2.6.2 - Demand-side policies

Monetary and Fiscal Policy

There are two main types of demand-side policy. Monetary policy is carried out by the central bank. Fiscal policy is carried out by the government. That distinction matters because they use different instruments and usually work at different speeds.

In the UK, monetary policy is run by the Bank of England rather than by the Treasury. The Monetary Policy Committee (MPC) has nine members, with five from inside the Bank and four external members. It meets eight times a year and votes by majority. The Chancellor sets the inflation target, but since 1997 the MPC has been operationally independent: it decides Bank Rate without political interference. Its main objective is price stability, meaning 2% CPI inflation over the medium term. Because rate changes take time to work, the MPC looks ahead, using forecasts and indicators such as GDP growth and the output gap, unemployment and wage growth, house prices, the exchange rate, and global commodity prices. If inflation moves more than 1 percentage point away from target, the Governor must explain why in a formal letter to the Chancellor.

Fiscal policy is controlled by the government. It often changes more slowly because Budgets, tax decisions, and spending plans take time to design and pass. However, it can be targeted more directly at particular households, firms, industries, or regions.

Monetary policy mainly works through interest rates and, when needed, quantitative easing. Fiscal policy mainly works through changes in government spending and taxation. In short, the Bank of England changes the cost and availability of money, while the government changes public spending and the tax burden.

Interest Rates and Aggregate Demand

The main conventional monetary-policy instrument is the interest rate. In the UK, the Bank of England sets Bank Rate, which influences the interest rates commercial banks charge borrowers and offer savers.

When interest rates rise, AD usually falls through several channels. Borrowing becomes more expensive, so households reduce credit-financed spending on things such as houses and cars, and firms cancel some investment projects. Saving becomes more attractive, so consumption falls. Higher rates can also reduce house prices, bond prices, and share prices, creating a negative wealth effect. They may weaken confidence because households and firms expect tighter economic conditions. Finally, higher UK interest rates may attract foreign capital, strengthen sterling, and reduce net exports because exports become less competitive and imports become cheaper.

When interest rates are cut, the process works in reverse. Borrowing becomes cheaper, saving is less attractive, wealth effects may become positive, confidence can improve, and a weaker pound may help export demand.

This can be seen clearly in the UK housing market. Between December 2021 and August 2023, the MPC raised Bank Rate fourteen times in a row, from 0.1% to 5.25%, to bring down high inflation. If Bank Rate rises, many mortgage payments and remortgaging costs increase, leaving households with less disposable income to spend elsewhere. That is one reason interest-rate changes can spread from the financial system into the wider economy.

Interest-rate policy is useful, but it is not automatic. Bank Rate can be changed at any MPC meeting, but monetary policy works with time lags: the full effect on output and inflation can take close to two years. If confidence is very weak, low rates may not persuade firms to invest or households to borrow. Some loans are fixed-rate, so changes in Bank Rate do not pass through evenly. There is also a lower-bound problem: once rates are already very low, there is much less room for further cuts. Exchange-rate movements can add extra uncertainty too.

Quantitative Easing

When interest rates are already close to zero and the economy still needs stimulus, the Bank of England may use quantitative easing instead. This is most useful in a liquidity trap, when conventional interest-rate cuts are no longer doing much to raise spending.

The process is fairly direct. The Bank of England creates money electronically and uses it to buy assets, mainly government bonds, from banks, pension funds, and insurance companies. Those institutions now hold more liquid funds, and banks hold higher reserves. Bond prices rise as the Bank buys them, which pushes bond yields down. In theory, this makes lending easier, lowers some borrowing costs, and increases the money circulating through the financial system.

QE can raise AD through several routes. Banks may become more willing to lend. Lower yields can reduce borrowing costs more widely. Asset prices may rise, creating positive wealth effects. Investors who sell bonds may rebalance their portfolios into shares, property, or spending, which can push up other asset prices and support demand.

QE also has important limits. It may boost the prices of existing financial assets more than real output, so some of the effect stays in second-hand asset markets rather than creating new production. It can increase inequality because people who already own assets benefit most. If used too aggressively, it can add to later inflationary pressure. It may also create a sense that the economy is dependent on continuing central-bank support.