1. Fiscal Policy
Fiscal policy involves changing the level of public spending and/or taxation to affect the level of aggregate demand.
During an economic recession, increasing the aggregate demand for goods and services can help boost output and reduce unemployment. If private sector spending is too low, then the government can increase its own spending. This can be combined with cuts on taxes on people’s income and firms’ profits. This will give them more money to spend. However, there is a risk that they will simply save this extra money or spend it on imported goods.
Increasing public spending and/or cutting taxes to boost aggregate demand, output and employment is known as expansionary fiscal policy.
During a period of high demand-pull inflation, fiscal policy may be used to deflate the economy by reducing the aggregate demand. this involves reducing public spending and/or raising taxes. However, a deflationary fiscal policy may increase unemployment and reduce growth in real output.
Problems with fiscal policy
The use of fiscal policy to influence the level of demand in an economy has been criticized by many economists. They argue that fiscal policy has not worked in the past. Instead inflation and unemployment got much worse in many countries. This is because:
1. fiscal policy is cumbersome to use
It is difficult for a government to know precisely when and by how much to expand public spending or cut taxes in a recession, or cut spending and raise taxes during a boom.
Boosting aggregate demand by increasing public spending and/or cutting taxes may cause an economy to ‘overheat’. That is, demand may rise too much and too quickly. If the quantity of goods and services does not rise as quickly as demand, there will be demand-pull inflation. On the other hand, government may cut spending and raise taxes by too much following a period of high inflation and cause unemployment to rise.
2. Public spending crowds out private spending
To finance an increase in public spending and/or cut in taxes, the government may borrow from the private sector. When the private sector lends money to the government, it reduces the money that is available for the private sector to spend. This is called crowding out.
3. Raising taxes on income and profits reduces work incentives, employment and economic growth.
If taxes are too high, people and firms may not work as hard. This reduces productivity, output and profits.
4. Expansionary fiscal policy increases expectations of inflation
As a result, people will push for higher wages to protect them from higher prices in the future. Rising wages increases production costs and reduces demand for labour. This in turn causes cost-push inflation and rising unemployment.
2. Monetary Policy
Monetary Policy refers to actions taken by a government to try to control either the supply of money in the economy or the price of money. Interest rates are prices of borrowing money or reward for lending money.
Monetary policy works by changing the rate of growth of demand for money; changes in interest rates affect the spending and savings behaviour of households and businesses
How monetary policy works
Monetary policy involves changes in the base (policy) rate of interest to influence the growth of AD, the money supply, output, jobs and inflation.
The following text is taken from Bank of England website as how it explains the use of monetary policy
When the Bank of England changes the official interest rate it is attempting to influence the overall level of expenditure in the economy. When the amount of money spent grows more quickly than the volume of output produced, inflation is the result. In this way, changes in interest rates are used to control inflation.
The Bank of England sets an interest rate at which it lends to financial institutions. This interest rate then affects the whole range of interest rates set by commercial banks, building societies and other institutions for their own savers and borrowers. It also tends to affect the price of financial assets, such as bonds and shares, and the exchange rate, which affect consumer and business demand in a variety of ways. Lowering or raising interest rates affects spending in the economy.
A reduction in interest rates makes saving less attractive and borrowing more attractive, which stimulates spending. Lower interest rates can affect consumers’ and firms’ cash-flow – a fall in interest rates reduces the income from savings and the interest payments due on loans. Borrowers tend to spend more of any extra money they have than lenders, so the net effect of lower interest rates through this cash-flow channel is to encourage higher spending in aggregate. The opposite occurs when interest rates are increased.
Lower interest rates can boost the prices of assets such as shares and houses. Higher house prices enable existing home owners to extend their mortgages in order to finance higher consumption. Higher share prices raise households’ wealth and can increase their willingness to spend.
Changes in interest rates can also affect the exchange rate. An unexpected rise in the rate of interest in the UK relative to overseas would give investors a higher return on UK assets relative to their foreign-currency equivalents, tending to make sterling assets more attractive. That should raise the value of sterling, reduce the price of imports, and reduce demand for UK goods and services abroad. However, the impact of interest rates on the exchange rate is, unfortunately, seldom that predictable.
Changes in spending feed through into output and, in turn, into employment. That can affect wage costs by changing the relative balance of demand and supply for workers. But it also influences wage bargainers’ expectations of inflation – an important consideration for the eventual settlement. The impact on output and wages feeds through to producers’ costs and prices, and eventually consumer prices.
Next topic: supply-side policies