The Impact of Macroeconomic Policies

The Possible Impact of Macroeconomic Policies

This topic brings together demand-side policies (unit 4.4.2) and supply-side policies (unit 4.4.3). Every policy reaches the economy through firms and households, and the same policy can help one group and hurt another.

Comparing Alternative Approaches

There is usually more than one way to tackle a problem, and each has a cost. The main comparisons are:

• Demand-side or supply-side: demand-side policy works within two years or so and suits a recession caused by weak spending. Supply-side policy takes years but raises capacity, so growth can last without inflation.
• Monetary or fiscal: the MPC can change Bank Rate at any meeting, but it hits every region and industry alike. Fiscal policy can be aimed at a group, such as low-income households, but it is slower to agree and adds to borrowing.
• Market-based or interventionist: tax cuts and deregulation cost the government less but can widen inequality. Spending on training and infrastructure fills gaps the market leaves but has a large opportunity cost.

In practice governments use a mix: demand-side policy to steady the economy now, and supply-side policy to raise its growth rate over time.

Criteria for Success

To judge whether a policy worked, first decide what success would look like. Useful criteria are:

• Did it hit its target? Inflation back to 2%, unemployment down, or growth up, measured against what the policy set out to do.
• How quickly? A policy that works after the problem has passed has failed, even if the numbers improve.
• At what cost? The money spent or tax revenue lost, and any damage to other objectives such as growth or the budget deficit.
• Who gained and who lost? A policy that meets its target but hits low-income households hardest may not count as a success.
• Did it last? A temporary boost is worth less than a lasting rise in capacity.

Evaluating Effectiveness

The same five factors decide how effective almost any policy is. The effect depends on:

• Time lags: monetary policy takes 18 to 24 months to work in full, and supply-side policy years. The economy may have changed by then.
• The size of the multiplier: where little of any extra income is saved, taxed or spent on imports, a change in spending has a larger final effect.
• Spare capacity: in a recession, extra demand raises output and jobs; near full capacity it mostly raises prices.
• Confidence: worried households and firms save rather than spend, so a tax cut or rate cut does less.
• Side effects: every policy has costs elsewhere, such as more borrowing or higher house prices. People can also respond in ways no one intended: a firm may bank a tax cut as profit instead of investing it.

Policy-makers also face shocks they cannot control, such as a jump in world energy prices, and data that arrive late and are often revised.

Applying the Framework: Interest Rates, 2021 to 2023

Between December 2021 and August 2023 the MPC raised Bank Rate fourteen times in a row, from 0.1% to 5.25%. CPI inflation had peaked at 11.1% in October 2022, driven largely by energy and food prices after Russia's invasion of Ukraine.

• Target: inflation fell back to 2.0% in May 2024, so by that test the policy succeeded.
• Time lags: many homeowners were on fixed-rate mortgages and only paid the higher rate when their deal ended, so the squeeze on spending built up over two years.
• The cause: higher rates cannot lower world gas prices. They work by cutting demand at home, so part of the fall in inflation came from energy prices falling back, not from the policy.
• Side effects: higher repayments for borrowers and firms → less spending and investment → very slow growth in 2023.

From October 2022 the government's Energy Price Guarantee capped household energy prices, holding a typical bill at about £2,500 a year. It worked within weeks and protected low-income households, but was paid for with extra borrowing. Monetary policy tackled the inflation; fiscal policy eased its cost for households while it lasted.