- Fiscal policy
- Fiscal policy is the use of government spending and tax policy to influence the path of the economy over time.
- Monetary policy
- Monetary policy is a central bank's management of interest rates and credit conditions to influence the level of economic activity.
The two directions of fiscal policy
Can you name the two directions fiscal policy can take?
Every tax or spending change pushes aggregate demand one way or the other.
Expansionary fiscal policy increases aggregate demand through higher government spending or lower tax rates, and suits a recession with output below potential GDP.
Can you think of an example?
In a recession a Chancellor cuts VAT on energy bills and adds £5 billion to spending on road repairs. Households have more left to spend elsewhere, and the roadworks add to demand directly.
Contractionary fiscal policy decreases aggregate demand through government spending cuts or tax increases, and suits an overheating economy with output above potential GDP.
Can you think of an example?
Two years later inflation is well above target, so the next Budget raises income tax by a penny in the pound and trims departmental budgets. Households spend less and government purchases fall.