The Main Instruments of Government Macro Economic Policy

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The Main Instruments Of

Government Macroeconomic Policy



Content

� Fiscal Policy± Government expenditure

± Taxation

± Influence on AD / AS� Monetary Policy

± Interest rates

± Money supply

± Exchange rates� Supply side policies

� .



What is fiscal policy

� Fiscal policy looks at how government spend their money and how

they control their taxes.

� There are 2 types of fiscal policy:

� Contractionary fiscal policy: Where the government reduce spendingand / or when they make taxes higher, they try to increase its PSBR(

public sector borrowing requirement) to fund the tax drops they also

do this to reduce its surplus on its budget for the fiscal year.

� Expansionary fiscal policy:W

here the government cut taxes or increase government spending. They will increase the amount the

government borrows to fund the expenditure.



Government Expenditure

� Government expenditure covers all spending by the public

sector

� The government spends money on many things including:

± Education

± Defence

± Welfare benefits

± Healthcare

± Infrastructure

± Police



Government Borrowing

� As well as gaining revenue through taxation the

government can also finance their spending through

borrowing� The public sector net cash requirement (PSNCR)

measures the annual borrowing requirement of the

government in an economy



Direct & indirect taxes

� Direct taxes are taxes of income and expenditure

e.g. income tax, corporation tax (levied on company

profits).� Indirect taxes are taxes such as VAT (value added

tax), changes in this type of tax has a rapid effect

on the level of economic activity. E.g. an increase in

VAT will cut consumption



Fiscal Policy and AD

� Taxation influences the AD curve because:± An increase in taxation will decrease the level of consumption in

the economy

± An increase in taxation will increase the level of governmentspending in the economy

± A decrease in taxation will increase the level of consumption inthe economy

± A decrease in taxation can decrease the level of government

expenditure in the economy� The impact of a change in government expenditure

depends on the size of the multiplier



Fiscal Policy and AD

� Governments can utilise fiscal policy to control the

level of AD in the economy

� There can be problems with this due to:± Time lags

± The size of the multiplier

± Fiscal crowding out

± Peoples reaction to cuts / rises in taxation



Fiscal Policy and AS

� Fiscal policy can be used to increase the productive

capacity of the economy

� This is because government expenditure can beused to:

± Increase the skill levels of workers

± Provide economic incentives to firms

± Increase factor mobility



Monetary Policy

� Monetary policy is the use of interest rates, money

supply and exchange rates to influence economic

growth and inflation

� Interest rates ± are the cost of borrowing money

� Exchange rates ± the value of one currency in

terms of another

� Money supply ± the amount of money in circulation

in an economy



Interest Rates

� The Bank of England are responsible for setting interestrates in the UK

� The Bank sets the rate after analysing macroeconomic

trends and risks associated with inflation� Since 1997 the UK government has used interest rates to

control the level of inflation in the economy (at a level of 1.5-3.5% - target = 2.5%)

� If the Bank believes the level of AD is rising too quicklypotentially causing cost push inflation they will decide toraise interest rates



Interest Rates and The Economy

� Changes to interest rates influence many things in

the economy:

± Housing prices and housing market ± if interest ratesrise the cost of mortgages increases therefore reducing

demand for housing in theory (this has not occurred

recently in the UK)

± Disposable income of house owners ± if interest ratesrise the real disposable income of home owners falls as

they have larger mortgage payments (variable rate only)



Interest Rates and The Economy

� Credit demand ± if interest rates rise the amount of

credit sales should decrease as it becomes more

expensive

� Investment ± if interest rates rise they lead to a

decrease in the level of investment

� Exchange rates ± An increase in interest rates may

lead to an appreciation of UK currency making

exports less attractive



Interest rates and Inflation

� Interest rates are used to control inflation as when

interest rates are increased consumption decreases

as peoples real incomes are eroded by mortgage

payments and credit payments and the opportunity

cost of spending has increased

� By controlling interest rates the government aims to

keep inflation at a low level



Interest and Exchange Rates

� Changes in the UK¶s interest rates will lead to changes inthe exchange value of the pound.

� If interest rates rise the value of the pound will rise so thepound will now buy more US dollars, Japanese Yen, Eurosetc.

� If interest rates fall the value of the pound will fall so the

pound will now buy less US dollars, Japanese Yen, Eurosetc



Exchange rates

� A fall in the exchange rate reduces the price of exports and increases the price of imports

� Domestic demand will be stimulated and morepeople will buy exports as they are cheaper

� This will create a deficit on the current account of the balance of payments

� As consumption will increase it will increase ADwhich will increase the level of output in theeconomy and more it towards full employment



Supply Side Policies

� Supply side policies are policies that improve the

supply-side of the economy increasing its efficiency

and thereby resulting in economic growth

� Supply side policies can act in the product and

labour markets



Supply side policies

� Trade union reforms

� Increased expenditure on training and education

�C

hanges in taxation� Changes to welfare system

� Privatisation

� Deregulation

� Free trade

� Incentives for small businesses




� Supply side policies cause economic growth as they

cause the LRAS to shift outwards increasing the

potential output of the economy

� If the economy is operating near full potential

increases in aggregate demand can cause cost

push inflation, by the LRAS curve shifting outwards

this inflationary pressure is reduced




� As supply side policies can cause the LRAS to shift

outwards they can lead to a fall in unemployment

levels

� Many supply side policies concentrate on the labour

market and increase skills for workers which help

reduce structural unemployment in the economy



Supply Side Policies

� As the LRAS shifts outwards businesses will have

lower average costs as productivity has increased

� Lower costs mean that businesses are able tocompete more internationally therefore making the

balance of payments more healthy



Summary

� Fiscal Policy is the use of government expenditure and taxation toinfluence the level of inflation / economic growth

� Government expenditure covers all things the public sector spendsmoney on

� Taxation earns revenue for the government either directly throughincome taxes or indirectly through VAT

� Monetary Policy is the control of the economy through interest rates,money supply and exchange rates

� The bank of England set the rate of interest in the UK

� The government uses interest rates to control the rate of inflationaround its target of 2.5%

� Supply side policies aim to increase productivity in the economytherefore stimulating economic growth

Documents

The Main Instruments of Government Macro Economic Policy