Monetary and Fiscal Policy in the UK

Readers Question: What do you understand by the terms ‘monetary policy’ and ‘fiscal policy’? Explain with reference to a country of your choice:-

a) How these policies have been used by the government to try to achieve its objectives

  • Monetary policy is the attempt to control macro economic variables in an economy (primarily inflation) through the use of interest rates. – Monetary Policy
  • Fiscal policy is the attempt to influence the level of economic activity through changing taxation and government spending – More on Fiscal Policy

The objectives of the government are:

  1. Low inflation CPI=2%
  2. Strong economic growth, but, not inflationary growth. Increasing long run trend rate of growth
  3. Reduce unemployment
  4. Avoid large deficit on current account balance of payments

In the UK, Monetary policy has been given to the Bank of England. Therefore, the Bank of England has independence in setting interest rates. The government only set the inflation target of 2% inflation.

If the MPC predict inflation will rise above the inflation target then they will increase interest rates. Higher interest rates reduce demand and prevent the economy expanding too fast.

If economic growth is sluggish, then interest rates can be cut, lower interest rates boost economic growth and help to reduce inflation.

Fiscal policy is not used so much in modern economies, but, in theory can be used to prevent recessions or prevent inflation.

If inflation is a problem the government can increase tax rates and cut spending. These will reduce Aggregate demand, and therefore, reduce inflationary pressure.

In a recession, the government can increase AD, by increasing government spending and cutting taxes. Lower taxes increase disposable income. This helps increase economic growth and reduce unemployment.

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