The Times is running regular briefings to coincide with Target Two Point Zero, the Bank of England contest for sixth formers run in conjunction with the newspaper. The competition challenges students to play the role of the Bank’s Monetary Policy Committee (MPC) and recommend the best level for interest rates.

This week: in the last of the series, as Alistair Darling prepares to deliver his first Budget on March 12, we look at the effect of fiscal policy on the MPC’s task, and the economy.

Why do decisions in Budgets and Pre-Budget Reports matter for setting monetary policy?

The Pre-Budget Report, delivered in late autumn, along with the spring Budget, frame government plans for tax and spending. These are the key elements that make up fiscal policy, which, alongside interest rates, are the main means by which policymakers can try to steer the economy.

Public spending is one of the key components of overall, or aggregate, demand in the economy, while taxation subtracts from demand, slowing growth. Both the scale of tax, and the way that it is levied, can affect the supply of goods, labour and capital.

Other things being equal, increased public spending, or lower taxation, should stimulate demand and growth, and so imply higher base rates in future than would have otherwise been the case, and vice versa.

To what extent does the Treasury use tax and spending to steer the economy?

Since 1997, the Labour Government has largely rejected the use of fiscal policy to “fine tune” demand and growth in the short-term. As Chancellor, Gordon Brown preferred that the emphasis of tax and spending policy should be on medium-term and supply-side aims, such as the effective delivery of services, or bolstering productivity.

However, the Treasury does attempt to set tax and spending levels so that they act “in support” of monetary (interest rate) policy. So the Chancellor tries to ensure that, when the economy is slowing, and interest rates are being cut to stimulate activity, a “looser” fiscal policy in the form of either of both higher spending or lower tax acts to reinforce measures by the MPC.

Conversely, when rates are being raised to restrain future inflation, the Chancellor tries to avoid "throwing petrol on the fire" with too lax a fiscal stance.

The Treasury has generally accepted that “automatic stabilisers” - automatic changes to spending and tax that happen as a result of shifts in the strength of growth - should be allowed to work unhindered.

For example, in a slowdown, weaker profits and earnings tend to cut tax revenues, reducing the amount being taken out of the economy by the Government, while payments of unemployment and other benefits tend to rise, supporting growth by injecting extra funds into overall demand.

How does the MPC assess the Chancellor's announcements?

The MPC bases its evaluation mainly on the Treasury’s published plans, which are presented in advance to the committee. The MPC receives confidential briefings on the plans and on the Chancellor’s view of their impact. MPC members will look for any significant change in the fiscal stance - through potential populist tax giveaways, for example. They also consider any risks to the Treasury’s plans and assessment of condtions.

How can the MPC gauge the impact of Budget plans?

The simplest measure of the fiscal stance is indicated by the size change in planned government net borrowing, which reflects the balance between tax and spending. The Treasury believes that it is important to strip out the impact of the economic cycle and to consider only discretionary changes, made as a matter of choice.

What is happening to fiscal policy at present?

After an ambitious spending drive intended to boost public services, fiscal policy is being tightened significantly. To pay for higher spending, taxes have been raised in a way seen as contributing to weakening consumer demand. Tax revenues are due to have risen by four percentage points of GDP since 2002, to 39.5 per cent in 2008-09.

Spending growth is now also planned to slow, to just 2 per cent in real terms over the next three years, half the pace over the previous nine years. The Chancellor’s scope to loosen this tight stance is seen as limited due to government borrowing levels that are still very high.

Times Recommends

• Darling under pressure on record public debt
• Mortgage drought deepens on 32% lending fall
• Oil prices firm after 10% drop to below $130