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
Definition – monetary and fiscal policy
- Monetary policy is managed by the Bank of England. They have a target to control inflation (CPI = 2% +/-1) and also consider economic growth. The Bank of England use interest rates and influencing the money supply to implement this policy.- Monetary Policy
- Fiscal policy is the attempt to influence the level of economic activity through changing taxation and government spending. Fiscal policy influences the level of government borrowing. – More on Fiscal Policy
Objectives of fiscal and monetary policy
- Low inflation CPI = 2%
- Strong economic growth, but, not inflationary growth. I
- Reduce unemployment
- Avoid large deficit on the current account balance of payments.
- Maintain sustainable public finances.
Monetary policy in UK
In the UK, Monetary policy has been given to the Monetary Policy Committee of the Bank of England. Interest rates used to be set by the chancellor, but in 1997 the Bank of England was given independence to set interest rates. The government only set the inflation target of 2% inflation.
Setting interest rates
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.
See – setting interest rates
In exceptional circumstances, the Bank of England may use unconventional monetary policy. For example, between 2009 and 2017, low-interest rates were insufficient to restore normal levels of economic growth, therefore the Bank of England pursued quantitative easing – a policy which involved increasing the money supply and buying government bonds.
Fiscal Policy in UK
Fiscal policy is not frequently used. In theory, the government could use fiscal policy to moderate economic cycle, but there are political difficulties to changing tax rates just to reduce inflationary pressures. The government tend to leave economic management to monetary policy and the Bank of England.
However, automatic fiscal stabilisers play a role in moderating the economic cycle – in a recession, the government automatically receives lower tax revenue and spends more on unemployment benefits.
Also, in exceptional circumstances, the government may pursue expansionary fiscal policy. For example, in 2009, the government cut the rate of VAT to try and stimulate economic activity in the period of deep recession. It caused borrowing to rise to over 10% of GDP.
This level of public borrowing helped to provide an economic stimulus to a depressed economy, but there was a high political cost to the level of government borrowing. It was a factor in the Labour government losing the 2010 election and the Conservatives winning – promising to follow a policy of austerity and cutting government spending.
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.