5.
1 Government economic policy
The public sector in an economy
The public sector is a major producer, employer and consumer in many modern
economies. Public sector organizations include:
• central and local government authorities and their administrative departments
• government agencies responsible for the delivery of public services
• public corporations
▲ In addition to civil servants, public sector employees will usually include members of the
armed forces, the police and judiciary, teachers, doctors and nurses
Public expenditure
Government spending or public expenditure accounts for a large share of total
spending or aggregate demand in many economies:
•current expenditure: recurring spending including the wages of public sector workers,
state pensions, welfare payments and the running costs of government offices
•capital expenditure: investments in long-lived assets such as computer equipment,
roads, dams, airports, schools and hospitals
▲ Public expenditure will benefit many private sector firms
Why do governments spend money?
A government can use its spending power to:
•provide goods and services that are in the public and economic interest,
such as street lighting, national parks, universal education and health care,
affordable housing
•invest in national infrastructure such as road and railway networks, airports
•support agriculture and key industries to provide jobs and output, and to
invest in staff training, new machinery, and the research and development
(R&D) of new products
•manage the economy, for example to boost total spending during an
economic recession to help firms and reduce unemployment
•reduce inequalities in incomes and help vulnerable people, for example by
providing welfare payments to people and families in need
The macroeconomy
▼ Total demand and supply in a simple macroeconomy
Aggregate demand for
goods and services =
consumer spending
+
business investment
+
public spending
+
spending on exports by
overseas residents
Aggregate supply of
goods and services =
gross domestic product
Macroeconomic objectives
Low and stable price inflation
High inflation will:
•reduce the purchasing power of people’s incomes
•cause hardship for people on low incomes
•increase business costs
•make goods and services produced in the economy less competitive
High and stable employment
High unemployment will:
•cause hardship for people who lose their jobs
•reduce spending on goods and services and cause production to fall
•increase public spending welfare payments to support the unemployed
and their families (other public spending may be cut)
Macroeconomic objectives
Economic growth in the national output
Growth will:
•boost firms’ revenues and profits
•boost output, incomes, jobs and living standards
•boost investments by firms in new capital and businesses
•increase tax revenues for government to finance its spending
A stable balance of international payments and trade
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 (causing imported inflation)
Fiscal policy
Changing the total level of government spending and taxation can have a
significant impact on the aggregate demand for goods and services, and
therefore on output, employment and prices
Contractionary fiscal policy Expansionary fiscal policy
Cut public spending Increase public spending
Raise taxes Cut taxes
Some problems with fiscal policy
• Too much public spending can cause inflation
• Increases in taxes on incomes and profits can reduce incentives
to work and enterprise
• Public spending can crowd out private spending
Public spending has to be financed:
by raising taxes from household and corporate incomes, or
by government borrowing from the private sector (an increase in
borrowing will raise interest rates
Increased taxes and lending
Private sector
Public sector
Monetary policy
Contractionary monetary policy
Increase interest rates to reduce consumer
borrowing and increase savings
Higher interest rates can also increase the exchange
rate and reduce prices of imported products
Expansionary monetary policy
Reduce interest rates to increase consumer
borrowing and reduce saving
Lower interest rates can also reduce the exchange
rate and reduce prices of exported products
What's the difference between
monetary policy and fiscal policy?
Monetary policy and fiscal policy refer to the two most widely recognized
"tools" used to influence a nation's economic activity. Monetary policy is
primarily concerned with the management of interest rates and the total
supply of money in circulation and is generally carried out by central
banks such as the Federal Reserve. Fiscal policy is the collective term
for the taxing and spending actions of governments. In the United
States, the national fiscal policy is determined by the Executive and
Legislative Branches.
Read more: What's the difference between monetary policy and fiscal policy? | Investopedia
http://www.investopedia.com/ask/answers/100314/whats-difference-between-monetary-policy-and-fiscal-
policy.asp#ixzz4tCMQ87Pk
Follow us: Investopedia on Facebook
11
Monetary Policy
Central banks have typically used monetary policy to either stimulate an economy
into faster growth or slow down growth over fears of issues such as inflation. The
theory is that, by incentivizing individuals and businesses to borrow and spend,
monetary policy will cause the economy to grow faster than normal. Conversely, by
restricting spending and incentivizing savings, the economy will grow less quickly
than normal.
The Federal Reserve, also known as the "Fed," has frequently used three
different policy tools to influence the economy: opening market operations,
changing reserve requirements for banks and setting the "discount rate." Open
market operations are carried out on a daily basis where the Fed buys and sells
U.S. government bonds to either inject money into the economy or pull money
out of circulation. By setting the reserve ratio, or the percentage of deposits that
banks are required to hold and not lend back out, the Fed directly influences the
amount of money created when banks make loans. The Fed can also target
changes in the discount rate, or the interest rate charged by the Fed when
making loans to financial institutions, which is intended to impact short-term
interest rates across the entire economy.
12
Fiscal Policy
Fiscal policy tools are numerous and hotly debated among economists and political
observers. Generally speaking, the aim of most government fiscal policies is to
target the total level of spending, the total composition of spending, or both in an
economy. The two most widely used means of affecting fiscal policy are changes in
the role of government spending or in tax policy.
If a government believes there is not enough spending and business activity in an
economy, it can increase the amount of money it spends, often referred to as
"stimulus" spending. If there are not enough tax receipts to pay for the spending
increases, governments borrow money by issuing debt securities such as
government bonds and, in the process, accumulate debt, or "deficit" spending.
By increasing taxes, governments pull money out of the economy and slow business
activity. Governments might lower taxes in an effort to encourage more activity,
hoping to boost economic growth. When a government spends money or changes
tax policy, it must choose where to spend or what to tax. In doing so, government
fiscal policy can target specific communities, industries, investments, or
commodities to either favor or discourage production. These considerations are
often determined based on considerations that are not entirely economic.
13
Read more: What's the difference between monetary policy and fiscal policy? | Investopedia
Supply-side policies
Increased growth = more jobs + more incomes + lower inflation
Supply-side policies attempt to boost the productive potential
selective tax incentives e.g. tax breaks to encourage
investment
•selective subsidies e.g. to support development of new
technologies
•improving education and training to raise skills and
productivity
•labour market reforms to restrict trade union power
•competition policy to outlaw anti-competitive behaviour
•removing barriers to trade to increase choice and
competition
•privatization transferring public sector activities to private
sector firms
•better regulation simplifying or removing old and
unnecessary regulations that otherwise raise costs and restrict
business activity
Can policy objectives conflict?
Yes No
‘Keeping price inflation low and stable will
‘Raising public spending, make domestic goods and services more
cutting taxes and interest rates competitive. Demand for them will rise at
to boost demand and home and overseas. This will help to
employment will increase improve the balance of trade and will boost
inflationary pressures and jobs, incomes and tax revenues.’
spending on imports.’
‘If workers expect inflation to remain low
‘Cutting public spending, they are less likely to push for big wage
raising taxes and interest rates increases. This will boost the demand for
to control inflation will reduce their labour. And if firms are more
demand and therefore increase confident in the future they are more likely
unemployment and reduce to invest in new capacity for growth. In
economic growth.’ contrast, rising inflation raises costs and
lowers profits.’
