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Government macroeconomic intervention (AS Level)

AS 9708 » Section 5

5.1 Government macroeconomic policy objectives

5.1.1 use of government policy to achieve macroeconomic objectives

5.2 Fiscal policy

definition

Fiscal policy — the use of government expenditure and taxation to influence the economy.

note

The main advantage of the use of fiscal policy is due to the multiplier effect.

5.2.1 meaning of government budget

definition

Government budget — annual financial statement showing estimates of expected revenue and expenditure during a fiscal year.

5.2.2 distinction between a government budget deficit and a government budget surplus

definition

Budget deficit — the debt of the country over a given financial year.
Budget surplus — the amount by which revenue exceeds expenditure of the country over a given financial year.

5.2.3 meaning and significance of the national debt

definition

National debt — the total debt of a country.

5.2.4 taxation

See 3.2.1.

5.2.5 government spending

Reasons for government spending

  • To improve macroeconomics performance
  • To correct market failure
  • To achieve a more desirable distribution of income and wealth
  • To achieve supply side enhancements to enhance productivity
  • To subsidize declining industries which may need financial support

Types of government spending - capital (investment) and current

  • Current expenditure is the spending on goods and services for current use.
  • Capital expenditure is the spending on goods and services intended to create future benefits, such as infrastructure investment.

Limitations of discretionary fiscal policy

  1. Increase inflation
  2. Time lags
  3. Implementation challenges (particularly tax changes)
  4. Political constraints
  5. Crowding out effect
  6. Ineffectiveness in a recession
  7. Debt sustainability
  8. Distributional effects
5.2.6 distinction between expansionary and contractionary fiscal policy

definition

Expansionary fiscal policy — the use of fiscal policy to enable the economy to grow
Contractionary fiscal policy — the use of fiscal policy to reduce the size of the economy (in order to reduce inflation)

5.2.7 AD/AS analysis of the impact of expansionary and contractionary fiscal policy

For expansionary fiscal policy, AD moves from AD to AD1 and vice versa for contractionary fiscal policy.

5.3 Monetary policy

5.3.1 definition of monetary policy

definition

Monetary policy — any policy measures or instruments to influence the price or quantity of money. The policy seeks to influence AD.

Monetary policy consists of

  • targeting the money supply
  • controlling interest rates
  • credit regulations
  • maintaining the exchange rate
5.3.2 tools of monetary policy: interest rates, money supply and credit regulations
  • Interest rate. It is the cost of borrowing money and the return on lending money.
  • Money supply. It is the total amount of money in an economy.
  • Credit regulations It is the rules affecting bank lending set by the central bank, such as setting limits on interest rates, imposing restrictions on the types of loans that can be offered, requiring lenders to disclose terms and conditions of credit agreements.
5.3.3 distinction between expansionary and contractionary monetary policy
5.3.4 AD/AS analysis of the impact of expansionary and contractionary monetary policy

Expansionary monetary policy shifts AD from AD to AD1, which

  • increases the money supply
  • decreases the interest rate
  • relaxes the credit regulations

Contractionary monetary policy shifts AD from AD1 to AD, which

  • decreases the money supply
  • increases the interest rate
  • tightens the credit regulations

Limitations of monetary policy

  1. Time lag (18 months)
  2. Liquidity trap (alternative: quantitative easing)
  3. Lack of consumer confidence
  4. Unstable demand for money makes it unpredictable
  5. Interest rate of rival countries
  6. Political influence if central bank is not independent

Evaluation for monetary policy

  • Time period – monetary policy is not affective in the long run.
  • Consumer confidence – eventual amount of borrowing depends on the confidence.
  • Size of multiplier

5.4 Supply-side policy

5.4.1 meaning of supply-side policy, in terms of its effect on LRAS curves

definition

Supply-side policy — is any policy designed to increase aggregate supply (LRAS).

5.4.2 objectives of supply-side policy: increasing productivity and productive capacity
5.4.3 tools of supply-side policy
Free-market oriented Interventionist
Privatisation Public sector investment
Deregulation Education
Income tax cuts Vocational training
Remove regulations / red tape Housing supply
Flexible labour markets Health spending
Free-trade agreements
Reduce welfare benefits

Interventionist supply-side policies

  1. Training and education
  2. Infrastructure and capital projects
  3. Investment into R&D
  4. Help to firms
    1. finance for research and development
    2. assistance to small firms
    3. providing information

Market-oriented supply-side policies

  1. Tax cuts
  2. Reducing welfare benefits
  3. Trade union reform
  4. Reducing government expenditures (reverse crowding out)
  5. Policies to encourage competition
    1. privatisation / deregulation
    2. free labor and capital movements
5.4.4 AD/AS analysis of the impact of supply-side policy

Advantages

  1. Decrease inflation
  2. Increase employment from lower taxes, subsidies and flexible labor market
  3. Improve productivity or quality of FoP from higher spending on education and healthcare
  4. Increase competition and efficiency from deregulation

Limitations

  1. Long implementation time
  2. Expensive
  3. No guarantee that this will be successful (e.g. corruption issues)
  4. Opportunity cost of government spending
  5. Privatization may lead to unemployment