Unit 5: The role of government in an economy

5.1 Government Economic Policy

Macro-economics is the study of how a national economy works. Most national governments have
similar macro-economic objectives. These are:

• Economic growth and prosperity

• A high and stable level of employment
• Low and stable price inflation
• A favourable balance of international payments

Economic growth in national output

Economic growth will boost output and incomes. This will help to raise living standards. Without
economic growth or worse still, if output falls over time, an economy will suffer because
• Employment, incomes and living standards will fall
• Government tax revenues will fall and government spending will have to be cut
• The revenues and profits of firms will fall
• Entrepreneurs will not invest in new firms

A high and stable level of employment

People who want to work but are unable to find a job will be unemployed. If unemployment rises:
• The total national output is likely to fall.
• A government may have to spend more on welfare payments to support the unemployed and
their families. This means that government may have to raise taxes on businesses and working
people. This will reduce their disposable incomes and spending on goods and services.
If people remain unemployment for a long time they may lose the skills they need to work in new
industrial sectors. High levels of employment therefore help to increase output, incomes, consumers
demand and living standards.

Low and stable price inflation

Inflation is a continuous rise in the average level of prices. If prices rise too quickly it can be bad for
business and an economy because:
• It reduces the purchasing power of people’s incomes
• It causes hardship for people on low incomes
• It increases business costs, especially if workers demand higher wages
• It makes goods and services produced in the economy more expensive to buy than those
purchased from other countries with lower rates of inflation
Low and stable price inflation therefore makes it easier for private sector firms to manage their costs,
for exporters to sell their products oversea and for consumers, especially those on low incomes, to
afford goods and services.

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A (stable) favourable balance of payments
Many countries sell exports of goods and services to oversea residents and receive other incomes and
investments from oversea. Inwards investments from oversea firms and the sales of exports help to
create new jobs and incomes in an economy.
At the same time, many countries buy imports from producers oversea and also make investment in
other countries. Most countries seek to balance their inflows and outflows of income from international
transactions. Sudden changes in the amount of money flowing into or out of an economy can be very
disruptive to the banking system, firms and government.
For example, the following may happen if a country has a deficit on its balance of payments with the
rest of the world:
• It may run out of foreign currency to buy imports
• The value of its currency may fall against other foreign currencies and make imports more
expensive to buy. This can cause an imported inflation.

Government can use different policy instruments, including taxes and regulations, to achieve their
objectives through their impact on the actions of producers and consumers. They are

• Fiscal policy
• Monetary policy
• Supply-side policy

Fiscal policy involves varying total public sector expenditure and/or the overall level of taxation to
influence the level of demand in an economy.

Expansionary fiscal policy may be used during an economic recession to boost demand for goods and
services through tax cuts or increases public sector spending. Firms may respond by hiring more labour
and increasing output.

However, increasing demand can force up market prices and involve spending more on imported goods
and services from overseas. Increasing imports will have a negative impact on the balance of payments.

Contractionary fiscal policy may be used to reduce price inflation. It involves reducing demand in an
economy through tax increases or cuts in public sector spending. However, firms may respond to falling
demand by cutting their output and reducing employment. Increased taxes may also reduce work
incentives and therefore productivity.

Fiscal policy instruments Impact on consumers Impact on producers

Increase income taxes Disposable income is reduced and Market prices and profits fall as
consumer spending falls. consumer demand falls. Firms
cut output and employment.
Reduce income taxes Disposable incomes and consumer Market prices and profits start to
spending rise. rise so firms expand output and
employ more labour.
Increase taxes on profits Consumers are not directly affected but After-tax profits fall. Firms may

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 may pay higher prices if firms cut output increase their prices and/or cut
output in response.
Cut taxes on profits Consumers may benefit from reduced After-tax profits rise so firms
prices as output rises. may expand their output and
employment.
Increase indirect taxes on Consumers on low incomes may be hit Consumers demand may
goods and services hardest by price rises because they contract and profits fall. Firms
spend all or most of their incomes. may cut output and reduce their
demand for labour.
Cut indirect taxes on Consumers may expand their demand Expanding demand will boost
goods and services for goods and services as after-tax price profits which are an incentive to
fall. firms to raise their output and
demand for labour.
Raise public expenditure Public sector workers could be paid Firms supplying goods and
more. Low income families may receive services to government will
more benefits. More public services enjoy increased revenues and
could be provided for free. profits, and may expand their
output and employment.
Cut public expenditure Public sector workers could suffer pay A cut in public spending on
cuts or be made unemployed. Welfare capital projects, such as road and
benefits may be reduced. school building, will cause
cutbacks in the construction
industry. Subsidies paid to other
firms may be cut.

Monetary policy involves varying the interest rate charged by the central bank for lending money to the
banking system in an economy.

Contractionary monetary policy may be used to reduce price inflation by increasing the interest rate.

Because banks have to pay more to borrow from the central bank they will increase the interest rates
they charge their own customers for loans to recover the increased cost. Banks will also raise interest
rates to encourage people to save more in bank deposit accounts so they can reduce their own
borrowing from the central bank.

As interest rates rise, consumers may save more and borrow less to spend on goods and services. Firms
may also reduce the amount of money they borrow to invest in new equipment. A reduction in capital
investment by firms will reduce their ability to increase output in the future. Higher interest rates may
therefore reduce economic growth and increase unemployment.

Expansionary monetary policy may be used during an economic recession to boost demand and
employment by cutting interest rates. However, increasing demand can push up prices and may increase
consumer spending on imported goods and services.

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Monetary policy Impacts on consumers Impacts on producers
instruments
Raise interest rates Spending falls as consumers save more Firms cut output and employment
and borrow less. in response to falling demand.
The foreign exchange rate of the Firms borrow less to invest in new
national currency may rise. This will capital equipment, which may harm
reduce the prices of imports. economic growth.
Consumers may buy more imports Prices of export sold oversea will
instead of home-produced goods and rise if the exchange rate increases.
services. Exporting firms may suffer falling
demand and profits.

Cut interest rates Spending rises and saving become less Firms increase output and demand
attractive and borrowing less expensive. more labour as demand rises.
The exchange rate may fall causing Firms may increase investment.
imported inflation. Prices of export oversea may fall if
the exchange rate rises. Demand
for export may rises.

Supply-side policies aim to increase economic growth by raising the productive potential of the
economy. An increase in the supply of goods and services will require more labour and other resources
to be employed, will reduce market prices, and provide more goods and services for export.

Supply-side policy instruments aim to encourage firms and employees to become more productive, and
to remove any barriers that may prevent this.

Supply-side policy instruments

Tax incentives Reducing taxes on profits and small firms can encourage enterprise.
Tax allowance can also be used to encourage investments in new capital
equipment and R&D.
Subsidies or grants These reduce production costs and also help firms to fund the research and
development ( R & D ) of new technologies.
Education and training Teaching new and existing workers new skills to make them more productive
at work.
Labour market Include minimum wage laws to encourage more people into work, and
regulations legislation to restrict the power of trade unions.
Competition policy Regulations that outlaw unfair and anti-competitive trading practices by
monopolies and other large powerful firms.
Free trade agreements Removing barriers to international trade to allow countries to trade their
goods and services more freely and cheaply.
deregulation Removing old, unnecessary and costly rules and regulations on business
activities.
privatization The transfer of public sector activities, such as refuse collection, to private
firms to provide them more efficiently.

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