Macroeconomics: fiscal, monetary and supply-side policy
What this domain tests
Fiscal, monetary and supply-side policy, and the macroeconomic environment. You must match instruments to objectives, explain transmission mechanisms, and evaluate conflicts and constraints.
Core rules
- Fiscal policy: government spending and taxation. Expansionary raises AD; contractionary lowers it. Automatic stabilisers dampen cycles.
- Monetary policy: central bank sets interest rates (or money supply) to target inflation and support output. Lower rates reduce saving and borrowing costs, raising C and I.
- Supply-side policies raise productive capacity: education, infrastructure, deregulation, labour-market reform. They shift LRAS right; market-based vs interventionist.
- Policy conflicts include inflation vs unemployment, growth vs current account, and short-run demand vs long-run supply.
Worked example
An economy has an output gap of 150 and MPC = 0.75. Multiplier = 1/(1-0.75)=4. A fiscal injection of 37.5 raises output by 37.5 × 4 = 150, closing the gap. If the gap is actually 100, the same injection overshoots by 50 and may cause demand-pull inflation. Reasoning: the multiplier is an estimate, and timing/lags matter.
Traps
Do not call automatic stabilisers discretionary policy. Monetary policy affects AD indirectly, not by directly changing government spending. Supply-side policies are long-run; demand policies are short-run. Crowding out can weaken fiscal expansion when government borrowing raises interest rates.