2.3.1a Fiscal policy and income and expenditure

Fiscal policy uses the budget to change spending

1. A government's budget is not only a plan for its own finances: it is also a powerful tool for managing the whole economy.
2. It is a demand-side policy, because it works by changing how much is spent in the economy.
3. A government can point fiscal policy in one of two directions, known as expansionary and contractionary fiscal policy.

Expansionary policy raises spending in the economy

1. Higher government spending puts money directly into the economy, for example through the wages of public sector workers who then spend them.
2. A tax cut leaves households and firms with more disposable income, so they are able to spend more.
3. As spending rises, firms receive more revenue and tend to produce and hire more, which raises incomes across the economy.

Contractionary policy lowers spending in the economy

1. Lower government spending removes money from the economy and reduces the income of those who would have received it.
2. A tax rise leaves households and firms with less disposable income, so they spend less.
3. As total spending falls, firms receive less revenue and incomes across the economy tend to fall.

The budget change flows through to incomes

1. The link runs from the budget to the flow of spending, and then from spending to incomes.
2. A change in spending or taxes changes how much money households and firms have available to spend.
3. Their spending becomes income for others, so the effect passes from one group to another around the economy.
4. In this way, a single change in the budget can influence income and expenditure across many households and firms.

2.3.1b Fiscal policy and government objectives

Fiscal policy targets the government's main goals

1. Governments use fiscal policy to help meet their main macroeconomic objectives.
2. These usually include economic growth, full employment, stable prices and a healthy balance of payments, alongside other goals such as a fairer distribution of income.
3. By choosing how much to spend and tax, a government tries to move the economy towards these goals.

Higher spending or lower tax can lift growth

1. To support economic growth, a government can raise spending or cut taxes so that total spending rises.
2. Spending on infrastructure such as roads and broadband can also raise the economy's capacity to produce.
3. As demand rises, firms often need more workers, which can lower unemployment.
4. Spending on education and training can improve skills and support jobs over the longer term.

Higher taxes or lower spending can cool inflation

1. To slow rising prices, a government can use contractionary measures such as higher taxes or lower spending.
2. Reducing total spending eases the pressure on prices when demand is growing too quickly.
3. With UK CPI inflation at 2.9 per cent in July 2026, above the government's 2 per cent target, contractionary fiscal policy is one tool that could in principle help ease price pressure.
4. A government must judge the size of the change with care, so that it cools price rises without causing job losses.

Redistribution and spending both carry an opportunity cost

1. Fiscal policy can make the distribution of income fairer by taxing higher earners more and spending on those with less.
2. Welfare and benefit payments, the government's largest single spending area at around £314bn a year, transfer income towards lower income households.
3. Every choice has an opportunity cost, because money spent on one programme cannot be used for another.
4. Tax raised also has an opportunity cost for households and firms, who could have spent or invested it themselves.

2.3.1c The government budget

The budget compares revenue with government spending

1. The government budget is the plan of how much money the government expects to raise and how much it expects to spend.
2. The budget position is found by taking revenue minus spending.
3. The answer to that sum tells you whether the budget is balanced, in deficit or in surplus.

The budget can be balanced, in deficit or surplus

1. A worked example below shows how to apply revenue minus spending and identify whether the result is a deficit or a surplus.

Deficits add to debt, surpluses can repay it

1. When there is a budget deficit, the government must borrow to cover the gap between spending and revenue.

1. Each year of borrowing adds to that debt, so a deficit today makes the debt bigger tomorrow.
2. A budget surplus can be used to repay some of that debt, so the total owed falls.
3. To see the scale, the OBR forecasts UK national debt at around 96 to 97 per cent of national income in 2026 to 27, built up from years of deficits.

How far a budget deficit matters depends on context

1. It depends on the size of the deficit relative to national income, because a small, manageable deficit such as the roughly 4 per cent of GDP forecast for 2026 to 27 is easier to sustain than a deficit reaching double figures.
2. It depends on what the borrowing is spent on, because deficit spending on investment such as infrastructure or education can raise future growth and future tax revenue, while borrowing to cover day-to-day costs simply adds to debt without building future capacity.
3. It depends on whether the deficit is temporary or persistent, because a one-off deficit during a downturn or emergency is far less concerning than a deficit that keeps recurring year after year.
4. It depends on the cost of servicing the resulting debt, because the government already spends around £105bn a year in interest on its debt, and a bigger debt pile means a bigger interest bill that crowds out spending on public services.
5. On balance, a budget deficit is not automatically a problem: whether it matters depends on its size, its purpose and how long it persists, rather than the headline number alone.

2.3.2a The meaning of monetary policy

Monetary policy steers the economy through money

1. Alongside fiscal policy, a country's central bank has its own set of tools for managing the economy.

1. Its two main levers are interest rates, the price of money, and the money supply, the quantity of money circulating in the economy.

The Monetary Policy Committee sets the base rate

1. In the UK, monetary policy is run by the Bank of England, the country's central bank.

1. The Monetary Policy Committee (MPC), the group of Bank officials and outside experts who meet regularly to set the base rate, meets eight times a year and is made up of five Bank insiders and four outside experts.
2. The Bank is operationally independent, so these decisions are made separately from day to day politics, even though the government sets the inflation target it aims for.

Bank Rate changes reach loans and savings quickly

1. Commercial banks base their own rates on the base rate, so a change there feeds through the whole banking system.
2. A lower base rate makes borrowing cheaper and saving less rewarding, while a higher base rate does the reverse.
3. The Bank of England cut its base rate to 3.75 per cent in December 2025 and has held it there through 2026, including at its meeting on 30 July 2026.
4. Exactly how a rate change alters households' and firms' decisions to borrow, spend or save is covered elsewhere; the point to hold onto here is that the change starts with the Bank of England.

2.3.2b Uses of monetary policy

Monetary policy first targets controlling inflation

1. The Bank of England's first job is to use monetary policy to control inflation, keeping it close to the government's target.
2. When inflation rises above target, the Bank tends to raise the base rate.
3. More expensive borrowing leads households and firms to borrow and spend less.
4. Higher rewards for saving encourage people to save rather than spend.
5. With weaker demand, the upward pressure on prices eases and inflation moves back towards the target.

Monetary policy also supports growth and jobs

1. When a central bank instead wants faster growth and more employment, it cuts the base rate.
2. Cheaper borrowing encourages households to raise spending and firms to raise investment.
3. Lower rewards for saving nudge people to spend rather than save, which supports demand and jobs.

Monetary policy can affect trade through the exchange rate

1. Changing the base rate can also move the exchange rate, the value of the pound against other currencies.
2. A higher rate tends to attract money into the country and raise the pound's value, while a lower rate can do the reverse.
3. A stronger pound makes UK exports dearer abroad and imports cheaper at home, which can widen a trade deficit.
4. The UK already runs a trade in goods deficit of around £59.5bn, 7.6 per cent of GDP, in the first quarter of 2026, so exchange rate effects on trade are a live policy concern.

How far rate changes deliver objectives depends on lags

1. It depends on time lags, because interest rate changes take many months to feed through the economy, so the Bank may end up acting on out of date information.
2. It depends on confidence, because even a low interest rate may fail to lift spending if households and firms feel too uncertain to borrow.
3. It depends on global factors, because a change in the base rate cannot offset a shock such as a global rise in energy prices.
4. It depends on who is affected, because a rate rise rewards savers but makes life harder for mortgaged borrowers, so the impact is uneven across groups.
5. On balance, higher or lower interest rates can move the economy in the intended direction, but time lags, confidence and events elsewhere in the world all limit how reliably and how quickly they deliver the objective.

2.3.3a Supply-side policies and their trade-offs

Supply-side policy aims to raise the economy's long-run capacity

1. The aim is to raise productive capacity, the maximum output the economy can produce when resources are used fully and efficiently, not to raise spending today.
2. This differs from demand-side policy, which changes total spending in the economy to affect output and jobs in the short run.
3. Because it changes the economy's underlying structure, supply-side policy is judged over years rather than weeks or months.

Policies target different parts of the supply side

Education and training raises skills to lift productivity

1. Education and training: government spending to improve workers' skills and knowledge, for example funding apprenticeships, T-levels and adult retraining.
2. Advantage: better-skilled workers produce more per hour, which raises productivity and can lower structural unemployment as skills match the jobs on offer more closely.
3. Disadvantage: training is expensive and funded from tax revenue, and it can take years before newly skilled workers enter the workforce.

Lower direct taxes aim to strengthen incentives to work

1. Lower direct taxes: cutting taxes paid directly on income, such as income tax or National Insurance, so workers keep more of what they earn.
2. Advantage: a bigger take-home wage can encourage more people to work, to work longer hours, or to delay retirement.
3. Disadvantage: cutting direct taxes reduces the tax revenue the government has available for public services.

Lower taxes on business profits aim to boost investment

1. Lower taxes on business profits: cutting corporation tax, the tax UK companies pay on their profits.
   1. In the 2026/27 tax year the main rate is 25 per cent on profits over £250,000, while a small profits rate of 19 per cent applies to profits of £50,000 or less, with marginal relief tapering the rate in between.
2. Advantage: firms keep more of their profit, which can be reinvested in new machinery, technology or premises, raising the capital available to each worker.
3. Disadvantage: the tax cut costs the government revenue, and there is no guarantee firms will actually invest the extra profit rather than pay it out to shareholders.

Trade union reform aims to flex the labour market

1. Trade union reform: laws that limit the power of trade unions, for example by requiring a minimum turnout before a strike can go ahead.
   1. The Trade Union Act 2016 requires at least 50 per cent of eligible union members to vote in a strike ballot before the strike is legal, and this threshold was still in force in 2026.
2. Advantage: fewer disruptive strikes can lower costs for firms and encourage investment and employment.
3. Disadvantage: weaker unions reduce workers' bargaining power, which can hold down wages and weaken protection against poor working conditions.

Privatisation and deregulation expose firms to competition

1. Advantage: a privatised firm faces competition and the profit motive, which can push it to cut costs and become more efficient, while easing the burden on government finances.
2. Disadvantage: a privatised firm can become a private monopoly and raise prices if real competition does not follow.
3. Advantage: fewer rules make it cheaper and easier for new firms to enter a market, increasing competition and choice.
4. Disadvantage: weaker rules can allow negative externalities, such as pollution or unsafe working conditions, to go unchecked.

How far supply-side policies succeed depends on design

1. It depends on how well targeted the policy is, because training aimed at a genuine skills gap raises productivity far more than a scheme few workers use.
2. It depends on how the policy is funded, because money spent on tax cuts or training has an opportunity cost, since it could have been spent on the NHS, education or reducing debt instead.
3. It depends on whether firms and workers actually respond, because a tax cut for business only raises investment if firms choose to spend the extra profit rather than save it.
4. It depends on how much time is allowed, because most measures take years to show results, so a policy judged too soon can look as if it has failed.
5. Overall, supply-side policies can raise the economy's long-run potential, but their success is uncertain and depends heavily on design, funding and patience.

2.3.3b Using supply-side policies

Higher productive capacity supports faster economic growth

1. By raising productive capacity, supply-side policy allows total output to rise over the long run, supporting the government's objective of economic growth.
2. As capacity grows, the economy can expand for longer without quickly running short of resources.
3. Investment in education and training adds to the economy's productive capacity by raising the skills of the workforce.

Skills and flexibility policies can lower structural unemployment

1. Education and training that better matches workers' skills to the jobs on offer can reduce structural unemployment, where people are jobless because their skills do not fit the available work.
2. Trade union reform and deregulation can make it easier for firms to take on staff, since more flexible pay and conditions let employers adjust rather than avoid hiring.
3. A more productive and flexible workforce makes it easier for firms to expand and take on more employees.

Higher productivity helps keep inflation low

1. When supply-side policy raises productivity, firms can produce each unit of output at a lower cost, which helps keep inflation low.
2. A greater ability to produce lets output grow to meet rising demand without prices being pushed up as quickly.

Lower costs can improve competitiveness and exports

1. Lower costs and higher quality can make UK goods more attractive at home and abroad, improving the country's international competitiveness.
2. More competitive firms can win overseas customers, raising exports and helping the government's balance of payments objective.
3. Lower taxes on business profits can fund the investment in machinery and technology that makes exporting firms more competitive.

Supply-side policy meets objectives only slowly

1. Many measures are expensive, and spending on training or tax cuts has an opportunity cost, since the money could be used elsewhere.
2. Benefits usually take years to appear, so supply-side policy cannot quickly fix a sudden recession or a sharp rise in unemployment.
3. Success is uncertain: a tax cut for business does not guarantee that firms will actually invest, and training does not guarantee workers gain the right skills.
4. Because effects are gradual, supply-side policy is normally used alongside monetary and fiscal policy rather than on its own.

How far supply-side policy meets objectives depends on timing

1. It depends on the state of the economy, because supply-side measures are of little use in a sudden downturn that needs an immediate response.
2. It depends on how well the measure matches the objective, because training helps most with structural unemployment but does little to directly control inflation.
3. It depends on how long the policy is given, because judging a slow-acting measure after only a year or two can wrongly make it look as if it has failed.
4. Overall, supply-side policy can move the economy closer to its objectives over time, but it works too slowly to be relied on alone.

2.3.4 Policies to correct positive and negative externalities

Government policy applies existing tools to externalities

1. Positive and negative externalities are defined in 1.6.2a and 1.6.2b, and general methods of government intervention are covered in 1.6.1b; this article applies those methods to correcting externalities, whether they arise from production or consumption.

Taxing a good changes its price and quantity

1. A tax on a good with a negative externality raises its price by shifting the supply curve left, cutting the quantity bought and sold.
2. Because the tax makes the harmful activity more expensive, less of it takes place once the price includes some of the external cost.
   1. How direct and indirect taxes differ is covered in 2.1.2b; the taxes used against externalities are indirect, added to the price of the good itself.

Subsidies make beneficial goods cheaper to encourage them

1. A subsidy on a good with a positive externality lowers its price by shifting the supply curve right, raising the quantity bought and sold.
2. Because the lower price makes the beneficial activity cheaper, more of it takes place than the market alone would provide.
3. The UK's Contracts for Difference scheme subsidises renewable electricity generation such as offshore wind, encouraging cleaner production; the Boiler Upgrade Scheme pays households a £7,500 grant towards a heat pump, rising to £9,000 for homes replacing an oil or LPG boiler, while separate grants towards insulating homes lower the cost of a more energy-efficient choice.
4. A subsidy is best thought of as a negative tax: money paid out to lower a price, rather than money taken in to raise one.

Regulation and bans limit harmful activities directly

1. Regulation sets rules or limits on an activity with a negative externality, while a ban stops the activity outright; both work directly, rather than through price.

Tradable permits cap total production pollution

1. Tradable pollution permits set a total limit on emissions and let firms buy or sell permits between themselves.
2. A firm that cuts its emissions can sell spare permits, while a firm that pollutes more must buy extra ones, so total emissions stay capped.

State provision and information change behaviour without price

1. State provision of a good with a positive externality, such as state education or NHS healthcare, raises consumption above what the market alone would supply.
2. Information provision closes the information gap behind many externalities by giving people facts to make better decisions.
3. Campaigns such as anti-smoking adverts and healthy-eating guidance aim to cut demand for goods with negative externalities, while labels such as calorie counts help consumers weigh the true costs and benefits.
4. Better information can also raise demand for goods with positive externalities, such as vaccination.