Fiscal and monetary policy, step by step

Macro policy questions look hard because the chain of effects is long. They get much easier once you learn the chain as a chain, one link at a time, rather than as a list of facts. Here are the two chains you need most, written out in full.

The building block: aggregate demand

Aggregate demand is total planned spending on a country's output at each price level. It has four parts:

• C, consumption, which is household spending.
• I, investment, which is firms spending on capital such as machinery and buildings.
• G, government spending.
• X minus M, exports minus imports.

Anything that changes one of those four shifts the AD curve. Draw AD sloping down and AS sloping up, with the price level on the vertical axis and real output on the horizontal axis. Every question below is a shift of AD.

Monetary policy: a cut in interest rates

The central bank lowers the interest rate. Follow it through:

• Borrowing becomes cheaper, so households take out more loans for cars, houses and other big items. Consumption rises.
• Saving pays less, so saving becomes less attractive. That also pushes consumption up.
• People with existing loans at variable rates have smaller repayments, so they have more money left each month. Consumption rises again.
• Firms find projects cheaper to finance, and more projects become worth doing. Investment rises.
• The currency tends to weaken, because foreign investors earn less by holding it. Exports become cheaper abroad and imports become dearer, so net exports rise.
• C, I and net exports are all up, so AD shifts right.
• Output rises, so firms need more workers and unemployment falls.
• The price level rises too, and how much depends on how close the economy is to full capacity.

That last line is where the evaluation starts. If there is a lot of spare capacity, most of the effect shows up as extra output and jobs. If the economy is already near capacity, most of it shows up as inflation.

A rise in interest rates runs the same chain backwards. Borrowing gets dearer, saving gets more attractive, consumption and investment fall, the currency strengthens, AD shifts left, output and inflation both fall and unemployment tends to rise.

Fiscal policy: a rise in government spending

Now the government decides to build roads and schools.

• G is a part of AD, so AD shifts right straight away. This is more direct than monetary policy, which has to work through what households and firms choose to do.
• Construction firms win contracts and hire workers. Those workers earn wages.
• Those workers spend part of their wages in shops, so other firms earn more and hire more. This is the multiplier, and it means the final rise in output is bigger than the first injection.
• Output rises and unemployment falls.
• The price level rises, again depending on spare capacity.
• In the long run, better roads and better schools can raise productive capacity, so AS shifts right too. That is the supply side effect of the same policy.

A tax cut works in a similar way but with one extra step. Households keep more of their income, so disposable income rises, so consumption rises, so AD shifts right. It is slightly weaker than direct spending, because some of the extra income is saved rather than spent.

Comparing the two

This is what discuss questions are really asking for.

• Speed. Fiscal spending can be quick to announce but slow to build. Interest rate changes take effect in months rather than weeks, because loans and contracts take time to reset.
• Precision. Fiscal policy can be aimed at one region or one group. Interest rates apply to everyone at once.
• Cost. Government spending has to be paid for by tax or borrowing. Changing an interest rate does not cost the government anything directly.
• Independence. In many countries the central bank sets interest rates independently, which keeps the decision away from short term politics.
• Reliability. A rate cut only works if people actually want to borrow. In a deep recession, confidence can be so low that cheap credit changes very little.

Watch what the question is aiming at

The same policy looks good or bad depending on the target.

If the aim is lower unemployment, expansionary policy helps, but it risks inflation. If the aim is lower inflation, contractionary policy helps, but it risks unemployment and slower growth. If the aim is economic growth in the long run, supply side policy matters more than either, because it moves AS rather than AD.

Say which aim you are judging against. An answer that recommends a policy without naming the objective cannot really justify anything.

A short drill

Pick any of these and write the chain out in five steps, ending with output, unemployment and the price level: a rise in income tax, a fall in the exchange rate, a cut in government spending, a rise in business confidence.

Do it in under four minutes each. If you can write the chain quickly, the essay writes itself, because analysis marks come from exactly these linked steps.