In spite of the fact that these actions can be used to help deal with a recession they are not thought to help economy achieve sustainable growth. Reflationary monetary policy involving reductions in interest rates to very low levels to deal with crisis situations tend to have very limited effect on an economy because consumers and workers refuse to spend until they are confident the crisis is over. Another weakness is that they can cause inflation when the UK economy runs out of spare capacity. Finally, it should be recognized that raising government spending on education, cutting tax rates, interest rates reductions also effect AS.
Apart from the short-run policies, there is a long-term supply-side policy that is aimed at increasing AS. First of all, all policies effect growth in the long term by reducing income tax rates, deregulating markets or improving education and training. Secondly, it increases competitiveness by improving the productivity of the economy. Finally, it increases quantity and improve quality of the factors of production. This leads to the outward shift of the PP curve and makes the economy more able to produce more and of a better quality.
However, it works very slow and cannot be used for dealing with a crisis, so it is useless during the recession. What is more, it relies on a rise in AD to occur at the same time. If AD is to fall, it is likely to have no effect on the economic growth.
The second macroeconomic objective is low stable inflation. It may be achieved using same policies like it was with economic growth.
This time deflationary fiscal policy has to be applied to have any effect on AD. Furthermore, there is a need to raise taxes and reduce government spending. AD would decrease as injections fall and withdrawals rise. Secondly, government budget deficit might improve as tax revenues are expected to rise and spending falls. Additionally, deflationary fiscal policy reduces imports due to falling consumption so the balance of payments would improve.
Deflationary monetary policy is likely to reduce inflation by raising interest rates, reducing bank lending or strengthen value of ŁSterling. Thanks to these factors, the average price level would fall as AD declines. Another advantage is that it can be changed every month by the Bank of England and is quick to have an impact. During a recession is really good to solve the problem of inflation. Same as deflationary fiscal policy helps to reduce imports so balance of payments would improve. What is really important, it has been very successful as UK inflation has been low for the past decade.
However, some problems arise. There is a typical conflict of objectives. Deflationary, both fiscal and monetary policies reduce inflation but it slows economic growth causing unemployment to rise. That is because less people are needed to work as less is produced. Companies do not need any additional workers and employment falls. Moreover, it reduces consumer spending leading to falling profits for businesses. Businesses investment fall as it has negative impact on AS and AD and consumers do not have a big choice because less is produced. It can lead to shortages in access to some products. Finally, if government tries to keep inflation too low, UK may fall into the recession if the interest rates will be raised too much.
The next UK objective is to keep unemployment at the low level. UK government uses reflationary fiscal policy to cope with that problem. It consist in cutting taxes, like VAT or Income Tax. It raises AD encouraging consumer spending to rise because people have more disposable income and can consume more. Together with more consumption firms stock levels decline. In response to that managers try to expand output and employ more workers. Cyclical unemployment falls. What is more, tax cut will have a multiplier effect around the economy and cause Real GDP to rise by an amount greater than tax cut. Finally, cut in income tax rates will also increase the incentive to work. As a result frictional unemployment will fall as people spend less time looking for a new job.
Expansionary monetary policy would reduce interest rates, bank lending and cause ŁSterling to depreciate. It will cause a rise in AD as consumers and businesses spend and borrow more. Cyclical unemployment falls. It also is quick to have an impact that is why it is sensible to be used during a recession. It moves AS curve to the right as well because of the rise in investment.
But there is a conflict of objectives as fall in unemployment causes inflation to rise. Itmay even lead to overheating the possibility and damage the long term growth prospects of economy. To be fair, it is only short term policy which is not likely to be effective at dealing with unemployment so much as with inflation.
In conclusion, policies help UK government to improve its performance in lots of ways. However, some of them are short-term and are only used to improve current situation but without looking at the future consequences.
