Government policies to increase economic growth are focused on trying to increase aggregate demand (demand side policies) or increase aggregate supply/productivity (supply side policies)
- Demand side policies include:
- Fiscal policy (cutting taxes/increasing government spending)
- Monetary policy (cutting interest rates)
- Supply side policies include:
- Privatisation, deregulation, tax cuts, free trade agreements (free market supply side policies)
- Improved education and training, improved infrastructure. (interventionist supply side policies)
Demand side policies are important during a recession or period of economic stagnation. Supply side policies are relevant for improving the long run growth in productivity.
Demand side policies
Demand side policies aim to increase aggregate demand (AD). This needs to be done during a recession or a period of below-trend growth. If there is spare capacity (negative output gap) then demand-side policies can play a role in increasing the rate of economic growth. However, if the economy is already close to full capacity (trend rate of growth) a further increase in AD will mainly cause inflation.
In this case, the economy at Y1 has spare capacity. Therefore an increase in AD leads to a rise in real GDP.
Monetary policy is the most common tool for influencing economic activity. To boost AD, the Central Bank (or government) can cut interest rates. Lower interest rates reduce the cost of borrowing, encouraging investment and consumer spending. Lower interest rates also reduce the incentive to save, making spending more attractive instead. Lower interest rates will also reduce mortgage interest payments, increasing disposable income for consumers.
In 2009, base rates were cut to 0.5% to try and stimulate economic growth in the UK.
More detail on the effect of lower interest rates.
Evaluation of Monetary Policy
Lower interest rates may not always boost spending. In a liquidity trap, lower interest rates may not increase spending because people are trying to pay back debts. In 2009, UK interest rates were cut to 0.5%, but spending remained subdued. Banks were unwilling to lend because of liquidity shortages. Therefore, although in theory, it was cheap to borrow, it was hard to actually create credit. Therefore, this shows monetary policy can be ineffective in boosting economic growth
Another criticism of monetary policy is that cutting interest rates very low could distort future economic activity. For example, the US cut interest rates following the economic uncertainty of 9/11. These low-interest rates encouraged people to take on ambitious loans and mortgages; this was a factor behind the US housing bubble. Therefore cutting interest rates, at the wrong time, can contribute to a future housing and asset bubble which will destabilise economic growth. However, in 2009-12, the depth of the financial crisis means there is no immediate danger of a housing bubble, so it was appropriate to keep interest rates at zero.
2. Quantitative Easing
In a liquidity trap, where lower interest rates fail to boost demand, the Central Bank may need to pursue more unconventional types of monetary policy. Quantitative easing involves increasing the money supply and buying bonds to keep bond rates low. The hope is that the increase in the money supply and lower interest rates will boost investment and economic activity. The fear is that increasing the money supply could cause inflation. Though evidence from 2009-12 suggests that the inflationary impact was minimal. Without quantitative easing, the recession was likely to be deeper, though QE alone failed to return the economy back to a normal growth projection.