Assess the contribution that fiscal policy and monetary policy can make in sustaining the recovery of an economy

A-Level Economics Paper 1 June 2017

Use the extracts and your knowledge of economics to assess the contribution that fiscal policy and monetary policy can make in sustaining the recovery of an economy, such as the UK.

• Plan
• Intro: state four macroeconomic objectives, define recovery, recession
• Paragraph 1
  • Clear argument: expansionary monetary policy can be effective
  • Diagram: right shift in AD
  • Evaluation: liquidity trap, confidence
• Paragraph 2
  • Clear argument: expansionary fiscal policy can be effective
  • Diagram: right shift in AD + multiplier effect
  • Evaluation: budget deficit, national debt
• Judgement

A recovery is a part of the economic cycle, and it comes after a recession, which has two consecutive quarters of negative economic growth, which means that real GDP was falling. There is also likely to be high unemployment and low inflation or deflation. Expansionary demand side policies can be used to sustain a recovery.

Expansionary monetary policy is when the central bank reduces interest rates. Interest rates are the cost of borrowing or reward for saving. A fall in interest rates makes it more attractive for consumers and businesses to borrow and less attractive for them to save. Overall, both consumer spending and business spending should increase as a result. Furthermore, lower interest rates cause an outflow of hot money away from the UK economy, which means that the pound would depreciate. This causes exports to increase and imports to decrease as exports are now cheaper and imports are more expensive. Aggregate demand is the total planned spending in the UK economy, and AD = C + I + G + (X-M). Hence, if consumer spending (C) or business spending on capital goods (I) increase and (X-M) increases, then AD would shift to the right.

Diagram

The diagram shows that this would cause real gdp to increase from y1 to y2, which means that the economy would be recovering. Also, this would cause unemployment to fall since more spending leads to more derived demand for labour, as workers are needed to produce the goods and servicess. The price level also increases, which should be a good thing if it is increasing towards the 2% target but could be damaging if it increases any further.

However, monetary policy is not guaranteed to support a recovery as there may be a liquidity trap. This is when, despite interest rates being low, people choose not to borrow, and still prefer to save. This is most likely to happen if there is low consumer confidence or low business confidence in the economy. For example, if there was a recession recently, people may have lost their jobs, and they do not feel confident spending money or making big purchases. They may instead prefer to build up some savings due to the uncertainty in the economy or due to their financial circumstances from the recession.

Fiscal policy could also be useful in sustaining an economic recovery. Fiscal policy is the use of government spending and taxation to influence aggregate demand. For example, if the government is aiming to help the economy recover from a recession, it can either increase government spending or reduce taxation. For example, to recover from the economic shock that COVID caused, the government spent money on Eat Out to Help Out. This meant that eligible meals became half price at restaurants. This led to more consumers going out, and the government covered half of the cost. As a result, both C and G increased, causing aggregate demand to increase, which is measured as C+I+G+(X-M). Furthermore, since businesses form an expectation that the economy will grow, they would also increase their business spending on capital goods, such as their kitchen equipment. This is known as the accelerator theory. This would cause I to also increase, so AD would increase even further. This is known as the multiplier effect.

Diagram

The diagram shows that real GDP in the economy increases from y1 to y3 as a result of expansionary fiscal policy, hence the recovery should be successful in theory.

However, the downsides of using expansionary fiscal policy are that it causes the budget deficit to increase. This is the difference between government spending and tax revenue. This then causes an increase in national debt, which is the accumulation of the budget deficit over the years. When national debt gets too high, the government will use a larger portion of future budgets just on interest payments. Also, the only way to reduce national debt is to run a budget surplus, which means raising taxes or reducing spending. Either of these options could lead to an increase in externalities (spillover effects), such as more crime or worse education or healthcare, which could mean that living standards worsen around the UK.

Overall, it is important that we carefully consider the differences between fiscal policy and monetary policy when trying to achieve an economic recovery. For example, if there is a deep recession, it is likely that monetary policy alone would not stimulate enough consumer spending, so an increase in government spending or a decrease in taxation may be necessary. However, if an economy is recovering from a shorter downturn, a fall in interest rates could be enough on its own and would not have consequences on the budget or national debt.