✅ Works well when...
The economy has spare capacity, such as unemployed workers and idle factories. Firms can then increase output without raising prices. This is common in a recession, when extra demand is most likely to create output.
Economic Growth » Policies to Promote Economic Growth
What you'll learn this session
Study time: 30 minutes
Cambridge spec: 4.5.5
- The three types of policy a government can use to promote economic growth
- How each policy leads to a rise in real GDP
- How effective each policy is, and the conditions when it works well or badly
- How to judge which policy suits a country's situation
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Unlock This CourseThe range of policies for growth
Governments like economic growth because it can mean more jobs, higher incomes and better services. Remember that growth is caused by a rise in total demand, or by more or better resources. A government can aim at either side, so it has a range of policies to choose from.
Key terms:
- Effectiveness: how well a policy achieves its aim, here a rise in real GDP, and at what cost.
💰 Expansionary fiscal policy
Cut taxes or raise government spending. This is aimed at total demand.
🏦 Expansionary monetary policy
Lower the rate of interest and increase the money supply. This is also aimed at total demand.
🎓 Supply-side policy
Improve education, training, infrastructure or incentives. This is aimed at the quantity and quality of resources.
The details of how each measure works were covered in the lessons on fiscal policy, monetary policy and supply-side policy measures. This lesson is about a different question: which one works, and when?
Policies that raise total demand
Expansionary fiscal policy and expansionary monetary policy both try to make people and firms spend more. Higher total demand makes firms sell more, so they produce more and real GDP rises.
❌ Works badly when...
The economy is already producing close to its maximum. Firms cannot produce more, so extra spending just pushes prices up and causes inflation instead of growth.
Fiscal policy: a cut in taxes leaves households and firms with more to spend, and higher government spending, for example on railways, adds directly to total demand. It can be targeted at particular areas. However, it can be slow, because it may take a long time to plan, and the government may have to borrow, so the budget deficit grows. If taxes are cut but people save the extra money, spending does not rise much.
Monetary policy: a lower interest rate makes borrowing cheaper and saving less attractive, so consumers and firms spend and invest more. It is usually the faster of the two, because the central bank can change it quickly. However, it only works if people actually borrow. If consumer confidence is low, households and firms may refuse to borrow even when rates are low. Banks may also be unwilling to lend.
Policies that raise the supply of goods
Supply-side policy tries to increase the quantity or quality of resources, so the economy can produce more. Spending on education and training makes workers more productive, new roads and ports help firms to move goods, and lower income tax may encourage more people to work.
✅ Works well when...
It is aimed at the real problem. For example, training in skills that firms actually need, or roads to places where firms want to expand. It is also useful for long-run growth that does not push up prices.
❌ Works badly when...
Results are slow and expensive. Schools take years to produce skilled workers. If people do not take up the training, or the new skills do not match the jobs available, then the money is wasted.
Comparing the policies
Demand-side policies can raise output within a shorter time than supply-side policies (monetary policy is usually the faster one), but they may cause inflation if the economy is close to full capacity. Supply-side policies are slow and costly, but they raise the economy's ability to produce and can lead to growth over a long period without pushing up prices.
Choosing between policies
No single policy is best in every country. A good answer says what the economy's situation is and then matches the policy to it.
| Situation | Most suitable policy | Why |
|---|---|---|
| Recession, many unemployed workers | Expansionary fiscal or monetary policy | Spare capacity means more demand creates output, not inflation |
| Near full capacity, but low skills | Supply-side policy | Spending would only raise prices, so the economy needs more productive resources |
| Government already has a large deficit | Expansionary monetary policy | A lower interest rate does not cut tax revenue or raise government spending, so it does not worsen the deficit directly |
Governments often use a mix, for example a fall in interest rates for a quick boost and spending on training for the long run. They also have to think about conflicts with other aims, such as stable prices.
Common mistakes
- Saying that a policy "always" works. Always state the condition, such as spare capacity or confident consumers.
- Forgetting the drawbacks. Higher demand may cause inflation and a bigger budget deficit.
- Thinking supply-side policy is quick. It usually takes years to have an effect.
- Describing the measure only. The spec asks how effective it is, so judge it.
Exam-style question
The country of Veltonia has had low growth for three years. About 12% of its workers are unemployed and many factories are not working at full capacity. The government wants to promote growth.
(a) Identify two types of policy that Veltonia's government could use to promote economic growth. [2 marks]
(b) Explain how expansionary fiscal policy could promote economic growth in Veltonia. [3 marks]
(c) Analyse why spending on education and training may be slow to promote economic growth. [4 marks]
(d) Discuss whether a cut in interest rates would be an effective way to promote growth in Veltonia. [6 marks]
Model answer
(a) Expansionary fiscal policy (1) and supply-side policy (1). Expansionary monetary policy is also correct.
(b) The government could cut taxes or increase its spending (1). Households and firms then have more to spend, so total demand rises (1). Firms sell more and produce more, so real GDP rises (1).
(c) It takes years to build schools and train people (1). Workers must complete their courses before they can use new skills in jobs (1). Training costs money now but the benefit comes later (1). If the skills do not match the jobs that firms offer, output may not rise much (1).
(d) For: lower rates make borrowing cheaper, so households and firms spend and invest more (1), and total demand rises (1). Veltonia has spare capacity and high unemployment, so firms can produce more without raising prices (1). Against: if consumers and firms are not confident, they may not borrow even at low rates (1), and banks may not lend (1). So the cut would be effective only if people respond by borrowing and spending (1).
Exam tip
In part (d), the command word "Discuss" needs both sides, then a conclusion. Include the condition on which the policy depends, such as spare capacity or confidence, and use the information about Veltonia.