Effectiveness of policy options
Fiscal policy: strengths and limits
- Acts directly and powerfully on demand; can target groups/regions. But:
- time lags (a budget is set once a year),
- large deficits add to the national debt,
- crowding out — heavy borrowing raises interest rates, cutting private investment.
- The Laffer curve: as the tax rate rises, revenue first rises then falls (very high rates discourage work) — there is a revenue-maximising rate.
Practice
Crowding out happens when:
Government borrowing pushes up interest rates, reducing (crowding out) private investment.
Practice
The Laffer curve shows that raising the tax rate too high will:
Beyond the revenue-maximising rate, very high taxes discourage work and avoidance rises, so revenue falls.
Monetary & supply-side
- Monetary policy is flexible (rate changes anytime) but has a long lag; in a deep slump, low rates may fail.
- Supply-side policy raises growth and lowers inflation together — but is slow, costly, and can widen inequality.
Putting it together
- No single policy hits every target. Governments combine demand-side (fiscal + monetary) for the short term with supply-side for the long term, and accept some trade-offs.
Practice
Governments usually combine demand-side policies for the short term with supply-side policy for the long term.
No single tool hits every target, so a mix is used, accepting some trade-offs.
You've got it
Key idea
- fiscal: powerful but time lags, debt, crowding out; the Laffer curve warns very high tax rates cut revenue
- monetary: flexible but lagged, weak in a slump; supply-side: growth + low inflation but slow
- best approach = a mix of demand-side (short term) and supply-side (long term)