Government Macroeconomic Intervention: Fiscal, Monetary and Supply-Side Policy
Domain 6 tests whether you can select the right instrument, explain its transmission mechanism, and evaluate it against objectives and conflicts.
Core rules
- Fiscal policy: taxation and government spending. Expansionary (higher spending, lower tax) raises aggregate demand; contractionary does the reverse. Automatic stabilisers work without a decision; discretionary policy needs deliberate action. Distinguish the budget deficit from the national debt.
- Monetary policy: interest rates, money supply, credit controls, exchange rate, quantitative easing. Higher rates raise borrowing costs, reduce investment and consumption, and may appreciate the currency.
- Supply-side policy raises productive capacity: education, training, deregulation, privatisation, labour-market reform, infrastructure. It is slow-acting but less inflationary.
- Conflicts: inflation versus unemployment (Phillips curve), growth versus the balance of payments, efficiency versus equity. Consider recognition, implementation and impact lags, plus crowding out.
Worked example
An economy has a deflationary gap of 80 billion and MPC = 0.75, so k = 4. A spending increase of 80 ÷ 4 = 20 billion closes the gap. A tax cut must be larger - 20 ÷ 0.75 ≈ 26.7 billion - because households save part of any tax reduction.
Traps
Listing monetary tools as fiscal ones; assuming higher government spending always raises output regardless of spare capacity and the multiplier; forgetting supply-side policy shifts long-run aggregate supply, not just demand; confusing a budget deficit with the national debt.