The seven objectives

• Economic growth — sustained, sustainable growth in real GDP, ideally driven by LRAS (potential growth) rather than by unsustainable AD booms. The UK's trend rate is around 2–2.5%.
• Low and stable inflation — the UK's target is CPI inflation of 2%, ±1 percentage point. Note the target is not zero: a small positive rate gives room for relative prices to adjust, allows real wages to fall without nominal pay cuts, and avoids the far greater danger of deflation (in which consumers delay purchases and the real burden of debt rises).
• Low unemployment — "full employment", meaning only frictional and some seasonal unemployment remains.
• Balance of payments equilibrium on the current account — a broadly sustainable position, neither a large persistent deficit nor a large surplus.
• Balanced government budget — over the cycle, to keep national debt sustainable and preserve fiscal room to respond to the next shock.
• Protection of the environment — cutting emissions and pollution; growth that does not deplete natural capital.
• Greater income equality — reducing relative poverty and inequality via progressive taxation and transfers.

Two are traditionally the "big" pair: low inflation and low unemployment. Notice that at least four of the seven can conflict with growth — which is the whole of section 2.6.4.

Fiscal policy

Fiscal policy is the use of government spending and taxation to influence AD. It is set by the Treasury / Chancellor.

• Expansionary: ↑G and/or ↓T → ↑AD (magnified by the multiplier, 2.4.4). Used in a recession to close a negative output gap.
• Contractionary (austerity): ↓G and/or ↑T → ↓AD. Used to curb demand-pull inflation or reduce a deficit.
• Direct taxes are levied on income and wealth (income tax, National Insurance, corporation tax, inheritance tax) — the burden cannot be passed on. Indirect taxes are levied on expenditure (VAT, excise duties) — the burden can be passed to consumers (1.2.9).
• A budget (fiscal) deficit means G > T in a year — the government must borrow. A surplus means T > G. The accumulation of past deficits is the national debt — a stock, where the deficit is a flow. Do not confuse them.

Cyclical vs structural. A cyclical deficit appears automatically in a recession (tax receipts fall, benefits rise) and disappears in the recovery — the automatic stabilisers at work. A structural deficit remains even at full employment; it is the part that requires real policy change to fix. Cutting spending to close a cyclical deficit in a slump is self-defeating: the negative multiplier shrinks GDP, tax revenue falls further and the deficit may barely improve.

Your turn — the budget balance

Your turn — the deficit as a % of GDP

Monetary policy and the Bank of England

Monetary policy is the manipulation of interest rates and the money supply to influence AD. Since 1997 the Bank of England has been operationally independent: the government sets the 2% CPI target, and the Bank decides how to hit it. Independence removes the temptation for politicians to cut rates before an election, which makes the target credible and helps anchor inflation expectations.

• The Monetary Policy Committee (MPC) — nine members (the Governor, three Deputy Governors, the Chief Economist and four external experts) — meets eight times a year and votes on Bank Rate. If the Bank misses the target by more than 1pp either way, the Governor must write an open letter to the Chancellor.
• The transmission mechanism of a rate rise: ↑Bank Rate → commercial banks raise their rates → borrowing is dearer and saving more attractive → C falls (especially credit-financed durables) and I falls (fewer projects clear the hurdle rate); mortgage payments rise, cutting homeowners' discretionary income; asset prices fall (a negative wealth effect); and higher rates attract "hot money" inflows, causing sterling to appreciate, which cuts (X − M) and lowers import prices. AD falls, and inflation falls.
• Quantitative easing (QE) — used when Bank Rate is already near zero (the "zero lower bound"), as after 2008 and in 2020. The Bank creates new central-bank reserves electronically and uses them to buy government bonds (gilts) from financial institutions. Buying bonds pushes their price up and so their yield (interest rate) down. That lowers long-term borrowing costs across the economy, raises asset prices (a wealth effect), and injects liquidity into banks so they can lend. AD rises.

Evaluation of QE: ❌ It is a blunt instrument — banks may simply hold the reserves rather than lend ("pushing on a string"). ❌ It inflates asset prices, and since the rich own most assets, it worsens wealth inequality. ❌ Risk of inflation if it is not unwound in time. ✅ But it was arguably decisive in preventing the 2008 crisis from becoming a second Great Depression.

Your turn — the real interest rate

Fiscal, monetary or supply-side?

Treasury and the tax system → fiscal. Bank of England → monetary. Raising productive capacity → supply-side.

The Great Depression and the 2008 crisis

• The Great Depression (1930s). The orthodox classical response was to balance the budget and wait for markets to clear. Keynes attacked this: with sticky wages and collapsed animal spirits, the economy could stay stuck at mass unemployment indefinitely. He argued for expansionary fiscal policy — public works financed by borrowing. Roosevelt's New Deal partly followed this, and rearmament finally delivered the enormous fiscal stimulus that ended the Depression.
• The Global Financial Crisis (2008). The UK and US initially responded with a coordinated fiscal stimulus (in the UK, a temporary VAT cut to 15%) plus bank bailouts, Bank Rate slashed to 0.5%, and QE from March 2009. From 2010 the UK switched to austerity to cut the deficit — a choice still fiercely contested. Critics argue that with the economy far below capacity, the fiscal multiplier was large, so austerity needlessly suppressed the recovery. The IMF conceded in 2013 that it had underestimated fiscal multipliers.

Different interpretations — the exam point. The Keynesian reading: a deficient-demand crisis requiring stimulus. The classical/monetarist reading: the crisis was caused by bad monetary policy and excessive debt, and the cure is fiscal consolidation plus supply-side reform. Your judgement should turn on the amount of spare capacity at the time (2.3, 2.5.2) — which was very large indeed in 2009.

Supply-side policies

Supply-side policies aim to shift LRAS to the right — raising productive capacity. Uniquely, they can deliver growth AND lower inflation AND lower unemployment at the same time, so they are the only way to escape the trade-offs. Two families:

• Market-based — remove barriers to the free operation of markets and sharpen incentives. Cut income tax and corporation tax (to boost work and investment incentives); cut benefits (to raise the incentive to take a job); deregulate; privatise; reduce trade union power; promote free trade and competition policy. Rooted in the classical view of 2.3.3.
• Interventionist — the state acts directly where markets fail. Spending on education and training (human capital); infrastructure (roads, rail, broadband); subsidies for R&D and for investment; regional policy; industrial strategy. Justified because education, training and R&D generate positive externalities and are therefore under-provided by the market (1.3.2).

On the AD/AS diagram: LRAS shifts right. Real output rises and the price level falls. Many supply-side policies (infrastructure, training subsidies) also raise AD in the short run, because government spending and investment are components of AD — a double benefit.

Evaluation: ✅ The only policy family that raises long-run growth without inflation. ❌ Time lags are enormous — educating a generation takes 15 years, so supply-side policy is useless against a recession happening now. ❌ Opportunity cost: interventionist policies are expensive and worsen the deficit. ❌ Equity concerns: cutting benefits and top tax rates, and weakening unions, tends to widen inequality — a direct conflict with the income-equality objective. ❌ No guarantee of success: a training scheme only works if it teaches the skills employers actually want. ❌ Deregulation may recreate the market failures the regulation was correcting (financial deregulation and 2008).

Your turn — the cost of a tax cut

Match the policy to its label

Tap a policy on the left, then the correct classification.

The short-run Phillips curve

In 1958 A. W. Phillips found a striking empirical relationship in nearly a century of UK data: an inverse relationship between unemployment and wage (and hence price) inflation.

The mechanism: as AD rises and unemployment falls, the labour market tightens. Firms must bid up wages to attract scarce workers; higher wage costs feed into prices. So lower unemployment comes at the price of higher inflation, and vice versa. It is the AD/AS model viewed from a different angle.

But — the crucial evaluation. The relationship broke down in the 1970s, when the UK suffered stagflation: high unemployment and high inflation together. Why? ❶ A cost-push shock (the 1973 oil crisis) shifts SRAS left, raising inflation AND unemployment — the Phillips curve only describes demand-side shifts. ❷ Friedman and Phelps: once workers expect inflation, they build it into wage demands, so the SRPC shifts up. Any attempt to hold unemployment below its natural rate produces ever-accelerating inflation. In the long run the Phillips curve is vertical at the natural rate — the exact analogue of a vertical classical LRAS. There is no permanent trade-off. The only escape is supply-side policy, which lowers the natural rate itself.

The other trade-offs

• Growth vs inflation. Demand-led growth beyond capacity creates a positive output gap and demand-pull inflation.
• Growth vs the current account. Rising real incomes suck in imports, so the current account worsens as the economy grows. A structural conflict for the UK.
• Growth vs the environment. More output usually means more emissions, congestion and resource depletion — negative externalities GDP does not count.
• Growth vs income equality. Free-market growth may concentrate gains among owners of capital and the highly skilled, so relative poverty can rise even as GDP does.
• Reducing the deficit vs growth and unemployment. Austerity (↓G, ↑T) cuts AD, and the negative multiplier reduces GDP and raises unemployment — which cuts tax revenue and raises benefit spending, so the deficit may barely improve. A genuine policy trap.
• Policy conflict. Fiscal and monetary policy can pull against each other: a fiscal stimulus that raises inflation may force the Bank to raise interest rates, choking off the very demand the Treasury was creating.

The one that escapes: effective supply-side policy raises LRAS, delivering higher growth, lower inflation and lower unemployment together. That is why it is the answer to almost every "how can the government achieve X and Y?" question — provided you then evaluate its long time lags, cost and equity effects.

Quantitative easing

The Phillips curve

Supply-side policy

The austerity trap

The big ideas to know

That completes Theme 2 — and the whole of Themes 1 and 2. Press Finish.