Discuss the strengths and weaknesses of demand-side policies (fiscal and monetary policy)

Deflationary demand-side policies decrease aggregate demand in the event of aggregate demand running ahead of aggregate supply and posing inflationary risks or leading to an unsustainable deficit on the balance of payments.

An example of when reflationary demand-side policies would be used is when aggregate demand is too low, so for instance when taxes are high and interest rates are high. The policies that would be used in order to shift out the aggregate demand curve would be lowering taxes and government spending, fiscal policy, and decreasing interest rates, monetary policy. This would shift the curve outwards due to the nature of aggregate demand and its related components. Consumer demand would increase if taxes went down and interest rates went down because consumers would in effect have ‘more in their pockets’ through relatively cheaper credit and less tax being deducted from their incomes. Investment would increase as it would become more lucrative to invest in the country due to lower taxes and cheaper credit. Government spending would decrease due to the nature of fiscal policy. Exports would increase due to an exchange rate that makes goods appear relatively cheaper for foreign countries to import, and imports would decrease as foreign goods appear relatively more expensive than before.

 A diagram showing the effects of reflationary policy

The other type of demand-side policy which may be used is deflationary policy, which is used to decrease the level of aggregate demand, for instance in a situation where aggregate demand is running ahead of aggregate supply and thus causing inflationary pressures. Deflationary policy is very much the opposite of inflationary policy, with increased taxes as part of fiscal policy, leading to decreased consumer demand and decreased investment and thus decreased aggregate demand, with the addition of increased interest rates, further decreasing consumer demand and increasing imports, decreasing exports. All of these factors add up to a total decrease in aggregate demand.

A diagram showing the effects of deflationary policy

        Even when considering both deflationary and reflationary policies, it is vital to consider three main factors. These are magnitude, the scale of the change, timing, the time period over which these changes occur, and anticipation, whether the change is foreseen or comes ‘out of the blue’.

For instance, a huge rise of 10% in inflation over a three-month period will have a greater effect on an economy than a huge rise of 10% in inflation over a three-year period. Similarly whether the rise was anticipated or not will affect the outcome of the inflation. If it was anticipated then the government could form measures to tackle the rise, however if it wasn’t, then the full force of the effects would be felt by the economy.

        Another factor upon which aggregate demand and thus inflation is dependent is long-run aggregate supply and the position of aggregate demand on the LRAS curve.

A diagram comparing different changes of aggregate demand against aggregate supply

For instance, a change in aggregate demand from AD1 → AD2 would be highly beneficial for an economy with an increase in real GDP, employment and economic growth, and a decrease in unemployment, for a relatively low increase in inflation. However a change from AD2 → AD3 would not be beneficial for an economy due to the amount of inflation for a relatively small amount of increase in growth, GDP and employment.

        This leads us onto the strengths and weaknesses of demand-side policies, because the change from AD1 → AD2 is a great positive to come out of demand-side policy however AD2 → AD3 is highly negative, which shows the strengths and weaknesses of the Keynesian LRAS curve. However it seems that there are far more weaknesses when referring to demand-side policies than there are strengths. For example, there are significant inaccuracies with regards to economic data. More often than not, data is collected many months before it is available and so it becomes out-of-date and so actions are made on data from months previous.