Government Macroeconomic Policies

Government Policy Objectives

Economic Policy
It is attempt made by the Government to generate increases in economic welfare

Main methods of regulating the economic welfare

Controlling Inflation, Unemployment and Economic Growth (GDP)

Macroeconomic Objectives of the Government

Economic Growth
It must be sustainable means it should not exhaust the natural resources or cause too much pollution.
Economic growth increases the Living Standards. It is good for developing countries as face No excessive
Structural/Environmental Difficulties

Price Stability
It does not Mean 0% inflation. Governments target steady levels of low-moderate inflation. High Rates
Must be Prevented Since they result reluctant investors, menu costs, concerns those on fixed incomes

Less Unemployment
Govt should target 0% Cyclical Unemployment. Natural Rate of Unemployment should be prevailed i.e.
Some seasonal, frictional and structural unemployment are acceptable & inevitable in the economy

Equilibrium in the Balance of Payments

In any given year, Country may run a deficit/surplus that’s not an issue unless it persists in the long run

Income & Wealth Inequality

This should be addressed. It refers to the distribution of income/wealth of a nation. There should be a
fair distribution. Though it is highly Subjective, its not a matter of simply deciding on a fixed number
however If Small Group has Very Large Proportion of national income it Could lead to social unrest and
dissatisfaction with the Government

Fiscal Policy
It is actually an annual financial statement showing the estimates of expected revenue and spending
during a fiscal year

Finance ministry presents a budget for upcoming financial year stating the expected public revenues and
public expenditures. In budget either there is a deficit or surplus. If there is no deficit and no surplus
that means there is an equilibrium i.e. public revenues = public expenditures

Budget Deficit
Government Spending is greater than Tax Revenue
Cyclical Deficit
Due to slowdown/recession in the Economy
Structural Deficit
New Section 1 Page 1
Structural Deficit
Consistently spending more than tax revenue; fiscally irresponsible Government

Budget Surplus
Government Spending is smaller than Tax Revenue

National Debt
National Debt is the amount of money Government owes both domestically and abroad, which has
accumulated over the years or in other words it is the accumulation of a nation’s budget deficit over time

How govt raise finance?

Printing more money, or by borrowing even more money. Both these methods increase the national debt

Printing more money

Reduces its actual value in the greater scheme/term, leading to inflation
Further Borrowing
Either short or long term, and domestic or foreign sources

National Debt is not same as BOP

National debt is internal, while BOP is external

Automatic Stabilizers
These are the mechanisms built into the government’s budgets in order to stimulate AD when economy
requires a boost. When AD’s situation improves, these stabilizers automatically turn off

Recession
It eases financial stress by decreasing tax bills, or giving away State benefits Without changes in the
tax code or legislation. It Limits the Impact of Changes in the Economic Cycle .

Reasons for Taxation

Taxation is used along other methods simultaneously to raise public revenue
It helps in managing Aggregate Demand. Taxation is one of various methods to meet the government’s
economic objectives
Alter Distribution of Income & Wealth. Income tax’s aim is to take money from the better off and give
it to the poorer
It manages market Failure or environmental Issues. Taxation is one way in which market failures can be
reduced/minimized

Main Types of Taxes

Direct Tax
Tax levied directly on incomes & wealth of individuals or firms. Examples are Income Tax, Corporation Tax,
Inheritance Tax, etc
Indirect Tax is levied when goods & services are bought, or we can say that taxes on expenditure.
Examples are Value Added Tax (VAT), Goods & Services Tax (GST)

Nature of Taxation

New Section 1 Page 2

Progressive Tax
A proportion of income paid in tax. The tax increases as the income increase Eg. -> Income Tax; richer
people spend a greater proportion of their income in income taxes
Regressive Tax
Proportion of income paid in tax falls as income increases Eg. -> IVA, VAT, GST; poorer people spend a
greater proportion of their income in consumption taxes
Proportional Tax
Same proportion of income is paid in tax, It is independent of the level of income
Average Rate of Tax -> Average percentage of total income that is paid in taxes Eg. -> Corporation Tax

Rates of Tax
Average Rate of Tax
It is calculated as ->
ART = (Total Tax Due) / (Total Taxable Income)

Marginal Rate of Tax

Proportion of Increase in Income which is Taken in Tax”
It is Calculated as ->
MRT = (Change in Tax Due) / (Total Taxable Income)

MRT is Greater Than ART as Income Increases -> In progressive tax systems

Government Spending
Capital Expenditure
It is Spending by the Government on goods & services intended to create future benefits
It includes Government Investments; Gross Capital Formation, Infrastructure -> Roads, buildings, etc.
Health & Education i.e. New hospitals, Schools or Sewage Systems, Research/Innovation -> Defense,
Space or Vaccinations

Current Expenditure
Government Consumption spending on goods & services for current use to directly satisfy the needs of
members of the community. For Examples -> Wages of Public Sector’s Workforce, Road Maintenance, etc.

Reasons for Government Spending

New Section 1 Page 3

Reasons for Government Spending
To Supply Goods & Services that Private Sector Would Fail to Do
To Achieve Supply-Side Improvements in Macroeconomy
To Reduce Negative Externalities
Subsidies the industries that are in Need of Financial Support
Redistribute Income to achieve the more equity
Inject Extra Spending into Macroeconomy

Types of Fiscal Policy

The fiscal policy is the use of Government Revenue and expenditure to control the economy, including
Government borrowing
The Purpose is to influence the level of AD within the economy

When there is a fall in Taxation the AD rises since consumers can spend more + firms have more
disposable (net) revenue to invest into business

Government Expenditure
Defense, Social Services, Infrastructure and Education
It is mainly financed through Taxes. Fiscal Policies may be used as a means of Supply-Side measures

Discretionary Fiscal Policy

Actions taken in response of economic events
Extreme Measures taken under fiscal policy
In order to offset the complex economic scenario

New Section 1 Page 4

New Section 1 Page 5
Monetary Policy
Monetary Policy refers to Central Bank’s use of interest rates, money supply and exchange rates to
control the economy
It is a type of Demand-Side Policy

It is all about Controlling the Interest Rates to target the Money Supply and maintaining the Exchange
Rate

Central Bank
Public institution that manages the currency of a country (or countries), controls the money supply and
monetary policy

Interest Rates

New Section 1 Page 6

Interest Rates
Cost of borrowing money, and reward on lending/saving money
Interest rates are used to influence AD, through consumers and businesses. Commercial Banks set their
rates according the Central Bank’s base rate. It is used to ensure targeted inflation rate and liquidity in
the economy

Types of Interest rates

Expansionary
The rates are lower which result in the rise of C, I and AD. Cost of borrowing is low so people can borrow
more. Savings are discouraged due to lesser reward. Consumption or spending exceed the saving

Contractionary
The rates are higher which result in the fall of C, I and AD. Cost of borrowing is high so people have to
pay more in order to borrow. Savings are encouraged due to higher reward. Consumption or spending sets
below the saving

Money Supply
It is referred to the total amount of money circulating in an economy at a given time
It considers Coins, Notes, Deposits, Current Accounts, etc.
Controlling money supply directly is Very complex, hence this method has been mostly replaced by managing
interest rates; yet it’s still relevant and applicable

Credit Regulations
The Use of qualitative control measures by the Central Bank to regulate the consumer credit on certain
products, mainly the ones affected by inflation or deflation
Inflation
Central Bank aims to make borrowing and spending harder due to which Price Level Falls = Stability

Deflation
Central Bank aims to make borrowing and spending easier due to which Price Level Rises = Stability

Exchange Rates
The value of domestic currency in relation to other currencies when there are higher Interest Rates the
Domestic currency appreciates in value
However the AD Falls which leads to a fall in Net Exports, since exports become more expensive abroad
and imports become cheaper. Moreover it Attracts Foreign Depositors which Increases the demand for
the domestic currency (hot money flows)

AD/AS Analytics of the Impact of Monetary Policy

Expansionary // Reflationary Monetary Policy:

This Policy is aimed at increasing the level of aggregate demand within the economy. It mainly focuses to
expand the money supply within the economy. They achieve this by decreasing interest rates which
results in a rise in C and I . Increasing Money Supply will tend C to rise and decreasing exchange rate
tend X to rise. However inflation rises as a result

New Section 1 Page 7

Expansionary Effects
AD Rises -> AD -> AD1
National Income Rises -> PL*Y -> PL1Y1
Real GDP Rises -> Y* -> Y1
Unemployment Falls -> Y* -> Y1
Price Level Rises -> P* -> P1

Contractionary // Deflationary Monetary Policy

This Policy is aimed at decreasing the level of aggregate demand within the economy. It mainly focuses
on decreasing the money supply within the economy by increasing the Interest Rates. As a result C and I
fall. Decreasing Money Supply will cause a fall in C while increasing Exchange Rate will make X fall

New Section 1 Page 8

Contractionary Effects
AD Falls -> AD -> AD1
National Income Falls -> PL*Y -> PL1Y1
Real GDP Falls -> Y* -> Y1
Unemployment Rises -> Y* -> Y1
Price Level Falls -> P* -> P1

Supply-Side Policy
It is the Policy that helps to improve a country’s productive potential of the economy. The main purpose
is to Shift the Long-Run Aggregate Supply Curve (LRAS) to the right. This objective is achieved by
increasing the quantity or quality of the FOPS.

New Section 1 Page 9

Effects of supply side policies on Macroeconomy
Economic Growth -> Real GDP rises
Unemployment -> Falls
Price Level -> Falls

Objectives of Supply-Side Policy

Main objective of supply side policy is Improving the productivity and productive capacity of the economy
Productivity
Quantity of goods & services produced per unit of input
Increasing Productivity
Real output can rise without an increase in the price level

Productive Capacity Increase

Potential output of the economy has increased

Shifting LRAS Outwards

PPC shifts Outwards -> Supply-side policies’ effect can be shown in either PPCs or LRAS graphs

New Section 1 Page 10

AD/AS Analysis of the Impact of Supply-Side Policy
Determinants of the Outcome of Supply-Side Policy
Shape of the AS Curve
Whether other Policies are Considered
If AD is also Changing

Eg. Better Education

AS Curve Rises -> AS -> AS1
Equilibrium National Income -> Rises
Real GDP Rises -> Y -> Y1
Unemployment Falls -> Y -> Y1
Price Level Falls -> P -> P1

New Section 1 Page 11

Original Equilibrium -> PY, AD = AS
If AD Rises to AD1 -> NNI, Real GDP and Employment all rise to Y1; Price Level rises to P1
AS Rises to AS 1 Simultaneously -> This further reinforces the rise in output
Price Level -> Returns back to P (original stability)

Evaluating Supply-Side Policy

Interventionist Policies
They may increase aggregate demand, due to an increase in Government Expenditure

Other Policies
They may have harmful effects on consumers, workers and the environment

Environmental Deregulation
Leads to negative externalities to society

Supply-Side Policies
They are usually effective at shifting LRAS, however they may take years in order to show their results

New Section 1 Page 12