Policy Instruments

The Four Policy Instruments

Policy instrument: a tool the government or the central bank uses to steer the economy towards its objectives (unit 2.6.1).

Fiscal and monetary policy change aggregate demand (AD), the total spending in the economy. Supply-side policies raise the economy's capacity to produce.

Fiscal Policy

Fiscal policy: changing the levels of government spending and taxation to affect aggregate demand.

Expansionary fiscal policy means spending more or taxing less, which raises AD. Contractionary fiscal policy does the opposite, to slow the economy or cut government borrowing. When spending is greater than tax revenue in a year, the gap is a budget deficit, covered by borrowing.

When the government spends more or cuts taxes:

• Suppliers to the government: spending on roads, schools or hospitals rises → contracts for builders and their suppliers → more output and more jobs.
• Households: income tax or VAT is cut → more take-home pay, or lower prices → more spending → higher sales for shops and restaurants.
• Firms: corporation tax is cut → more profit kept after tax → more to invest.

Tax rises and spending cuts reverse each chain. The effect depends on:

• Whether households spend or save: if confidence is low, a tax cut is saved and sales barely move.
• How it is paid for: spending funded by borrowing adds to the national debt and its interest, which may mean higher taxes later.
• Spare capacity: if firms are already near full capacity, extra demand raises prices more than output.

The full analysis, with diagrams, is in unit 4.4.2.

Monetary Policy

Monetary policy: changing interest rates to affect aggregate demand.

The Bank of England's Monetary Policy Committee sets Bank Rate to keep CPI inflation at the government's 2% target. Banks' rates on loans, mortgages and savings follow it.

When Bank Rate rises:

• Households: mortgage and loan repayments go up and saving pays more → less spending → lower sales, worst for goods often bought on credit, such as cars.
• Firms: loans and overdrafts cost more → higher costs, and fewer projects worth borrowing for → less investment.
• Exporters: higher UK rates attract savings from abroad → the pound tends to rise → UK goods cost more overseas → export sales fall.

Together these lower AD, which brings inflation down. A cut in Bank Rate works the other way. The effect depends on:

• How much people and firms borrow: a firm with no debt feels little, and one with cash in the bank gains from higher rates.
• Fixed or variable rates: many mortgages and business loans are fixed for some years, so the change arrives only when the deal ends.
• Time lags: the Bank of England says a change usually takes up to two years to have its full effect on inflation.

Unit 4.5.3 covers how the Bank sets rates.

Supply-Side Policies

Supply-side policies: policies that raise the economy's capacity to produce, by improving the quantity or quality of its workers and capital or how well markets work.

The spec names five:

• Taxes: lower income tax → work pays more → more people take jobs or work longer hours → a larger workforce.
• Benefits: lower benefits or stricter rules for claiming → a bigger gap between income in and out of work → more people look for jobs → firms find it easier to recruit.
• Education and training: more spending on skills and apprenticeships → workers can do more skilled jobs → higher productivity and lower unit costs, and less occupational immobility (unit 2.5.4).
• Grants and subsidies: money towards research, new equipment or starting a business → lower costs of investing → more innovation and new firms.
• Infrastructure: better roads, rail and broadband → goods and staff move faster and more cheaply → lower costs and access to wider markets.

How well these policies work depends on:

• Time lags: a new rail line or a better-trained workforce takes years to arrive.
• Whether people respond: a firm may take a grant for an investment it would have made anyway, and a tax cut does not always mean more hours worked.
• Who loses: cutting benefits pushes some people into work but leaves those who cannot work poorer.

Unit 4.4.3 splits these into market-based and interventionist policies.

Exchange Rate Policy: a Floating Rate

Floating exchange rate: an exchange rate set by the demand for and supply of a currency on the foreign exchange market, with no target from the government or central bank.

The UK lets the pound float, so it rises and falls with trade, investment and interest rates (unit 2.4.4). Under a fixed exchange rate, the central bank would buy and sell its currency to hold an agreed value.

A floating pound helps the economy in two ways:

• It adjusts on its own: the UK buys more imports than it sells exports → more pounds are sold → the pound falls → exports get cheaper abroad and imports dearer → the deficit narrows.
• It leaves interest rates free: the Bank does not have to set rates to defend the pound → it can set them for the 2% inflation target.

The cost for firms is uncertainty: the pound moves → an exporter's revenue and an importer's costs in pounds change from month to month → margins are harder to predict → some firms hold back on investment, or pay their bank to fix a rate months ahead.

How much this matters depends on how much the firm trades abroad. A café with local suppliers hardly notices, while a car maker importing parts and exporting cars is exposed on both sides.