Economic Policy

The Government uses four main policies to stimulate the economy but this list is by no means exhaustive with smaller policies also being adopted. So what are the main four and how do they operate?

Fiscal Policy

Fiscal Policy refers to the Government's use of taxation, spending and borrowing in order to stimulate the economy. This can create demand and so result in growth, increased output and the employment which results from the increase in output produced by firms.

The government's spending may directly create demand. For example if they chose to build a school, then this creates demand in the construction industry to physically build the school. However if the Government lowers income tax, people's real incomes increase as they're paying less in taxes out of their monthly pay-packet and so have more to spend in other industries.

If the Government has a Fiscal Deficit where tax revenue doesn't cover expenditure it may borrow in order to continue to boost the economy - or issue government bonds for the public to buy.

Monetary Policy

Monetary Policy puts the emphasis on interest rates. In times of recession interest rates may be lowered. (In the recent UK Double Dip Recession the base rate was cut to 0.5%) This means that the cost of credit is cheaper and so encourages people to buy more whilst still low. Those with mortgages and loans will find that monthly interest payments are less and so their purchasing power increases. And Finally, it due to a low return it becomes less worthwhile for savers to save their money in a bank and so spend it and create demand which fuels growth. Of course, these outcomes can be reversed if the base rate was to rise again.

However there is a danger of causing inflation due to the increased demand for goods and services created by Monetary Policy. Increasing demand causes upward pressure on price (see Demand and Supply) and so the Bank of England aims to meet the Government's target of 2% and monitors the situation constantly to keep inflation at bay.

The Monetary Policy Committee (MPC) are instrumental in setting the short term interest rates at their monthly meetings.

Supply side Policy

This focuses on making firms produce more output. It is correct to think of subsidies immediately when thinking about SS Policy as export subsidies are commonplace in the manufacturing and agricultural industries. They are basically a financial incentive for producers to produce more and become more competitive in their respective markets.

This becomes apparent when looking at the situation in terms of Supply and Demand. A farmer produces more and so supply increases. Hence, providing demand remains similar the price per unit will fall - which doesn't initially sound good for farmers.However lower prices potentially attract more buyers from overseas as well as domestically as their prices are more competitive alongside the foreign competition. So, in addition to growth this is a useful policy as growth can be sustained without inflation of prices.

Exchange Rate Policy

So, we know that an exchange rate measures how much a currency is worth in terms of another currency. Hence when the rate fluctuates (which it does slightly every few seconds) one currency becomes stronger or weaker relative to the other.

Therefore by manipulating the exchange rate using policies the government can achieve the desired effect - to boost or slow down the economy in terms of exports or imports.

Let's say we the Government devalue the GB Pound. Hence it becomes weaker. If the rate was between the Pound and the US Dollar then the dollar gets stronger. Hence to the Americans, British exports seem cheaper as 1 US Dollar buys more pounds (as the pound is weaker) and so British exports should theoretically increase.

We must remember though that altering one currency will have a direct impact on the other currency in the exchange rate.