Pearson Edexcel IAL Economics: Fiscal and monetary policy and central banks (YEC11)

This guide is aligned to the Pearson Edexcel International Advanced Subsidiary/Advanced Level Economics specification (Issue 2, June 2018, first teaching September 2018). It covers section 2.3.6, item 4, parts a to e: demand-side policies. In the specification, Units 1 and 2 are the International AS content and Units 3 and 4 are the extra International A2 content. This topic sits in Unit 2, Macroeconomic performance and policy, which is an International AS compulsory unit and is also part of the full International A Level.

Related pages: revision notes, practice questions, course hub, checklist, economic growth guide, exam preparation and the free diagnostics. Objectives and their conflicts, and supply-side policies, have their own pages. This one is about demand-side policy only.

All numbers below are invented for illustration. Country A is not a real country.

What you must be able to do

Spec item	You must be able to
4a	Distinguish fiscal from monetary policy, and reflationary from deflationary policy
4b	Explain government spending and taxation as fiscal instruments
4c	Explain interest rates, quantitative easing, lending criteria and reserve asset (liquidity) requirements
4d	Explain the central bank’s roles: implementing monetary policy, an inflation target, banker to the government, banker to the banks
4e	Weigh the strengths and weaknesses of different demand-side policies

4a: Fiscal versus monetary, reflation versus deflation

Demand-side policies try to change aggregate demand (AD), which is consumption plus investment plus government spending plus net exports.

• Fiscal policy changes government spending and taxation. The elected government sets it.
• Monetary policy changes the cost, availability or quantity of money and credit. In most countries the central bank carries it out.

The second distinction is about direction.

• Reflationary policy raises AD. It is used when output is below potential or unemployment is high.
• Deflationary policy lowers AD. It is used when AD is pushing prices up faster than the target.

	Reflationary	Deflationary
Fiscal	Higher spending, lower taxes	Lower spending, higher taxes
Monetary	Lower interest rates, QE, looser lending, lower reserve requirements	Higher interest rates, tighter lending, higher reserve requirements

Do not confuse “deflationary policy” with “deflation”. Deflationary policy slows demand. Deflation is a falling price level.

4b: Fiscal instruments

Government spending includes current spending (wages, health, transfers such as unemployment benefit) and capital spending (roads, schools). Spending is an injection, so a rise shifts AD right directly.

Taxation works indirectly. A lower tax rate raises disposable income, and households save some of it and spend some on imports. So a tax cut of a given size usually raises AD by less than a spending rise of the same size.

The budget deficit is government spending minus tax revenue. If Country A spends 120bn and collects 108bn, the deficit is 12bn, or 3.0% of a 400bn GDP.

Worked example: closing a negative output gap

Country A has potential output of 420bn and actual output of 400bn. The output gap is 20bn, which is 20/420 = 4.76% of potential. Withdrawals from each extra unit of income: saving 0.15, tax 0.15, imports 0.10.

1. Multiplier = 1 / (0.15 + 0.15 + 0.10) = 1 / 0.40 = 2.5.
2. Spending needed = 20 / 2.5 = 8bn.
3. Output rises by 8 × 2.5 = 20bn, so the gap closes.
4. Tax revenue rises by 0.15 × 20 = 3bn, so the net budget cost is 8 − 3 = 5bn.

Now compare a lump-sum tax cut of 10bn. Households spend (1 − 0.15 − 0.10) = 0.75 of it at home, so the first-round injection is 7.5bn. Output rises by 7.5 × 2.5 = 18.75bn. To close the whole 20bn gap by tax alone you would need 20 / 1.875 = 10.67bn. Spending is “more powerful per unit of budget cost” because none of it leaks into saving or imports in the first round.

This assumes spare capacity. If the economy is already at full capacity, extra AD mainly raises the price level.

4c: Monetary instruments

Interest rates

The central bank sets the policy rate. Commercial banks usually move their loan and deposit rates in the same direction. A rise in rates:

• raises the cost of borrowing, so consumers and firms postpone spending (consumption and investment fall);
• raises the reward for saving;
• raises the interest paid by borrowers on variable-rate debt, reducing disposable income;
• tends to attract foreign funds and lift the currency, so exports cost foreigners more and imports cost less at home, lowering net exports.

Worked example. A household has a 200,000 variable-rate mortgage. If the rate falls from 7% to 6%, annual interest falls from 14,000 to 12,000. That is 2,000 a year (about 166.67 a month) of extra disposable income, and a chain of effects: lower cost of borrowing, more disposable income, higher consumption, higher AD.

Real versus nominal. Real rate = nominal rate − inflation (approximately). If the policy rate falls from 5% to 4% while inflation stays at 3%, the real rate falls from 2% to 1%. Spending decisions respond to the real rate.

Quantitative easing (asset purchases)

In quantitative easing (QE) the central bank creates money electronically and buys financial assets, usually government bonds, from banks and other holders. The aims: raise the money supply, raise bank reserves, and push down long-term interest rates.

Take a bond with a face value of 100 that pays 6 a year. At a price of 100 the yield is 6%. If central bank buying raises the price to 110, the yield is 6 / 110 = 5.45%. At 125 it is 4.80%. Lower yields reduce the cost of borrowing for the government and firms, and sellers may buy other assets, raising their prices.

QE is used when the policy rate is already very low, so cutting it further is not possible or not effective.

Lending criteria

The authorities can require banks to lend more cautiously or less cautiously. Example: a maximum loan-to-value ratio on mortgages. For a house costing 250,000, a 90% limit allows a 225,000 loan and needs a 25,000 deposit. An 80% limit allows 200,000 and needs a 50,000 deposit. Tighter criteria cut the number of people who can borrow, reduce demand for houses and consumer credit, and so deflate AD without changing the interest rate.

Reserve asset (liquidity) requirements

Banks must hold a minimum share of deposits as liquid assets. A higher ratio leaves less to lend. In a simplified case, new reserves of 5bn support at most 5 / 0.10 = 50bn of deposits at a 10% requirement, but 5 / 0.12 = 41.67bn at 12%. Lending capacity falls from 45bn to 36.67bn. This is a ceiling, since banks may hold extra reserves and may not find enough borrowers.

4d: The role of central banks

1. Implementing monetary policy. It sets the policy interest rate, runs QE and applies any reserve or lending rules.
2. Achieving an inflation target. Many central banks are given a target. Suppose Country A’s target is 2%. The price index rises from 125.0 to 129.5, so inflation = (129.5 − 125.0) / 125.0 = 3.6%. That is 1.6 percentage points above target. Next year’s index would need to be about 132.09 (129.5 × 1.02) to hit it. The central bank would consider deflationary monetary policy.
3. Banker to the government. It holds the government’s accounts, handles payments and helps the government issue and manage its debt.
4. Banker to the banks, and lender of last resort. Commercial banks hold reserve accounts with it, which they use to settle debts with each other. If a solvent bank cannot meet withdrawals because it cannot get funds elsewhere, the central bank steps in with a loan so that a loss of confidence does not spread. Drawback: moral hazard, since banks may take bigger risks if they expect rescue.

4e: Strengths and weaknesses

Policy	Strengths	Weaknesses
Fiscal	Direct effect on AD; can target regions or groups; multiplier; can raise capital spending	Time lags in decisions and spending; political pressure; bigger deficit and debt; possible crowding out; tax rises may weaken incentives
Interest rates	Quick to change; reversible; set by experts, away from elections	Households may not respond (low confidence, high debt); lags; one rate for the whole economy; cannot fall below about zero
QE	Works when rates are very low	Uncertain effect on lending; may mainly raise asset prices, favouring asset owners; hard to unwind
Lending criteria / reserve rules	Can target housing credit; do not depend on interest-rate response	Firms and households may find other lenders; may restrict credit to good borrowers

All demand-side policies share limits. They cannot fix a supply-side cause of low output. They work best with spare capacity. They can conflict with other objectives, for instance reflation may worsen the current account through imports. The output gap and the multiplier can only be estimated, so the dose of policy may turn out wrong.

Evaluation chain

Do not stop at “fiscal is slow”. Build a chain: reflationary fiscal policy raises spending, the multiplier raises income, so output rises if spare capacity exists. However, a larger deficit may need borrowing, which could push up interest rates and crowd out private investment. The overall judgement depends on how much spare capacity there is, how close interest rates are to zero, how high debt already is, and the time horizon.

Common errors

• Writing that a central bank “controls the money supply” fully. It influences it.
• Saying a tax cut and a spending rise have the same effect per unit. The first round differs.
• Forgetting that a rate cut raises AD through several channels and that each needs a link in the chain.
• Treating QE as printing banknotes.
• Using “inflation” and “price level” as if they were the same.
• Leaving out the condition: spare capacity.

Official syllabus

Pearson Edexcel International Advanced Subsidiary/Advanced Level in Economics specification, Issue 2, June 2018, Pearson Education Limited, section 2.3.6 item 4.