Macroeconomic policy

What the spec says we need to know about...

• Fiscal policies
• Monetary policies
• Supply-side policies

Fiscal policy

Fiscal policy (sometimes referred to as budgetary policy) is all to do with the government spending and taxation.

It can have both macroeconomic effects (i.e. fiscal policy can influence the economy as a whole) and microeconomic effects (i.e. it can influence individual firms and people).

Traditionally, fiscal policy has been used to influence aggregate demand- this is a macroeconomic effect.

The aim of managing demand in this way was to 'smooth out' the fluctuations in the economic cycle. In other words, the government would try to:

• Boost demand when the economy was in a recession/slump- to stimulate economic growth and reduce unemployment
• Reduce demand when the economy was booming- to control inflation and aviod imports rising too high

Reflationary fiscal policy increases aggregate demand. Reflationary fiscal policy is somethimes referred to as 'expansionary', or 'loose'. This involves one or more of:

• Increasing government spending
• Lowering taxes

In a recession fiscal policy becomes reflationary to increase demand. There are various measures the government can take:

• Decreasing income tax means consumers will have more disposable income to spend
• Decreasing indirect taxes (such as VAT) makes goods less expensive (meaning consumers can buy more)
• Increasing welfare payments means that people with lower incomes will have more disposable income to spend
• Building new infrastructure (e.g. schools, hospitals or roads) means more jobs and higher incomes, which also means that people will have more disposable income to spend

All of the above represent lower withdrawals from the circular flow of income (e.g. tax cuts means less tax leaks out of the circular), or greater injections (i.e. higher government spending or investment). The effect should be an increase in aggregate demand.

Deflationary fiscal policy reduces aggregate demand. Deflationary fiscal policy is sometimes called 'contractionary', or 'tight'. This involves one or both of:

• Reducing government spending
• Raising taxes

In a boom fiscal policy becomes deflationary to reduce demand. Again, there are various measures the government can take:

• Increasing income tax means consumers will have less disposable income to spend
• Increasing indirect taxes (such as VAT) makes goods more expensive
• Reducing welfare payments means that people with lower incomes will have less disposable income to spend
• Reducing government spending on new infrastructure means fewer jobs and lower incomes- this also means that people have less disposable income to spend

All of the above represent higher withdrawals from the circular flow of income, or smaller injections. The effect should be a fall in aggregate demand.

When aggregate demand is boosted, the current account of the balance of payments worsens. A current account deficit will get bigger and a current account surplus will get smaller. This is because, as people's incomes increase, they tend to spend more on imports. 

Fiscal policy is a tricky tool to use. Managing aggregate demand sounds fairly easy, but in practice it's a very difficult thing to get right.

Government spending may take a long time to…