Discuss whether supply side policy is more likely to be successful than fiscal policy when an economy is faced with inflation
Answers
Introduction – Both Fiscal policy and monetary policy are demand management policy, they are aim at influencing the Aggregate Demand of the economy and achieve the macroeconomic aims.
N.B. When drawing AD/AS diagram, don’t make the mistake of using Price and Quantity on the axis. It MUST be Price Level and National Income/Output.
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Fiscal policy is a policy tool for the government to influence the level of economic activity through changes in government expenditure and taxation.
Each year, the government will prepare a budget for the coming year expenditure and income. It may be surplus, G<T, deficit G>T or balanced budget G=T. In a recession, a deficit budget to boost AD.
When G>T, G, being a component of AD [C+I+G+(X-M)], the AD will increase directly. This will then stimulates further increase in C and I, as households and firms have more income. (Multiplier effect is leave out here, as it a A2 topic).
Diagram showing AD/AS, with AD shifting to the right, with higher price level and higher output.
Monetary policy – government manipulates the money supply to achieve its macroeconomic aims. Conventional tools include interest rate (overnight rate) and OMO Open Market Operation. The government do not directly spend money, but manipulate the money supply through monetary tools.
During a recession, the Central Bank may reduce interest rate. This will lead to higher borrowing by firms and household. A lower interest rates will thus boost more borrowing and spending. This will increase AD.
Central Bank may also manipulate the money supply in the economy through Open Market Operation. Here, they sell and buy bonds in the Open Market. To increase AD, the Central Bank will increase the price of bonds. This will encourage bondholders to sell to the CB. This increases money supply in the market and also reduces interest rate. AD increase