There are two types of economic policies employed in the UK: monetary and fiscal policy. These are used by policy makers to influence the behaviours of participants in the economy for optimal effect.
Fiscal policy is implemented by the Chancellor of the Exchequer with the approval of the Houses of Parliament. The main instrument of fiscal policy is the budget. The main controls are taxes and spending.
Fundamentals of fiscal policy
Fiscal policy rests on the idea that if the government spends money, by buying goods and services from the private sector, it increases economic activity, and therefore improves the economy. If it cuts back on spending, the economy will slow. Furthermore, if the government decreases taxes, people are inclined to spend more and increase economic activity; when they increase taxes, activity in the economy slows. Therefore, to expand the economy, taxes are cut, and spending is increased; When the economy needs to be slowed, the opposite policies are employed.
Monetarists propose that the best way to influence the economy is through control of the money supply and interest rates. These levers are traditionally the responsibility of the Bank of England. However, as the British governments own the Bank of England the Chancellor of the Exchequer has the power to set monetary policy.
Fundamentals of monetary policy
Monetary policy rests on the idea that to expand the economy, one must increase the money supply. This is done by either printing more money, lending more money to banks, lowering the interest rate to encourage borrowing and discourage savings, and by the central bank buying bonds from the market and paying with cash, which enters the economy. To slow or contract the economy, the opposite approach is pursued.
Advantages of monetary policy: inflation
Monetary policy, though often strongest when used in coordination with fiscal policy, has several advantages to fiscal policy. For one, fiscal policy has a tendency to cause massive inflation. Government infusion of money into the economy through spending can cause massive increases in inflation. It is politically difficult to slow inflation by cutting spending and raising taxes, thereby contracting the economy, and thus it rarely works as an effective way to contract the economy. Monetary policy, by contrast, can cause inflation, but raising and lowering interest rates, and increasing and decreasing the money supply tend to be effective ways of economic control that aren't excessively inflationary.
Advantages of monetary policy: speed of results
The speed that policies enacted produce results is another contrast. Fiscal policy is slowly enacted.Parliament must debate legislation, and any action may take months to pass through both Houses and be signed into law. Monetary policy, however, can be acted on immediately to respond quickly to economic circumstances. Monetary policy is primarily controlled by economists, while fiscal policy is often subject to politics.