Changes in Aggregate Demand: Monetary and Fiscal Policy - Essay Example

Your Full Your and section number March 4. Examine the ways in which monetary and fiscal policy can influence aggregate demand. Giving reasons for your answer and indicate which policy is likely to be most effective in boosting aggregate demand in the current economic situation in the UK. Changes in Aggregate Demand: Monetary & Fiscal Policy 1. Aggregate Demand Aggregate demand (AD) is a macroeconomic term. It sums up the total demand for output in an economy. Therefore: "Aggregate Demand is the total output demanded in the economy in terms of goods and services." The demand for goods and services in a country broadly comes from its national consumers, government and overseas demand. 'Krugman & Obstfeld derive the following basic equation for aggregate demand (AD): AD = C + I + G + CA Where, C = Demand from Household Consumption I = Demand from Planned Investments G = Demand from Government Consumption CA = Current Account, i.e. difference between a country's total Exports and total Imports.'1 Like any other demand curve the aggregate demand curve is also downward sloping, i.e. aggregate output demanded falls as the price increases. The graphical representation is as follows: Y-axis represents the 'Price Level' and X-axis represents the 'Total Output'. Aggregate demand of a consumer depends on the following factors: The purchasing power of households, i.e. the disposable income which is nothing but the income left with the households to spend on consumption, after paying the taxes. The planned investments of the firms for the production of output. The current account deficit or surplus. The quantity of money supplied in the economy (monetary policy). The taxation and expenditure decisions of the government of and economy (fiscal policy). Any change in the monetary policy or the fiscal policy of an economy brings a change in the aggregate demand and graphically speaking results in a shift in the aggregate demand curve. 2. Monetary Policy The monetary policy implies the quantity of money supplied in the economy. This directly affects the aggregate demand. 'According to DornBusch (2005), a change in the nominal money stock brings a proportionate change in the aggregate demand schedule.'2 There is a positive correlation between the aggregate demand and the changes in monetary policy. 'If the government wants to increase the quantity or the supply of money in its economy then it undertakes an "expansionary monetary" policy and similarly if it wants to reduce the quantity of money in the economy it adapts a "contractionary monetary policy. (Case & Fair, 2002)"'3 This means that if the quantity of money increases in the economy then the aggregate demand shifts outwards or to the right, i.e. more output is demanded at the same price. Conversely, if the supply of money shrinks in the economy then the aggregate demand shifts inward or to the left as a result of a decrease in demand of output at all the various levels of price in the economy. Graphically it can be as follows: 'Case & Fair (2002) explain that when the quantity of money increases in the economy then the interest rates fall due to which the cost of carrying out planned investment decreases and therefore there is higher investment expenditure. This in turn increases the output at each price level and the opposite happens when the quantity of money decreases in the economy.'4 Therefore, the changes in the AD can be summed up as follows according to the changes in the quantity of money: Increase in the supply of money - Aggregate Demand shifts to its 'right.' Decrease in the supply of money - Aggregate Demand shifts to its 'left.' 3. Fiscal Policy Fiscal policy includes two components: Government spending and expenditure. Changes in the taxation policy by the government. 3.1 Government spending and expenditure The government also demands the output in terms of goods and services. Therefore, a change in the government spending or purchases influences the aggregate demand. Government spending and aggregate demand have a positive correlation. It is simple logic that if government demands more output and hence increases its spending and expenditure in the economy then the aggregate demand shifts to the right or outwards as now more goods and services will be demanded at each price level. On the contrary, if the government reduces the spending in the economy then the aggregate demand shifts towards the left or inwards as now lesser output will be demanded at each price level. 3.2 Taxation Policy The tax levels and aggregate demand have a negative correlation that is they both act in an opposite manner with respect to each other. If the government decides to increase the taxes then the aggregate demand shifts towards the left or inwards and the output that is demanded at each price level falls. This is because, as the taxes increase the disposable income reduces and the demand of consumption falls. Similarly, if the government reduces the taxes then the disposable income increases and the consumers can spend and demand more which results into a rightward or outward shift in the aggregate demand. Both the above can be graphically represented as: Hence the aggregate demand shifts in the following trend whenever there is a change in the monetary and fiscal policy: Changes in the respective Policies. Shifts in the Aggregate Demand 1. Monetary Policy Increase in the money supply. Towards the right Decrease in the money supply. Towards the left 2. Fiscal Policy Increase in the Government Expenditure. Towards the right Decrease in the Government Expenditure. Towards the left Increase in the Taxes. Towards the left Decrease in the Taxes. Towards the right 4. Economy of United Kingdom: Monetary & Fiscal Policies. Last year, the global economy was affected by the financial meltdown and since then major economies are trying to recover from the huge losses suffered by the financial sector (in terms of bankruptcies and shut-downs) and the service sector (in terms of job losses). UK was no exception to it. 'The unemployment rate is at 7.8% in the current quarter of 2010 which is 1.4% higher than the year 2009. Talking in terms of numbers it shows that the labour force has gone down by 1200 people in the first quarter of the year 2010. (HRM Guide 2010)'5 In the order to revive the economy from the shocks, the government had cut down it interest rates to a really low level which is almost close to 'zero'. Not only that the government also agreed to increase its spending and expenditure in the economy. 'As stated in Bank of England's quarterly bulletin (2009 Q2) - Monetary Policy Committee (UK) has opted for spending and purchasing both the private and the public sector assets. This two-way spending approach aims at boosting the economy more this way.' 6 The government and the monetary committee of UK have taken a right decision by adopting an expansionary fiscal policy, i.e. increase in government spending. It has also lowered its interest rates. The economy also plans on introducing stimulus packages for the recovery purpose.' But in such a crisis, fiscal policy expansion is better than the monetary expansion. As the reduction in taxes and increased government spending directly affect the households and the production sectors, thereby increasing the aggregate demand. (Tutor2u)'7 But there is one impediment that stands tall in the recovery plans and it is the taxation structure of UK. Britain is famous for its high taxation slabs. 'For example- currently the corporate tax is at 28% which is claimed to be the lowest rate in UK ever, but still it is relatively very high when compared to its immediate neighbours. (Turner 2010)' 8 Therefore, I feel it is essential for the government to rather adopt a good and effective fiscal policy which can boost the overall demand in the economy. Above all, it must try to lower its tax rates rather than injecting the economy with monetary stimulus. As lower taxes will directly give the power of a higher disposable income to household, the firms and the enterprises to spend more. Hence, this would result in a direct and a faster impact on increasing the aggregate demand. Work Cited Read More