The economy is going into recession, output has dropped, and the government needs to act quickly to save the economy from falling. One way to prevent the recession is by giving more money to individuals to start spending and reactivate the economic machine. What should the government do? Should it cut taxes? Should it spend more money on infrastructure? Or should it leave it to the Fed to deal with it?
We invite you to keep reading to find out how the government can rapidly act to prevent a recession with different types of demand-side policies. You'll have a pretty good idea of what the government should do once you finish reading this article.
Types of Demand-Side Policies
Types of demand-side policies include fiscal policy and monetary policy.
In macroeconomics, the branch of economics that studies the broad economy, demand refers to aggregate demand or the total of all spending. There are four components of aggregate demand: Consumption spending (C), gross private domestic investment (I), government expenditures (G), and net exports (XN).
A demand-side policy is an economic policy focused on increasing or decreasing aggregate demand to influence unemployment, real output, and the general price level in the economy.
Demand-side policies are fiscal policies that involve taxation and/or government spending adjustments.
A tax cut leaves businesses and consumers with extra cash, which they are encouraged to spend to stimulate the economy during a recession. By increasing spending, the government has increased aggregate demand and can reduce unemployment by stimulating the economy.
When there is too much inflation, meaning prices rise too quickly, the government can do the reverse. By cutting government spending and/or raising taxes, total spending is reduced, and aggregate demand decreases. This will reduce the price level, meaning inflation.
In addition to fiscal policies, monetary policies are also known as demand-side policies. Monetary policies are controlled by the central bank -- in the U.S., this is the Federal Reserve. Monetary policy directly impacts the interest rate, which then influences the amount of investment and consumer spending in the economy, both essential components of aggregate demand.
Suppose that the Fed sets a low interest rate. This encourages more investment spending as it is cheaper to borrow. Therefore, this will lead to an increase in aggregate demand.
These types of demand-side policies are often called Keynesian economics, named after the economist John Maynard Keynes. Keynes and other Keynesian economists argue that the government should implement expansionary fiscal policies and the central bank should increase the money supply to stimulate total spending in the economy to get out of a recession. Keynes' theory suggests that any change in the components of aggregate demand would lead to a larger change in total output.
Demand-Side Policies Examples
Let's consider some demand-side policies that make use of fiscal policy. Regarding fiscal policy, a change in government spending (G) is a typical example of a demand-side policy.
Assume that the government invests $20 billion in building infrastructure across the country. This would mean the government will have to go to a construction company and pay them $20 billion to build roads. The company then receives a significant amount of money and uses it to hire new workers and buy more materials to build the roads.
The workers who are hired didn't have a job and didn't receive any income. Now, they have an income because of the government's spending on infrastructure. They can then use this income to buy goods and services in the economy. This spending by the workers, in turn, provides payment for others as well. In addition, the company contracted by the government to build the roads also uses some of the money to buy materials that it needs for the construction of the roads.
This means that other businesses also receive more revenue, which they use to hire new workers or spend on another project. So from the government's $20 billion increase in spending, there was demand created not only for the construction company's services but also for other individuals and businesses in the economy.
As such aggregate demand (total demand) in the economy increases. This is known as the multiplier effect, by which an increase in government spending leads to an even higher increase in aggregate demand.
Do you want to learn more about how government fiscal policies can have a larger impact on the economy? Check out our in-depth explanation: Multiplier Effect of Fiscal Policy.
Figure 1. Using demand-side policy to increase aggregate demand, StudySmarter Originals
Figure 1 shows an increase in aggregate demand as a result of an increase in government spending. On the horizontal axis, you have the real GDP, which is the overall output produced. On the vertical axis, you have the price level. After the government spends $20 billion, the aggregate demand shifts from AD1 to AD2. The new equilibrium of the economy is at E2, where the AD2 intersects with the short-run aggregate supply (SRAS) curve. This results in an increase in real output from Y1 to Y2, and the price level increases from P1 to P2.
The graph in Figure 1 is known as the aggregate demand--aggregate supply model, you can learn more about it with our explanation: AD-AS Model.
Another example of a demand-side policy is monetary policy.
When the Federal Reserve increases the money supply, it causes interest rates (i) to decrease. Lower interest rates mean increased borrowing by businesses and consumers, which results in increased investment and consumer spending. Thus, the aggregate demand is now higher.
During times of high inflation, the Fed does the opposite. When inflation is above 2 percent, the Fed may decide to decrease the money supply to force interest rates to rise. Higher interest rates dissuade many businesses and consumers from borrowing money, which reduces investment and consumer spending.
The reduction in the usual rate of borrowing and spending causes aggregate demand to decrease, helping ease the inflationary gap. Increasing interest rates (i) reduces investment and consumer spending, which reduces AD.
Supply-Side vs Demand-Side Policies
What is the main difference when it comes to supply-side vs. demand-side policies? Supply-side policies aim to improve productivity and efficiency and thus boost long-run aggregate supply. On the other hand, demand-side policies aim to increase aggregate demand to boost output in the short run.
Reducing taxes has a supply-side effect by making it less expensive for firms to operate. Lower interest rates also have a supply-side effect as they make borrowing less costly. A change in regulations can have similar effects by making the business environment more friendly for firms to operate. These encourage firms to invest in their production capacity and ways to increase efficiency.
Supply-side policies incentivize businesses to produce more through lower taxes, lower interest rates, or better regulations. As enterprises are provided with an environment that encourages them to make more, more output will be delivered to the economy, raising the real GDP in the long run. It is important to note that an increase in long-run aggregate supply is associated with a decrease in the price level in the long run.
On the other hand, demand-side policies increase the aggregate demand in the short run, which in turn leads to an increase in the output produced in the economy. However, contrary to a supply-side policy, an increase in production through demand-side policies is associated with an increase in the price level in the short run.
Demand-Side policies Pros and Cons
A major benefit of demand-side policies is speed. Government spending and/or tax cuts can get money into the hands of the public quickly, such as Economic Impact Payments sent to U.S. citizens during the Covid pandemic in 2020 and 2021. Additional spending requires no new infrastructure to be built, so it can be effective within weeks or months rather than years.
More specifically when it comes to government spending, the benefit of that is the ability to direct spending where it is needed more. A reduction in interest rates may increase business investment, but not necessarily in areas that are the most beneficial.
During times of dire economic crisis, demand-side policies are often implemented because they work more swiftly and thoroughly than supply-side policies, which may take many years to have an effect on increasing production capacity.
However, a significant downside of demand-side policies is inflation. Rapid government spending increases and interest rate decreases may be too effective and may result in inflationary pressures. Some blame the fiscal stimulus policies during the Covid pandemic for increasing inflation in 2022, allegedly causing the economy to overheat.
A second downside is a partisan disagreement leading to political gridlock when it comes to how to set fiscal policies. Although monetary policy is conducted by a nonpartisan body, the Federal Reserve, fiscal policy is controlled by a partisan Congress and the President. Decisions on increasing or decreasing government spending and increasing or decreasing taxes require political bargaining. This can make fiscal policy less effective as politicians argue over the priorities of fiscal policy and delay its implementation.
Limitations of Demand-Side Policies
The primary limitation of demand-side policies is that they are only effective in the short run.
In economics, the short run is defined as the period during which one or more factors of production, usually physical capital, are fixed in quantity.
Only in the longer term can society increase its production capacity by building more factories and acquiring new pieces of machinery.
Demand-side policies can increase output in the short run. Eventually, aggregate supply will adjust to a higher price level, and the output will be back to its long-run potential level.
Until production capacity is increased, there is a ceiling on where output. In the long run, attempts to increase output by demand-side policies will only result in a higher price level and higher nominal wages while real output remains at where it has started, the long-run potential output.
Demand-side Policies - Key takeaways
- A demand-side policy is an economic policy focused on increasing or decreasing aggregate demand to influence unemployment, real output, and the price level in the economy.
- Demand-side policies include fiscal policies that involve taxation and/or government spending adjustments.
- In addition to fiscal policies, monetary policies are also known as demand-side policies. Monetary policies are controlled by the central bank.
- The primary limitation of demand-side policies is that they are only effective in the short run.
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