Economics - Module 2 - Unit 4

Instruments of Government Policy

The key macroeconomic objectives of the government are: Price stability Low unemployment Sustainable economic growth Trade balance on the current account To achieve these macroeconomic objectives, the government has 3 policy instruments: Fiscal policy Monetary policy Supply-side policies

Fiscal PolicyThe Fiscal policy is the use of government spending and taxation to influence the components of economic activity such as output and employment. There are three types of government spending - capital, current and transfer.Public spending: Capital spending - this is spending on items which benefit the economy for more than one year such as buildings, roads, and factories. Current spending - this is spending on items which benefit the economy for less than one year such as salaries for public sector workers. Transfer spending - this is spending on welfare such as benefits e.g. disability or unemployment, or pensions. Higher government spending can have a positive multiplier effect because it is an injection into the circular flow.Government taxation: Direct taxes on income and wealth such as - Income tax, National insurance, Corporate tax, Council tax, Inheritance tax etc. Indirect taxes on consumer spending such as - VAT, excise taxes (particularly on demerit goods), road tax, fuel tax etc. Budget deficit vs budget surplusEach year in March, the Chancellor of the Exchequer will present the fiscal budget which sets out the spending, taxing and borrowing plans of the government for the next financial year. Fiscal surplus means tax revenues exceed governement spending. This will have a negative multiplier effect on the economy bwcause withdrawals exceed injections. Fiscal deficit mans government spending exceeds tax revenues. This will have a postive multipier effect on the economy because injections exceed withdrawals. An expansionary fiscal policy means the government will spend more and tax less leading to a fiscal deficit. A contractionary fiscal policy means the government will spend less and tax more leading to a fiscal surplus. Austerity the result of the government applying a contractionary fiscal policy to ultimately reduce the budget deficit. The macroeconomic impact of the Fiscal policy

Higher public spending Government spending is a component of aggregate demand Threrefore the aggregate demand curve will shift to the right This will lead to rise in the price level and a rise in output and employment Higher output will lead to higher investment spending according to the acclerator principle Higher investing spending will have a postive multiplier effect on GDP growth

Decrease in public spending Governement spending is a component of aggregate demand Therefore the aggregate demand curve will shift to the left This will lead to a fall in the price leval and a fall in output and employment Lower output will lead to lower investment according to the accelerator principle Lower investment spending will have a negative multiplier effect on GDP.

The microeconomic impact of the fiscal policyThe fiscal policy can be used to correct market failure: Consumption of demerit goods can be reduced by indirect taxes Consumption of merit goods can be increased through government spending on subsidies Negative externalities can be reduced by taxation on production of goods Positive externalities can be increased by subsidising production of goods Inequalities of income can be reduced by welfare spending on low income households

Monetary PolicyThis is the use of monetary instruments such as base insterest rates, money supply and exchange rate to influence the level of prices, output and employment in the economy. The monetary instruments are: Interest rates Money supply Exchange rates

The Bank of England (also known as the Central Bank) is responsible for conducting the governments monetary policy, and is responsible for: Setting the base interest rate The control of money supply The core process of the Bank of England is to maintain the value and integrity of the national currency (sterling). Inflation is regarded as the key threat to the integrity and value of money. The target rate of inflation set by the government for the Bank of England at 2%. This is seen as the key to price stability and sustainable levels of output and employment. The Monetary Policy Committe is responsible for stting the base interest rate. The MPC will raise interest rates if inflation is above the 2% target, and lower interest rates if inflation is below the 2% target, to influence the level of AD in the economy.

Since January 2009 following the economic recession, interest rates have remained constant at 0.5%, as otherwise people will struggle to cope with higher interest rates, particularly mortgages in the housing market.How interest rates control inflationHigher interest rates raises the cost of borrowing and encourages saving. Consumers respond by cutting spending and consumption. Lower consumer spending leads to a greater fall in aggregate demand (multiplier). Suppliers will respond to lower aggegate demand by cutting prices. Inflation above the 2% target implies the output gap is positive and AD is growing above LRAS leading to demand pull inflation. The MPC will respond by raising base interets rates to lower aggregate demand. Lower interest rates Lowers the cost of borrowing and encourages spending. Consumers respond by increasing production and consumption. Higher consumption leads to a greater increase in aggregate demand (multiplier). Suppliers will respond to higher aggregate demand by raising prices. Inflation below the 2% target implies the output gap is negative and AD is gtowing below LRAS leading to deflationary risks and unemployment. The MPC will respond by cutting interest rates to increae aggregate demand. The effect of the interest rate on the exchange rate A rise in UK base interest rates should in theory lead to an appreciation of the exchange rate This will mean imports are cheaper and exports are dearer. A fall in UK base interest rates should in theory lead to a depreciation of the exchange rate This will mean imports are dearer and exports are cheaper. Money supply and Quantitative Easing The Bank of England is repsonsible for respsonsible for controlling the supply of money. Quantitative easing is when the Bank of England increase the supply of money into the economy by printing extra notes and coin. The effect of quantitative easing is lower interest rates, which lead to increased borrowing. An increase in borrowing leads to higher consumption and higher aggregate demand in the economy. Quantitative easing can be inflationary if the economy is operating above its trend rate of growth.

Supply side policiesSupply side policies are micro-economic policies designed to raise the underlying trend rate of economic growth without generating inflationary pressures. They involve making production, labour and capital markets operate more efficiently and so increase long run aggregate supply.For example:1. Cutting indirect taxes on incomes and profits to incentivise employers and employees Cutting income tax rates increases disposable income and makes work more attractive than unemployment and welfare. Cutting coprporation taxes allows firms to keep more profits after tax that can be used for investment. 2. Liberisation of marketsThis increases competition in the markets and leads to better allocative efficiency as consumers have more choice and pay lower prices.3. Mobility of labour The government can use taxes and unemployment benefits to encourage the unemployed back into work. Spending on education and training reduces the likelihood of unemployment in the future. 4. Deregulation Cutting the rules and regulations that restrict firms can lead to greater enterprise and innovation. Offering tax breaks and subsidies to new businesses - one in three new businesses goes bust within the first year. 5. Reducing the power of trade unionsThis will reduce the likelihood of trade unions organsising strikes, which disrupt activities in the related markets.6. MigrationThis allows skillled workers from overseas to be imported into the economy, and particularly in markets where there are shortages.

The effect of supply side policies on the LRASSupply side policies increase long run aggregate supply and allow the economy to cope with an increase in excess demand without generating inflationary pressures.