2.6.2 Policy instruments


    There are four main instruments used to influence the economy which are fiscal policy, monetary policy, supply-side policy and exchange rate policy. Fiscal and monetary policy are used to affect AD and can be contractionary (used when inflation is high) or expansionary (when there is high unemployment and low economic growth). Supply-side policies are used affect AS to enable businesses to lower costs and so improve competitiveness and productivity of firms. Exchange rate policies are used to influence the balance of payment and the UK current account deficit.


    Fiscal and monetary policy are demand-side policies, the former uses Government spending and tax changes to influence AD whereas the latter uses interest rates. Both mainly affect consumer spending as increasing/decreasing taxes and/or interest rates will affect the amount of disposable income that consumers have. Government spending will affect public sector jobs which will then affect the income of such employees.

    Monetary policy consists of mainly interest rates which can also affect the exchange rate through hot money flows. International investor gain from moving money between countries.

    Hot money flows – money/capital moving to countries with higher interest rates.

    Limitations of fiscal policy

    • Limits Government spending (with expansionary policy).
    • If interest rates are high, fiscal policy may not be effective for increasing demand.
    • If the Government spends too much there could be an increased deficit making it difficult to borrow in future.
    • If the government has imperfect information about the economy it could lead to inefficient spending.


    Limitations of monetary policy

    • There are time lags with the changing of the base rate to affect the interest rates as banks adopt the change.
    • Banks may not pass the base rate onto consumers therefore it may not have the intended effect.
    • Even if the cost of borrowing is low, banks may not be willing to lend as they are risk averse.
    • Interest rates are less effective if firm and consumer confidence is low as if the economy seems risky they are less likely to spend despite low interest rates.



    Supply-side policies aim to increase the productive capacity and output of the economy. This increases the quantity and quality of the factors of production by increasing AS. The ways in which this is done is through changing taxes, benefits, education and training, grant and subsidies, and infrastructure development.

    • By reducing income and corporation tac, governments encourage spending and investment. Tax reforms encourage more people to work e.g. working tax credits which are paid to those who work 20 hours or more.
    • If benefits were reduced more people are encouraged to work as they get less money when unemployed than they could get working.
    • If education and training gained more money through Government training schemes and apprenticeships as there are more skilled people entering the workforce who are more productive.
    • Grants and subsidies are paid to businesses in order to increase production/output and helps to lower production costs.
    • An improvement in infrastructure e.g. improved roads will cause faster, quicker transport for businesses which reduces business costs.


    Strengths and weaknesses of supply-side policies

    • They are the only policies which can deal with structural unemployment as the labour market can be directly improved with education and training.
    • Significant time lags for people to enter the labour market.
    • Some policies, such as reducing the rate of tax, could lead to a more unequal distribution of wealth.
    • Demand-side policies are more effective dealing with cyclical unemployment since they can reduce a negative output gap.



    The value of the exchange rate in a floating system is determined by the forces of supply and demand. The demand for a currency is equal to exports plus capital inflows, the supply of a currency is equal to imports plus capital outflows. Exchange rates are influenced by inflation and interest rates.


    A reduction in the exchange rate causes exports to become cheaper (to foreign consumers) which increases exports, assuming that demand for exports is price elastic. It would also cause imports to become relatively expensive in comparison which would mean that the domestic market would improve. Overall exports would overtake imports which reduces the UK current account deficit. However, this is inflationary as the rising cost of imports increases the costs of production for firms, causing cost-push inflation.


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