Fiscal and Monetary Policy
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Last updated 31 May 2022
There are two main parts to a government's economic policy - fiscal and monetary.
Fiscal policy involves the use of government spending, direct and indirect taxation and government borrowing to affect the level and growth of aggregate demand in the economy, output and jobs.
Fiscal policy is also used to change the pattern of spending on goods and services e.g. spending on health care and scarce resources allocated to renewable energy.
Fiscal policy is also a means by which a redistribution of income & wealth can be achieved for example by changing tax rates on different levels of income or wealth.
There two main parts to fiscal policy:
- Government spending
Welfare protection is the largest single element of government spending in the UK, with the NHS and Education the biggest single departmental items.
Government spending takes up around 40% of annual GDP. The three main areas of government spending are:
- Transfer Payments - welfare payments made to benefit recipients such as state pensions and other benefits
- Current Spending - spending on state-provided goods & services such as education and health
- Capital Spending - infrastructure spending such as spending on new roads, hospitals, motorways and prisons
Why have government spending?
Government spending enables direct government (public sector) provision of:
- Public goods
- Merit goods
It also facilitates state welfare support for low income households / the unemployed.
Government spending is also a means of redistributing income within society e.g. to reduce the scale of relative poverty.
Government spending can also be used as a tool to manage aggregate demand (GDP) as part of macroeconomic policy.
Taxation is required by any government in order to:
- Raise revenue - to finance government spending
- Manage demand in the economy - to help meet the government's macroeconomic objectives
- Change the distribution of income and wealth
- Address market failure and environmental targets - taxes may help correct market failures
Monetary policy involves the use of interest rates and changes to the money supply to achieve relevant economic objectives.
Since 1997 monetary policy has been controlled by the Bank of England who make decisions about changes in interest rates and the money supply
The main objective of monetary policy has been keeping inflation low and stable. However, the Bank also tries to support stability of economic growth.