus of dollars will weaken the exchange rate between dollars and other trading currencies. In addition, lower interest rates will make the U.S. a less attractive place to invest relative to yields that are available in other countries. Thus, with lower interest rates, there will be an outflow of capital resulting from the sale of domestic assets and then dollars on foreign exchange markets. Again, we end up with a weaker dollar. This weaker dollar makes U.S. exports relatively cheaper to foreign buyers and thus stimulates the demand for U.S. produced goods. Also, the weaker dollar makes foreign goods more expensive to domestic buyers reducing the demand for imported goods. The net result is an increase in Net Export expenditure.

Monetary policy is governed by the central bank -- the Federal Reserve System, via decisions made by the Board of Governors as part of the Federal Open Market Committee.

10.1.3 Policy Asymmetry

It is important to note that expansionary policies and contractionary policies are not symmetric in their implementation. Fiscal expansions tend to be politically popular (i.e., more spending and/or less taxes) and thus easier to pursue by elected officials (the executive and legislative branch of the Federal Government). Contractionary policies (spending cuts or higher taxes), by contrast, tend to be politically unpopular and less likely to be used even if so dictated by economic conditions (i.e., an overheated economy). Thus in times of large budget deficits, Fiscal policy tends to be missing from the policy-maker's tool box or it will make one problem worse (the Federal Debt) in an attempt to address another (a recessionary gap).

There is also an asymmetry to the implementation of monetary policy. Unlike fiscal policy which has political ramifications, monetary policy is implemented (usually) by an independent central bank. This separation from political considerations is by design to avoid actions that may benefit one constituency over another.

Monetary expansions are often less effective and less predictable as compared to monetary contractions. For example, suppose that the Federal Reserve is concerned about weak economic growth or relatively high rates of unemployment. The policy reaction would be to increase bank reserves (excess reserves) through open market purchases. Banks would then be expected to convert these excess reserves into loans with their customers - an availability of loans signaled via lower borrowing rates. However, if bankers are somewhat pessimistic about their future reserve position (expecting higher than usual withdrawal activity or fewer new deposits), they might just sit on these reserves with no change in lending rates. Even if bankers want to convert these reserves into loans, potential customers may not have the incentive to borrow at any rate. A sluggish economy could be matched with sluggish demand for goods and services thus eliminating the incentive for investment in inventories or productive capacity. A common saying in this case is that you can't push a rope meaning that it is difficult to push interest rates down and push borrowing up in efforts to stimulate investment spending.

Recently (since the Great Recession of 2008), a different issue has emerged with expansionary monetary policy -- that of the lower-bound in nominal interest rates. Either due to agressive action by the Fed to combat this recession or because of weak investment demand or lack of investment opportunities combined with a global savings glut, nominal interest rates have been very low -- near zero. Once the zero-lower-bound is reached, conventional monetary policy runs out of ammunition as a tool to stimulate spending. This has led the Federal Reserve to apply new tools to support the economy -- those of quantitative easing and various repurchase agreements-- an expansion of it's balance sheet by buying a variety of debt instruments from the non-bank public. These alternative tools are used to prevent finacial markets from freezing and as an approach to inject liquidity into the banking system

In contrast, contractionary monetary policy is always effective. Open market operations that remove reserves from the banking system (an open market sale of securities), will require that these banks curtail lending activity and allow competition for fewer available loans to push interest rates upward. Higher interest rates will always make certain investment projects unprofitable thus leading to the abandonment of these projects. In this case we find that the Fed can pull on a rope - pull reserves out of the banking system and pull interest rates up will lead to a decline in investment spending.

Concepts for Review:
  • Capital Outflows (outflow of capital)
  • Contractionary Policy
  • Demand-side Policy
  • Expansionary Policy
  • Federal Debt
  • Federal Reserve System
  • Foreign Exchange Markets
  • Inflationary economy (inflationary gap)
  • Lower-bound (zero-lower-bound)
  • Monetary Policy
  • Quantitative Easing
  • Recessionary economy (recessionary gap)
  • Savings Glut

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© 1999-2020, Douglas A.Ruby (05-20-2020)