Macroeconomic policy

Fiscal policy
- Fiscal policy involves the government changing the levels of taxation and government
spending in order to influence aggregate demand (AD) and the level of economic activity.
- Sometimes, aggregate supply may be affected to ( e.g. lower tax having incentive effects)
but Fiscal Policy is a demand side policy.
- Contractionary/tight Fiscal policy ( raising taxation, lowering government spending) may
lower AD and lower inflation.
- Expansionary/loose Fiscal Policy ( lowering taxation, rasing government spending) may
raise AD, increasing GDP and lowering unemployment. This will tent to worsen the
government budget deficit, and the government will need to increase borrowing

Criticism of fiscal policy

u The government may have poor information about the state of the economy and
struggle to have the best information about what the economy needs.
u Time lags. To increase government spending will take time. It could take several
months for a government decision to filter through into the economy and actually
affect AD. By then it may be too late.
u Crowding out. Some economists argue that expansionary fiscal policy (higher
government spending) will not increase AD because the higher government spending
will crowd out the private sector. This is because the government have to borrow from
the private sector who will then have lower funds for private investment.
u Government spending is inefficient. Free market economists argue that higher
government spending will tend to be wasted on inefficient spending projects. Also, it
can then be difficult to reduce spending in the future because interest groups put
political pressure on maintaining stimulus spending as permanent.
u Higher borrowing costs. Under certain conditions, expansionary fiscal policy can lead
to higher bond yields, increasing the cost of debt repayments.
Evaluation of Fiscal policy
u The success of fiscal policy will depend on several factors, such as
u It depends on the size of the multiplier. If the multiplier effect is large, then changes in
government spending will have a bigger effect on overall demand.
u It depends on the state of the economy. Fiscal policy is most effective in a deep
recession where monetary policy is insufficient to boost demand. In a deep recession
(liquidity trap). Higher government spending will not cause crowding out because the
private sector saving has increased substantially. See: Liquidity trap and fiscal policy
– why fiscal policy is more important during a liquidity trap.
u It depends on other factors in the economy. For example, if the government pursues
expansionary fiscal policy, but interest rates rise, and the global economy is in a
recession, it may be insufficient to boost demand.
u Bond yields. If there is concern over the state of government finances, the government
may not be able to borrow to finance fiscal policy. Countries in the Eurozone
experienced this problem in the 2008-13 recession.

Monetary Policy
u Monetary policy involves using interest rates, money supply and *exchange rates to
influence the levels of consumer spending, Investment and aggregate demand (AD).
In particular monetary policy aims to stabilise the economic cycle – keep inflation
low and avoid recessions.
 u Expansionary Monetary Policy involves lowering interest rates, increasing the money
supply or lowering exchange rates.
u Contractionary Monetary Policy involves raising interest rates, reducing the money
supply or lowering exchange rates.
u * exchange rates are sometimes not viewed as monetary policy but CAIE considers
them to be.
u Lower interest rates, in theory, should stimulate economic activity. This is because
lower interest rates reduce borrowing costs. This increases the disposable income of
consumers with mortgage interest payments and should encourage spending.
u Lower interest rates also reduce the reward for saving and encourage spending
u These factors should therefore increase Consumption, shifting AD to the right
u Borrowing costs will also fall for firms so lower interest rates may also increase
investments.
u Lower interest rates also may cause hot money outflows and so an increased supply of
the currency/fall in demand for currency and lower the exchange rate. This may
further stimulate AD via an increase in net exports.

Quantitative Easing
u Quantitative Easing. This involves the Central Bank increasing the money supply
and using these electronically created funds to buy government bonds or other
securities.
u Increase economic activity – Q.E. aims to encourage bank lending, investment and
therefore help improve the rate of economic growth.
u Higher inflation rate. Quantitative easing may also be used to avoid the prospect of
deflation
u Lower interest rates on assets
How Quantitative Easing Works
The Central Bank creates money electronically. (This is a similar effect to printing money,
except they are increasing bank reserves which don’t need to be printed in the form of cash)
The Central Bank uses these extra reserves to buy various securities. These include
government bond and corporate bonds.
u Buying these securities achieves two things:
u Increased liquidity. Banks sell assets (bonds) for cash. Therefore banks see an
increase in their liquidity (cash reserves). In theory, the bank will then be more willing
to lend to customers. This lending will be important for increasing investment and
consumer spending.
u Lower interest rates. Buying assets reduce their interest rate. Lower interest rates on
these securities may also encourage banks to lend rather than keep securities which
are paying low interest. Higher lending should help improve economic growth.
u Therefore, the aim of quantitative easing is to:
u Increase bank lending leading to higher investment. This should stimulate economic
growth
u Increase inflation. Quantitative easing may be pursued when there is underlying core-
inflation close to 0%. 0% inflation and deflation can lead to lower spending and
economic growth. Therefore, aiming for a higher inflation rate can encourage
spending.
Supply side policy
u Supply side policies are government policies which seek to increase the productivity
and efficiency of the economy. They can involve interventionist supply side policies
 (e.g. government spending on education) or free market supply-side policies (e.g.
reduce government legislation)
u Supply side policies involve increasing the quantity and/or quality of the factors of
production and will shift the LRAS curve to the right.
Supply Side policies – analysis
u Supply side policies and unemployment
u Supply side policies are of great importance in reducing the natural rate of
unemployment. The natural rate of unemployment includes supply side
unemployment such as structural and frictional unemployment.
u Supply side policies and inflation
u To attain low inflation, supply side policies can help reduce costs and increase
productivity. For example, privatisation and deregulation can help reduce costs.
u Supply side policies and balance of payments
u Increased productivity can also help the balance of payments. If firms become more
competitive, then UK goods will be in greater demand, increasing exports (perhaps
reducing imports)and improving the current account deficit.
Supply side policies – Issues
u Supply side policies can take a long time to have an effect.
u They often involve government spending so there may be an opportunity cost.
u They may not be appropriate if the problem is caused by demand side factors.