Special Dispatch from the United Kingdom: Fiscal or Monetary Policy?

How did the David Cameron government in 2010 overcome a trade-off between fiscal imbalances and economic growth?
Published by
Central Office
on August 19, 2023
on August 19, 2023
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The British Prime Minister, David Cameron, giving a speech in front of 10, Downing Street.

When the Cameron government was elected in May 2010, the British macroeconomics were looking entangled: an inflation rate of 3.4% (the highest since the 1990s with the exception of 2008), an unemployment rate of 7.9% (the highest since 1996), an economic recovery of 2.4% annual growth following two years of negative rates in 2008 and 2009 as a consequence of the 2007-2008 financial crisis, with a Gross domestic product per capita in GBP of 29,893, a lower value compared with 2007 and 2008, but higher than the 29,417 registered in 2009 which meant that the economy was on the right track ( When it comes to government finances, the government spending expressed as a percentage of GDP was between 46.4% and 45.7% after a decade of constant increases, governmental revenues of 37% of GDP, a public sector borrowing of 8.7% percent of GDP (the highest since the end of the WWII), general government deficit (net borrowing) as a percentage of GDP of 8.7% (lower than the 10% registered in the previous year, but the highest since the early 1970s, the starting point of our covered date), and a public sector net debt expressed as a percentage of GDP of 70.8% (the highest since the late 1960s) ( (Office for National Statistics). Having these data at our disposal, we can say that the British economy was recovering from the 2007-2008 financial crisis, but with the price of a budget that weighed more and more due to government intervention in ensuring public expenses. When the popular vote for the conservatives came, many international observers expected a change in terms of national finances and a greater attention to the burdening of the budget with additional expenses. Given the circumstances to be discussed in the following section, the Cameron government tried to exceed expectations.

As a result of public spending uncovered by government savings/revenues, the budget deficit puts pressure on national public finances by the need to cover the differences through external financing (Goodwin et al, 2018). As any foreign loan bears an interest which in turn is dependent on multiple equilibria on the financial markets, covering the budget hole can be ensured by an increase in the public debt, which in turn might turn a positive equilibrium (low interest rates for external financing) into negative because of increasing the possibility of a default once the debt reaches alarming levels for foreign investors (De Grauwe, 2018). Normally, a budget deficit is the result of automatic stabilizers present in the economy because of current business cycles. When the business cycle goes through a downward slope (a recessionary phase), the economic stabilizers automatically adjust to the nature of the economy, meaning tax revenues (tax base) decreases as a result of lower income levels, and public spending increases as unemployment benefits apply to a higher percentage of the affected population (Goodwin et al, 2018). Alternatively, the stabilizers turn in the other direction during an economic growth (inflationary phase) when increasing income is followed by higher tax revenues for the government and lower unemployment rate means that fewer people are eligible for unemployment benefits (Goodwin et al, 2018). Because of the automatic stabilizers, the budget can go from a deficit in recessionary periods to a surplus in periods of economic growth. In such situations, government intervention through fiscal policy (spending and taxation aimed to adjust the aggregate demand) is unnecessary since the economy is readjusting itself while the automatic stabilizers ease the burden of the transition from one business cycle to another.

Having a look at the situation in the UK during David Cameron's term as Prime Minister (2010-2016), we observe a decrease in the budget deficit from 8.7% of GDP in 2010/2011 to 2.7% in 2016/2017 (Office for National Statistics). Also, the total managed expenditure expressed as a percentage of GDP reduced from 45.7% in 2010/2011 to 40.2% in 2016/2017, and total public sector current receipts expressed as a percentage of GDP increased from 37% in 2010/2011 to 37.4% in 2016/2017 ( Given the decreasing budget deficit, the British economy faced a public sector borrowing (excluding public sector banks) of 5.2 million GBP from 9.2 million GBP in April 2010 (Office for National Statistics). Moreover, the British economy registered an average annual economic growth of 2-3% between 2010-2016 which indicated that the business cycle was sloping upwards again after -2% growth in 2008 and -4.5% in 2009 ( Since a decrease in budget deficit comes as a result of an economic growth, it is important to reflect on how and what provided for the latter.

A positive economic growth could have been possible through a "recovery'' of the aggregate demand. Because many economists would argue that an economic depression is in fact a lack of demand issue, an increase in aggregate expenditure (measured as household consumption C + government consumption Gc + government investment Gi + private investment Ii + Net exports (exports-imports) was the core of pushing the national economy towards income accumulation (Krugman, 2012). Imagine the economy like a bracelet with three expensive pearls (output, income, expenditure). If a single pearl breaks down, the overall bracelet loses its value (economic growth is decreasing). Based on the assumption that production increases income, an increase in output generates higher income (and low unemployment), income then used for consumption. The higher the aggregate demand for products, the greater the output once firms demand more labour to increase production. If spending lacks injections resulting in lower product demand, the output decreases, dragging down the income level (higher unemployment). The output-income-spending flow of an economy in equilibrium shows how one piece drags up or down the entire flow of income in an economy and thus become representative for the real source in changing business cycles (Goodwin et al, 2018). Consequently, a British economic recovery could have been possible once aggregate demand moved to the right, providing a lifeboat for domestic production once the recessionary phase ended in 2010. But how was this economic growth possible? Since aggregate demand is represented by the units described above (C+Gc+Gi+Ii+X-M), one or more elements must have contributed to boosting aggregate demand (Goodwin et al, 2018). But we know from earlier statistics that the budget deficit and expenditure as a % of GDP decreased under the Conservative government, which means that the (Gc) and (Gi) remained out of touch. An increase in household consumption, private investment or exports should have provided an answer to the positive result of the equation. But to see which element contributed the most to the positive boost of aggregate demand, it is necessary to look towards monetary, not fiscal policy. A long-lasting debate between economists over which economic policy best addresses a deficit aggregate demand, the choice between fiscal and monetary policy became a choice between government intervention through spending (G) and taxation (T) and an independent Central Bank's decision on money supply (M) (Baumol & Alan S Blinder, 2006). The former is in the veins of Keynesianism when aggregate demand (AD) = C+G+I+ (X-M) when the government provides stimulus directly through public spending (G), or indirectly through taxation (T) that in turn determines how much of (C) enters the economy (Baumol & Alan S Blinder, 2006). But fiscal policy can also affect investments since an increase in (AD) raises both real and nominal GDP, and the price level (P) (Baumol & Alan S Blinder, 2006). An increase in (P) decreases the demand for savings since households need more cash to pay for higher priced goods. A decrease in saving deposits raises interest rates in the banking sector, discouraging private investments (Ii). On the other hand, an independent Central Bank acting on increasing/decreasing money supply (M) is more in the language of monetarists where M x V = P x Y, meaning that any increases in (M) raises prices (P) and output (Y) (V representing the velocity of circulation). Moreover, an increase in (M) provides liquidity to the banking sector and therefore boosts credit for business investment at lower interest rates (Baumol & Alan S Blinder, 2006).

Taking into consideration the indicators reflecting both monetary and fiscal policy, we can conclude that the Conservative mandate over the British economy used a monetarist approach in providing economic growth and therefore reducing the national budget deficit. Between August 2013 and September 2016, the Bank of England official rate was between 0.25-0.5%, meaning that the liquidity provided to the banking sector was set so low for the latter to decrease its own rates demanded to the business sector for private investment (Bank of England Database). In 2016 (Q4), business investment reached 160, from 111 registered in 2010 (Q2) (Office for National Statistics). Additionally, a decrease in interest rates makes the profits for foreign investments on the British financial market decrease, which leads to a low demand for pounds and thus a depreciation of the national currency that makes British exports (X) very attractive on foreign markets and imports (M) unattractive since more pounds are needed to pay for goods and services in higher-valued currencies. Similar to (Ii), as (X) exceeds (M), the net export unit (X-M) from the aggregate demand provides a monetary policy-empowered stimulus to the national economy, bringing economic growth and low budget deficit in the absence of governmental-initiated fiscal policies (Goodwin et al, 2018).



Goodwin, N., Harris, J., Nelson, J., Rajkarnikar, P., Roach, B., Torras, M. (2018), Macroeconomics in Context, 3rd Edition, Routledge.

Chapter 14 ‘Fiscal and monetary policy’ in Baumol, W., and Blinder, A., 2006 Macroeconomics: Principles and Policy, Cengage Learning.

Krugman, Paul, End This Depression Now, City University of New York, 2012.

De Grauwe, Paul, Economics of Monetary Union, Oxford University Press, 2018.

Home - Office for National Statistics (

Bank of England Database

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