Monetary Policy

Actions taken by the Central Bank to manage the money supply, interest rates, and credit conditions to influence Aggregate Demand (AD).

Fiscal Policy

Actions taken by the Government (Treasury) to manage spending and taxation to influence Aggregate Demand (AD).

Expansionary Demand-side Policy

We use expansionary policies to boost Aggregate Demand (AD) during a Recession or a Trough in the business cycle. The primary objective is to eliminate a Negative Output Gap by utilising the economy's spare capacity and reducing cyclical unemployment.

Global Financial Crisis (2008-2009): The Bank of England cut the Bank Rate from 5% in 2007 to an unprecedented low of 0.5% (and eventually 0.1%) to drastically reduce borrowing costs and encourage consumer spending (C) and business investment (I).

COVID-19 Stimulus: Temporary cuts to VAT or increases in the Income Tax Personal Allowance were used to boost household disposable income, quickly increasing consumption (C).

Contractionary Demand-side Policy

We use contractionary policies when the economy is in a rapid Boom or at a Peak of the business cycle.

We rarely aim to reduce Real GDP directly, but rather to prevent the economy from overheating. The main purpose of contractionary policy is to combat high Demand-Pull Inflation that occurs when AD is growing faster than the economy's productive capacity, resulting in a Positive Output Gap.

UK Inflation Surge (2022-2023): As UK inflation (CPI) peaked at 11.1% in October 2022 (a 41-year high), the Bank of England raised the Base Rate sequentially from 0.1% in late 2021 to a peak of 5.25% by mid-2023.

Post-COVID Fiscal Repair (2022-2024): To begin paying down the massive COVID debt and cool the economy, the government announced tax hikes, such as increasing the Corporation Tax rate and freezing income tax thresholds (causing Fiscal Drag).

⭐ Examiner Tip: Evaluating Policy Impact ⭐

When evaluating the effect of any demand-side policy, the crucial analysis point is always the starting position of AD on the Keynesian LRAS curve.

• If the economy has Spare Capacity (Recession): Expansionary policy (e.g., lower rates) is highly effective, leading primarily to a rise in Real GDP and unemployment falls, with little cost in terms of inflation.

• If the economy is at Full Employment (Boom): Expansionary policy is highly ineffective, leading only to a sharp rise in the Price Level (inflation) rises and no increase in output.

Monetary Policy Instruments

Monetary policy is primarily managed through controlling the interest rate used for short-term lending between banks, which influences rates across the economy.

Interest Rates

• Mechanism: The Central Bank sets the official Bank Rate (or base rate). Commercial banks use this as a benchmark for their own lending and saving rates.

• Expansionary Policy (Lower Rates): A cut in the base rate lowers borrowing costs for firms (investment, I) and households (consumption, C). It also reduces the return on saving. This stimulates C and I, shifting AD to the right.

• Contractionary Policy (Higher Rates): A rise in the base rate increases borrowing costs, encourages saving, and discourages C and I. This dampens AD, shifting AD to the left.

Asset Purchases (Quantitative Easing - QE)

• Mechanism: The Central Bank electronically creates money and uses it to purchase assets, typically government bonds, from commercial banks and other financial institutions.

• Goal: To inject liquidity (cash) into the banking system and broader economy when interest rates are already near zero and cannot be cut further (the "zero lower bound").

• Impact:

  • Lowers Long-Term Interest Rates: Buying bonds drives up their price and lowers their effective yield (interest rate), encouraging investment.

  • Boosts Money Supply: Increases the cash reserves of commercial banks, hopefully encouraging them to increase lending.

  • Wealth Effect: Can push up asset prices (stocks, bonds), making asset holders feel wealthier and encouraging consumption.

• Quantitative Tightening (QT): The reverse process, where the Central Bank sells the assets it holds, reducing the money supply.

Fiscal Policy Instruments

Fiscal policy uses the government's budget levers to manage AD.

Government Spending (G)

• Expansionary: Increasing spending on public services (health, education) or infrastructure directly increases G (an injection), shifting AD to the right. This effect is magnified by the multiplier.

• Contractionary: Cutting government spending reduces G, shifting AD to the left.

Taxation (T)

• Expansionary: Reducing taxes (direct or indirect) increases household disposable income, boosting C, and/or increases firms' profitability, boosting I. This shifts AD to the right.

• Contractionary: Raising taxes reduces disposable income, cutting C and potentially I, shifting AD to the left.

Direct Tax

Levied directly on income, wealth, or profit. Cannot be shifted to another person.

Indirect Tax

Levied on spending (goods and services). Can be shifted, in whole or part, to the consumer.

Distinction Between Government Budget (Fiscal) Deficit and Surplus

Budget (Fiscal) Deficit:

Occurs when Government Expenditure (G) is greater than Government Revenue (T) (G>T) in a given fiscal year. The government must borrow to cover the difference, adding to the national debt.

The UK Budget Deficit peaked at a peacetime high of over $300 billion in 2020/21 due to the massive cost of COVID support schemes.

Budget (Fiscal) Surplus:

Occurs when Government Revenue (T) is greater than Government Expenditure (G) (T>G) in a given fiscal year. The government can use the surplus to pay down existing national debt.