Unit 4 Fiscal Rules, Fiscal’s Microeconomic effects and Limitations

The UK fiscal rules would include the Golden Rule and The Sustainable Investment Rule. The Golden Rule is that new money that needs to be borrowed would have to be for new social capital for schools, hosptals etc. However in order for other spending such as transfer payments the old debt would have to be cleared first. While the Sustainable Investment rule is that the debt cannot exceed 40% of its GDP. This is one of the reasons why Monetary policy is favored but sometimes the government need to help to reduce the budget deficit so would have stealth taxes in order to raise revenue. These are taxes that are designed to go unnoticed. 

What can the Fiscal Policy do to affect the SUPPLY SIDE?

  • Incentives to work- lower income tax may encourage the people to work more as they have a higher opportunity to work more. Government may reduce welfare benefits in order to reduce the poverty trap.
  • The pattern of demand: This is where increasing taxes ad government subsidies can be used to influence the pattern of demand for goods and services. So this could mean markets for merit goods would have higher demand
  • Business Investment may be encouraged if there was lower taxes like corparation tax which would also encourage entrepreneurship. On the large scale this would help to increase output. 

Limitations of Fiscal Policy:

Even though Fiscal Policy is a policy that is able to affect both supply and demand side in a good way, one of the main reasons why monetary is used over fiscal is it is more precise in terms of what it is going to do. For example it is hard to fine tune. Also fiscal policy is to do with the government more, so it might take longer plus a time lag and government plans make take years to initiate.  The time lags tend to be longer compared to monetary policy if we use the education and training point, meaning it is impossible for it to be a fine tuning tool. Multiplier effects may take several years. 

Also increasing fiscal policy could potentially lead to crowding out which are disincentive effects for private sector. 


Unit 4: Fiscal Policy OUTLINE PART 1: Taxation

What is Fiscal Policy? 

Fiscal Policy can be said to be the manipulation of public spending, taxation and borrowing to achieve the government’s macroeconomic objectives. 

  • It is based on the two components of Taxation and Expenditure
  • An increase in expenditure and a decrease in taxation would mean a boost to aggregate demand.
  • However fiscal reforms can also help to influence the supply side of the economy aswell.


What are the main objectives of Taxation?

  • Funding government spending
  • Managing the economy as a whole
  • Redistribution of income
  • Correct market failure  

There are Direct and Indirect Taxes. Direct taxes are taxes that are paid directly to Her Majesty’s Revenue and Customs. This would include income tax, inheritance tax, capital gains tax and also corporation tax. While Indirect Taxes would include VAT on goods they make buy, goods like tobacco, alcohol would normally have excise duties on their goods aswell..

Some people would say taxes are bad but most people would say there should be some kind of tax in order to finance some essential goods like healthcare. Therefore in order to judge taxation is good they would have to go under Adam Smith’s Principle of Taxation. Taxes should be: 

  1. Economical
  2. Equitable
  3. Convenient
  4. Certain 
  5. Efficient
  6. Flexible 

There could also be HYPOTHECATION where taxes are earmarked for a specific purpose. For example taxes on cigarette packets were raised to help tackle smoking related diseases by the NHS and also take money from those creating negative externalities. 

What are the benefits and downturns of indirect taxes


  • Influencing spending patterns- indirect taxes can help change what goods and services consumers would spend their money on. 
  • Correcting externalities 
  • Incentive effects – Indirect taxes have less impact of work vs leisure choies.
  • Flexibility – can be changed more easily compared to direct taxes( only changed once a year at the time of the budget)
  • Choice – allows people to choose if they should consume the good or not instead of direct taxes which leave people with less of their take home play which are also hard to avoid.


  • Crime 
  • Distributional effects( regressive tax)- can take more off the poorer people than richer people.
  • Inflationary effects – trigger cost push inflation as taxes would increase cost for firm.
  • Lack of announcement effects – people are uncertain how much they are paying with indirect taxes. 

Taxes can be progressive– which is where the proportion of the person’s income would increase as income increases. The income tax in the UK is indeed progressive as the average tax from brackets of £5000-7499 increased from 2% to almost 18% for people in the £30,000-49,999. 

Regressive is where the proportion paid in tax falls as income increases. E.g. Indirect taxes

Proportional is where the proportion of income paid in tax stays the same as income increases. 

NEXT—> FISCAL PART 2 Government Expenditure

Unit 4: June 11 Essay 1 Question 8 – Supply Side Policies

08: Assess the contribution which supply side reforms might make in helping major recessions

Introduction and Development:

  • Supply Side Reforms- policies/measures that would help to affect the total output of the economy- supply side policies
  • Recession is where there is two or more consecutive quarters with negative economic growth.

Point 1- What can supply side policies do first 

Supply side policies as said can affect aggregate supply and with these policies there could be the potential outcome of both high output( gdp) and also lower prices. This can be shown by the diagram-

From Tutor2U Aggregate Supply

  • Aggregate Supply shifts to the right due to these measures meaning price moves from p1 to P2 and output increases from Y1 to Y2. This should mean that lower prices would attract more consumers to buy goods.( no conflict between macroeconomic objectives) 
  • Potentially lead to an increase in AD as consumption increases,
  • Plus also could mean our exports could be cheaper therefore also potentially increase our international competitiveness 
  • Therefore could help us avoid a recession and help to sustain growth itself 


Supply Side Reform 1: Investing in education and training

  • This could help to increase occupational mobility as people who did not have, have more skills to do higher level jobs leading to an increase in output for the economy,
  • Additionally education and training in regional areas where structural unemployment has been a problem over the year due to deindustrialisation would definitely benefit society. 


  • Education and Training can take up to years depending on people aswell as we assume people will definitely become qualified, well trained. Recession is two quarters (6 months) and it may be  too long to prevent one. 
  • Some people may not have the incentive due to again the time it takes and sometimes the costs such as transport etc. 

Supply Side Reform 2: Creating Incentives for Businesses 

  • This would include lower taxation for businesses such as corporation taxes, less insurance for its workers 
  • This could encourage investment in such of new machinery which could increase output in the future, also potentially increase ADemand as well( I ) 
  • There could be benefits or less tax for businesses in terms of research and development so they could help to develop new products, new machinery in order to help increase total output
  • Additionally could help to increase new businesses by subsidizing them like the Princess Diana Award.


  • Need to consider how much tax for the business will be cut? If it is still remains a quite a large proportion of their revenue businesses might have no incentive to invest.
  • Opportunity cost for government if it is at a large scale, would they want to invest at anywhere else. Government are in high debt in terms of spending and this may increase it. 
  • Also 2008/2009 recession had been global so effects in terms of new goods from these measures might not show effect until other major trading partners improve aswell. 

Additionally it also seems due to the long term of these supply side policies there must be a stimulant for the short term aswell. These would include demand side policies such as government spending aswell but on bigger projects such as infrastructure- building new roads, hospitals, schools. Therefore creating jobs. 

This would hopefully help to create a multiplier effect and get the economic into boom or recovery mode again. 1930s Keynsian Policies. 

Conc : Overall Supply side policies are definitely needed because there a huge number of people who need them in terms of finding new jobs which could help us to increase output of the whole economy for the long term so there could be a more sustained growth. However the main disadvantage of supply side policies is it is not a short term policy and a recession might occur during when supply side policies have still not taken effect. So demand side policies might be needed aswell such as increase in government spending on infrastructure.Demand side would stimulate and supply side would sustain, hopefully avoiding a recession.

Unit 4 June 2011 Essay 1: Question 07- Recession

07: Explain possible reasons for an economy moving from a period of prosperity to one of recession ( 15 marks )

A recession is when there is two or more quarters with negative economic growth. For example economic growth has been -2% in the 3rd quarter of 2008 and -4% in 4th quarter of 2008. While prosperity can be said to be the boom period which is where there were strong economic growth. These two can be shown by the economic cycle before.

From Tutor2u – Economic Cycle

The causes of recession would include:

  1. The 2008/2009 Global Recession started due to the Credit Crisis in the US. The Credit Crunch which is where due to the lack of money being able to lend to people via banks they would have to restrict on their lending. This is by higher interest rates, this can then affect aggregate demand ( total spending in the economy c+i+g+(x-m) aswell
  • Consumers would have to spend less as they would borrow less DOWN – Consumption
  • Business would be likely to invest less as they would not have the money to do so- so DOWN -Investment.
  • The interest rates going up would mean mortgages are hard to get so house prices will go down. When house prices go down people would spend less as houses is a source of wealth and therefore they would try to save this money. 
  • Overall confidence will go down- multiplier effect as a leakage from AD leads to unemployment which could then lead to these workers spending less causing the second wave of recession. So the overall loss of GDP is much bigger. 

2. Cost Push Inflation 

  • This includes the costs of food, oil and other commodities increasing in price probably due to a supply shock. 
  • This could mean higher costs for both businesses and consumption. Businesses would be facing costs so it would have tend to increase its prices. This would then see prices rise and consumption would be faced with higher costs therefore spend less.
  • However as supply decreases GDP will decrease and it is very hard to fix because both price and output have been affected.

3) One of the major components of the cause of recession is CONFIDENCE

  • As mentioned as a signifcant decrease in demand will lead to uncertainty to act for example consumers would want to save rather than spend, business would rather not invest as they don’t know what the future holds.
  • Confidence is hard to revive unless there is some sort of spending like government to boost up the economy again. 

Monetary Policy: The Evaluation

The Question is how successful has the monetary Policy been? 

  • The Global Recession had said to be one of the lowest points for the UK in terms of economics. So before 2008 the Monetary Policy was said to be generally extremely successful because the rate of inflation almost lied down to between 1 and 2%. We do assume it is the Monetary Policy who lead to this but could also be a result of benign conditions like increase in tech.
  • However after 2008 when the recession struck there was said to be deep trouble as there were :
  1. Economic Shocks which had included increase prices of commodity such as food, oil, that had lead the rate of inflation to reach above 3% ( the ceiling)  By october 2011 the rates of RPI and CPI inflation were at three year highs of 5.6% and 5.2%
  2. Between 2008 and 2011 the results of inflation had shown that there was success from the MPC. Their objective wasn’t really to control inflation but instead to help stimulate the economy again. Which they were not successful due to LIQUIDITY TRAP as the interest rate was cut to its lowest- still showed no success. 

As we can also see that there has been quite a lot of measures put in quickly to help the economy flow again, there are time lags when implementing monetary policy? so was the Government impatient in regards of the interest rate?

Has Quantitative Easing showed any improvements?

  • As seen from the first QE it did not show rapid recovery but instead the money was used for the bank’s sake. 
  • The critics of QE had said it was wrong to put QE in the first place as when QE 2 came it was when there was record high inflation and that could have potentially increased it higher
  • However governments wouldn’t high inflation as this would cause depreciation in the currency then eventually it will reduce the prices of exports potentially attracted more exports—> increase in AD
  • And also real value of government debt
  • Finally QE had said to eroded income of pensioners due to the increasing price of government bonds leading to the reduction of the effective of interest of these gilts. 

The UK Monetary Policy – Outline and the background

To Understand the Monetary Policy we need to understand the concept of ‘money’ What is money? Money is best defined by the two main functions it performs:

  • Medium of exchange; e.g. buying a good 
  • Store of value or wealth; 

The two biggest forms of money; Cash and Bank Deposits – Cash is said to be a small change of monetary compared to Bank Deposits. 

Background of Monetary Policy:

Before the current monetary policy there was the belief of Monetarism so it was monetarist( Late 70s to Mid 80s). They were called this because they believed that inflation caused by prior excess growth of the money supply( quantity theory of money). They said for inflation to decrease it must have the money supply in strict control. These policies did not work and it had stopped being monetarist after mid 1980s. 

However after this it was at 1992 when today’s monetary policy took its place to control inflation and was taken hold plus modified in 1997 by the New Labour government. The MPC was also made independent by this party and would lower or raise interest rates to meet its target. 

Interest Rate : Interest Rate is just basically the price paid to borrow money or the reward for lending money. Bank of England’s interest rate is called the Bank Rate as when the bank rate is changed the interest rates for these banks and other financial institution would change aswell- ‘announcement effect.’ 

As said its aim is to help the country meet its 2% target however over the recent years it has been also used to help stimulate demand due to the recession in 2008.

However it is said that this policy is not always the best as over the years there has been an over reliance of it and the consequences had shown in the 2008 recession where interest rates were put as low as 0.5% to attract more borrowers( therefore spenders) but there is just no use.- LIQUIDITY TRAP. 

So another policy had been installed for the monetary policy that is Quantitative Easing. This is just the production of electronic money for the public in order to increase spending. This was due to the credit crunch where due to the lack of capital assets, banks has to restrict its lending. However what happens if the banks have more money? This is where QE comes into place where the banks who normally get their capital assets by buying up gilts from the bond market, have them bought by the government. This money from the government is pumped into banks hoping they will give money to the public to spend.

However that is not the case as when QE1 had taken place the banks had received electronic money but they just simply used that money to help them correct their capital problems. Therefore there was no use and after that it was ceased until October 2011 when an extra £75 billion (QE2) had been pumped in. 

This is just a brief outline of the Monetary Policy

NEXT—> Evaluating the Monetary Policy and the Monetary Transmission Mechanism




Unit 4 June 2011 Essay 3 Question 12- PLAN/OUTLINE:

12) Evaluate the possible macroeconomic consequences for an economy of a rise in the exchange rate of its currency 

Introduction + Development 

  • Macroeconomic Consequences( DEF) – This would include economic growth, inflation, unemployment, balance of payments 
  • Rise in the exchange rate- meaning an appreciation in the value of the currency. E.g. £1=$2 is now £1=$2.50
  • Can have both good and bad macroeconomic consequences 

Point 1 – Appreciation would mean increase price for our exports- their domestic goods

  • This could mean a decrease in our demand for exports, which is a part of Aggregate demand( def), other things being equal it could mean a decrease in AD + Diagram

    from google images

  • This could lead to a negative multiplier effect(DEF) as other firms will be effected leading to a much bigger leakage to the economy
  • Additionally it would lead to increase of unemployment due to decrease in exports meaning firms has to cut down its costs as they be making less profit. This could be due to the multiplier effect aswell.


  • However an appreciation today could mean a depreciation in the future because demand for exports will decrease causing a decrease in value of currency. So exports may rise in the future.
  • Additionally imports themselves would be cheaper and may benefit firms that are import based in terms of raw materials. This could also mean the price of some goods to be cheaper than normal. 

Point 2- Affects the Balance of Payments 

  • Balance of Payments  are a record of the financial transactions over a period of time between a country and its trading partners.
  • An appreciation would lead to exports being more expensive therefore could contribute t a balance of payments deficit. 
  • A lack of international competitiveness aswell , aswell as jobs and in the long run it could be the undermining of the standard of living. 


  • Depends in the elasticity of the exports- marshall lerner condition. If the exports have a low elasticity maybe due to quality an increase in the exchange rate would be greater the level demanded for exports. 
  • Consider the capital and financial flows which tend to make up the deficit 
  • Consider how much the exchange rate has increased by

The macroeconomic impacts of the value of currency increasing can affect the whole economy in terms of growth where aggregate demand is affected then potentially leading to a negative multiplier effect. However many things need to be considered as said if the exchange rate increase is only short term and only increase by a little there is no need to worry.