Fiscal and Monetary Policy
What the exam tests
Fiscal and monetary policy is about stabilisation. CB2 tests instruments, multipliers, transmission mechanisms, crowding out, lags and policy mix.
Core rules
- Fiscal policy uses government spending and taxation. The budget balance is revenue minus spending; a deficit is not the same as debt.
- Automatic stabilisers (taxes and welfare) dampen the cycle without new legislation; discretionary policy requires deliberate action.
- The simple spending multiplier is 1/(1 - MPC). The tax multiplier is -MPC/(1 - MPC), smaller in absolute value. With proportional tax rate t, the multiplier is 1/(1 - MPC(1 - t)).
- Crowding out occurs when fiscal expansion raises interest rates and reduces private investment.
- Monetary policy uses the policy rate, open market operations, reserve requirements, forward guidance and quantitative easing. Transmission works through interest rates, asset prices, credit and expectations.
- Lags: recognition, decision and implementation lags are typically longer for fiscal policy; monetary policy acts faster but affects the economy with a delay.
Worked example
If MPC = 0.8, the spending multiplier is 1/0.2 = 5. A 50 billion increase in government spending raises equilibrium output by up to 250 billion if there is spare capacity. A 50 billion tax cut raises output by 0.8 × 50 × 5 = 200 billion, because the first-round effect is smaller. If the government sells bonds to finance the deficit and interest rates rise, investment may fall, so the final increase is less than 250 billion.
Traps
- Assuming the multiplier is always fully realised; it depends on spare capacity and leakages.
- Treating the tax multiplier as equal to the spending multiplier.
- Confusing the deficit with the debt stock.
- Ignoring crowding out and the policy mix.
- Assuming monetary policy works in a liquidity trap or that central banks control all interest rates.