2.6.2a Monetary and fiscal policy instruments

Monetary and Fiscal Policy

$$AD=C+I+G+(X-M)$$

1. Both are demand-side policies that work by shifting aggregate demand to meet objectives such as growth and low inflation, but they use different instruments and different institutions.
2. Monetary policy is run by the independent Bank of England, while fiscal policy is run by the government through the Treasury and HMRC.

Monetary Policy Instruments

1. A cut in Bank Rate lowers the cost of borrowing and the reward for saving, so households and firms borrow and spend more, raising consumption and investment and shifting AD to the right.
2. QE is used when Bank Rate is already near the zero lower bound; by buying bonds the Bank lowers longer-term interest rates and raises asset prices, and the resulting wealth effect and cheaper credit support demand.

Fiscal Policy Instruments

1. Expansionary fiscal policy raises government spending or cuts taxes, injecting demand and shifting AD to the right, while contractionary fiscal policy cuts spending or raises taxes, shifting AD to the left.
2. The deficit is a yearly flow of new borrowing, whereas the national debt is the accumulated stock of past deficits, so running surpluses over time is what allows the debt to be paid down.

Direct and Indirect Taxes

1. The distinction matters for policy: changing direct taxes acts on disposable income and work incentives, while changing indirect taxes acts through the prices consumers pay.

Demand-side Policy on AD/AS

1. On an AD/AS diagram the axes are the average price level (vertical) and real output (horizontal), not price and quantity.
2. Expansionary demand-side policy shifts AD to the right, raising real output and the price level, while contractionary policy shifts AD to the left, lowering output and easing inflation.

Is monetary or fiscal policy more effective?

1. Monetary policy scores well because the independent MPC can adjust Bank Rate quickly and its credibility helps anchor inflation expectations, so it is well suited to fine-tuning demand.
2. But monetary policy is blunt and loses traction at the zero lower bound, whereas fiscal policy can target specific groups and regions and still works when rates are near zero.
3. However, fiscal policy is slower because it must pass through the political process, and a large fiscal stimulus can widen the deficit and add to the national debt.
4. On balance it depends on the shock and the state of the economy: monetary policy suits normal times, but in a deep slump with rates near zero fiscal policy tends to be the more powerful tool, and the two are often used together.

2.6.2b Bank of England and policy evaluation

The Bank of England

1. Before it raises, cuts or holds Bank Rate, the MPC weighs forecast inflation against growth, unemployment, the output gap and the exchange rate.
2. It acts on forecast inflation rather than today's figure because a rate change affects the economy only after a long time lag, and its independence keeps policy free from short-term political pressure.

The Transmission Mechanism

1. A lower Bank Rate makes borrowing cheaper and saving less rewarding, so consumption and investment rise; it also tends to weaken the pound, making exports cheaper and imports dearer, which lifts net exports.
2. Higher asset prices raise wealth and confidence, and together these channels shift aggregate demand to the right, raising output and, over time, inflation.

The Depression and 2008

1. In the Great Depression of the 1930s, Keynesians argued that deficient aggregate demand needed active fiscal stimulus, while classical economists expected markets to self-correct and favoured leaving them alone.
2. In the Global Financial Crisis of 2008, the Bank of England cut Bank Rate to $0.5\%$ and launched QE, while the US Federal Reserve cut rates close to zero and ran its own QE.
3. Both governments also used fiscal stimulus at first, though interpretations differed over how far to intervene and how quickly to switch to austerity to control borrowing.

Strengths and Weaknesses

1. Demand-side policies are flexible and can steer the economic cycle: monetary policy can be adjusted often, while fiscal policy can target specific groups and regions.
2. Their weaknesses are time lags, weak effect when confidence is low, the zero lower bound, and uneven impact on borrowers, savers and firms; crucially they manage demand rather than raise long-run potential output.

Are demand-side policies always effective?

1. It holds because a rate cut or fiscal stimulus can quickly boost aggregate demand in a recession, and an independent MPC adds credibility that anchors inflation expectations.
2. But long time lags mean policy can be mistimed, and at the zero lower bound rate cuts lose traction while QE mainly lifts asset prices, benefiting wealthier holders most.
3. In a deep confidence crisis, households and firms may refuse to borrow however cheap credit is, so the transmission mechanism breaks down.
4. On balance it depends on the size of the shock, the level of confidence and how close rates are to zero, so demand-side tools often need supply-side or fiscal support to work.