Micro Economics

(AS)

Government Policies
(Unit 5)

 Fiscal Policy
 Monetary Policy
 Supply Side Policies
 Exchange Rate Policy

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Fiscal Policy

Fiscal policy involves the use of government spending, taxation and borrowing to influence both the pattern
of economic activity and also the level and growth of aggregate demand, output and employment.

➢ A rise in government expenditure, or a fall in the burden of taxation, should increase aggregate
demand and boost employment. The size of the resulting final change in equilibrium national income
is determined by the multiplier effect. The larger the national income multiplier, the greater the change
in national income will be.
➢ Fiscal policy is also used to influence the supply-side performance of the economy. For example,
changes in fiscal policy can affect competitive conditions individual markets and industries and change
the incentives for people to look for work and for companies to invest and engages in research and
development.
➢ Government capital spending on transport infrastructure and public sector investment in
education and health can also have a direct but unpredictable effect in the long run on the
competitiveness and costs of businesses in every industry.

Government spending

Spending by the public sector can be broken down into three main areas:

Current Government Spending: i.e. spending on state-provided goods & services that are provided on a
recurrent basis every week, month and year, for example salaries paid to people working in public sector and
resources used in providing state education and defence. Current spending is recurring because these services
have to be provided day to day throughout the country.

Capital Spending: Capital spending would include infrastructural spending such as spending on new
motorways and roads, hospitals, schools and prisons. This investment spending by the government adds to the
economy’s capital stock and clearly can have important demand and supply side effects in the medium to long
term.

Transfer Payments: Transfer payments are government welfare payments made available through the
social security system including the Jobseekers’ Allowance, Child Benefit, the basic State Pension,
Housing Benefit and Income.

These transfer payments are not included in the national income accounts because they are not a
payment for output produced directly by a factor of production. Neither are they included in general
government spending on goods and services. The main aim of transfer payments is to provide a basic
floor of income or minimum standard of living for low-income households in our society and they
provide a means by which the government can change the overall distribution of income in a country.

Government Spending and Fiscal Policy Objectives

Government spending is justified on economic and social grounds including the desire to correct for perceived
market failure when the market mechanism might fail to provide sufficient public and merit goods for social
welfare to be maximized.

The Government has main goals of fiscal policy to be the following:

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Funding government spending: To meet the government’s spending and tax priorities without a damaging rise
in the burden of government debt

The benefit principle: This principle seeks to ensure that those who benefit from public services such as the
benefits from education, health and transport also meet as far as possible the costs of the services they consume

Macroeconomic stability: Fiscal policy in is now designed to support monetary policy in ‘smoothing the path
of aggregate demand over the economic cycle’ and in contributing to an environment of sustainable growth and
stable inflation – this is the main macroeconomic objective of fiscal policy.

Redistribution of income: To ensure that government spending and taxation impact fairly within and across
generations – fiscal policy should be equitable to current and future generations.

Therefore we justify government spending on these grounds:

• To provide a socially efficient level of public goods and merit goods

• To provide a safety-net system of welfare benefits to supplement the incomes of the poorest in society
– this is also part of the process of redistributing income and wealth
• To provide necessary infrastructure via capital spending on transport, education and health facilities –
an important component of a country’s long run aggregate supply

Sources of Government Revenue

Taxation: taxes are imposed to generate revenue so that public spending can be financed, to discourage
production and consumption of de-merit goods or to redistribute income.

Direct taxes – are paid directly to the tax authority by the individual taxpayer – usually through “pay as
you earn” (PAYE). Burdon of Tax liability cannot be transferred onto someone else. Normally direct
taxes are progressive in their nature so are considered fair and just and these are also helpful in re-
distribution of income.

Indirect taxes –are imposed on production, import and consumption of goods and services. Indirect
taxes are considered unfair as these taxes are regressive and cause disparity in the society. Indirect taxes
include VAT, GST and a range of excise duties. The burden of an indirect tax can be passed on by the
supplier to the final consumer – depending on the price elasticity of demand and supply for the product.

Arguments for Using Indirect Taxation:

➢ They are a useful instrument in controlling and correcting for externalities – all governments have
moved towards a more frequent use of indirect taxes as a means of making the polluter pay and
“internalizing the external costs” of production and consumption.
➢ Indirect taxes are less likely to distort the choices that people have to between work and leisure and
therefore have less of a negative effect on work incentives. Higher indirect taxes allow a reduction in
direct tax rates (e.g. lower starting rates of income tax).
➢ Indirect taxes can be changed more easily than direct taxes – this gives economic policy-makers more
flexibility when setting fiscal policy. Direct taxes can only be changed once a year at Budget time.
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 ➢ Indirect taxes are less easy to avoid by the final tax-payer who might be unaware of how much indirect
tax they are paying.
➢ Indirect taxes leave people free to make a choice whereas direct taxes leave people with less of their
gross income in their pockets

Arguments against Using Indirect Taxation

➢ Many indirect taxes make the distribution of income more unequal (less equitable) because indirect
taxes are more regressive than direct taxes
➢ Higher indirect taxes can cause cost-push inflation which can lead to a rise in inflation expectations
➢ Revenue from indirect taxes can be uncertain particularly when inflation is low or there is a recession
causing a fall in consume spending
➢ There is a potential loss of economic welfare (taxes can create a deadweight loss of consumer and
producers surplus)
➢ Higher indirect taxes affect households on lower incomes who are least able to save in the first place
➢ Many people are unaware of how much they are paying in indirect taxes – this goes against one of the
basic principles of a good tax system – namely that taxes should be transparent.

Progressive, proportional and regressive taxes

With a progressive tax, the marginal rate of tax rises as income rises. I.e. as people earn more income, the rate
of tax on each extra pound earned goes up. This causes a rise in the average rate of tax (the percentage of
income paid in tax).

With a proportional tax, the marginal rate of tax is constant. For example, we might have an income tax
system that applied a standard rate of tax of 25% across all income levels. If the marginal rate of tax is constant,
the average rate of tax will also be constant.

With a regressive tax, the rate of tax falls as incomes rise – I.e. the average rate of tax is lower for people of
higher incomes. Most examples of regressive taxes come from excise duties of items of spending such as
cigarettes and alcohol.

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The main objectives of a tax system

The burden of tax: To keep the tax burden as low as possible (the burden of tax for a country can be measured
by the % of GDP taken in taxes and is shown in the chart above)

To improve incentives: The government believes that reducing tax rates on income and business profits helps
to sharpen incentives to work and create wealth in the economy as a strategy to enhance long-run growth

Tax spending rather than income: To shift the balance of taxation away from taxes on income towards taxes
on spending – this is because it is thought that taxes on income have a greater effect on work incentives

Equitable taxes: To ensure taxes are applied equally and fairly to everyone. Equality is not always the same as
fairness – see the notes below on the canons of taxation

Correct for market failure: As with many other governments in other countries, the UK government believes
in the use of taxes to make markets work better (including taking account of externalities) – this is an important
microeconomic objective. The government is committed to using the tax system as an instrument of correcting
for market failures.

The Laffer curve

The Laffer curve is a theory built on the incentive effects of lower taxation which suggests that total tax revenue
coming into the government may increase at a lower tax rate. As the tax rate further increases, the marginal
revenue from lower taxes may tend to fall at an increasing rate up to optimal tax revenues, at tax rate X. After
this point, any increase in the tax rate prompts people to work less, or to do more to avoid the tax, thereby
reducing total revenue as the opportunity cost of paying the tax rises. Hypothetically at a 100 percent tax rate,
nobody would have any incentive to work at all, since the Government collects everything people earn. Laffer’s
ultimate prediction is if you cut taxes you can increase tax revenues and create a virtuous circle.

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Principles of a good tax system

Efficiency - an efficient tax system raises sufficient revenue to pay for government spending, without creating
negative distortions such as reducing work-incentives for individuals and investment incentives for companies

Equity – the principle of equity is that taxes should be fair and based on people's ‘ability to pay’. Income tax
satisfies this condition because it is a progressive tax system, the marginal and average rate of tax rises with
income – but some indirect taxes may not – for example the duty on cigarettes is said to have a regressive effect
on the overall distribution of income

The ‘benefit principle of taxation’ – this principle is that taxes paid by people have a link with the benefit that
the person paying the tax actually receives from government spending. However, there are some problems with
too much emphasis on the benefit principle. Firstly if ignores the redistributive aims of taxation. A second
problem is that the benefit principle assumes correct revelation of preferences by consumers – whereas in
reality many consumers do not have to pay for the public goods and services provided for them (consider the
‘free rider problem’). It is also difficult for the government to assess individual benefits from public goods.

Transparency and certainty - taxpayers should understand how the system works and should be able to plan
their tax affairs with a reasonably degree of certainty. Taxes should also be difficult to evade – we know that in
many countries there is a fast-growing industry that provides information to people on how to reduce their tax
liabilities. Collection costs should be kept to an acceptable level so that the costs of collection are very low
relative to the total tax revenues collected.

The microeconomic effects of fiscal policy

Taxation and work incentives: The rise in direct tax has the effect of reducing the post-tax income (PDI) of
those in work because for each hour of work taken the total net income is now lower. This might encourage the
individual to work more hours to maintain his/her target income. On the other hand, it may have a negative
impact as the effect might be to encourage less work since the higher tax might act as a disincentive to work.

Taxation and the Pattern of Demand: Changes to indirect taxes in particular can have an effect on the pattern
of demand for goods and services. For example, the rising value of duty on cigarettes and alcohol is designed to
cause a substitution effect among consumers and thereby reduce the demand for what are perceived as “de-merit
goods”. In contrast, a government financial subsidy to producers has the effect of reducing their costs of
production, lowering the market price and encouraging an expansion of demand.

The use of indirect taxation and subsidies is often justified on the grounds of instances of market failure. But
there might also be a justification based on achieving a more equitable allocation of resources – e.g. providing
basic state health care free at the point of use.

Taxation and labour productivity: sometimes taxes can have a significant effect on the intensity with which
people work and their overall efficiency and productivity. But there is little substantive empirical evidence to
support this view. Many factors contribute to improving productivity – tax changes can play a role - but
isolating the impact of tax cuts on productivity is extremely difficult.

Taxation and business investment decisions: Lower rates of corporation tax and other business taxes can
stimulate an increase in business fixed capital investment spending. If planned investment increases, the
nation’s capital stock can rise and the capital stock per worker employed can rise.

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The government might also use tax allowances to stimulate increases in research and development and
encourage more business start-ups. A favourable tax regime could also be attractive to inflows of foreign direct
investment – a stimulus to the economy that might benefit both aggregate demand and supply. The Irish
economy is often touted as an example of how substantial cuts in the rate of corporation tax can act as a magnet
for large amounts of inward investment.

Capital investment should not be seen solely in terms of the purchase of new machines. Changes to the tax
system and specific areas of government spending might also be used to stimulate investment in technology,
innovation, the skills of the labour force and social infrastructure.

Government Budget

A government budget is an annual forecasted financial statement presenting the government's proposed
revenues and spending for a financial year. This document estimates the anticipated government revenues and
government expenditures for the ensuing (current) financial year.

➢ If forecasted revenue exceeds forecasted government spending, it is known as budget surplus

➢ If forecasted revenue is less than forecasted government spending, it is known as budget deficit
➢ If forecasted revenue is equal to forecasted government spending, it is known as balanced budget

Problems with budget deficit

A persistently large budget deficit can be a problem for the government and the economy. Three of the reasons
for this are as follows:

Financing a deficit:A budget deficit has to be financed on day-to-day basis, the issue of new government bonds
or certificates to domestic or overseas investors can do this. But it may be that if the budget deficit rises to a
high level, in the medium term the government may have to offer higher interest rates to attract sufficient
buyers of government debt. This in turn will have a negative effect on economic growth

A government debt mountain: In the long run, government borrowing adds to the accumulated National Debt.
This means that the Government has to spend more each year in debt-interest payments to holders of
government bonds and other securities. There is an opportunity cost involved here because this money might
be used in more productive ways, for example an increase in spending on health services or extra investment in
education. It also represents a transfer of income from people and businesses that pay taxes to those who hold
government debt and cause a redistribution of income and wealth in the economy

Crowding-out - the need for higher interest rates and higher taxes: Eventually the budget deficit has to be
reduced. This can be achieved by either by cutting back on public sector spending or by raising the burden of
taxation. If a larger budget deficit leads to higher interest rates and taxation in the medium term and thereby has
a negative effect on growth in consumption and investment spending, then a process of ‘fiscal crowding-out’ is
said to be occurring.

Wasteful public spending: Neo-liberal economists are naturally opposed to a high level of government
spending. They believe that a rising share of GDP taken by the state sector has a negative effect on the growth
of the private sector of the economy. They are sceptical about the benefits of higher spending believing that the
scale of waste in the public sector is high – money that would be better off being used by the private sector.

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Potential benefits of a budget deficit

Government borrowing can benefit economic growth: A budget deficit can have positive macroeconomic
effects in the long run if it is used to finance extra capital spending that leads to an increase in the stock of
national assets. For example, spending on the transport infrastructure improves the supply-side capacity of the
economy. And increased investment in health and education can bring positive effects on productivity and
employment.

The budget deficit as a tool of demand management: An increase in borrowing can be a useful stimulus to
demand when other sectors of the economy are suffering from weak or falling spending. The argument is that
the government can and should use fiscal policy to keep real national output closer to potential GDP so that we
avoid a large negative output gap.

Fiscal Policy and Aggregate Demand

Traditionally fiscal policy has been seen as an instrument of demand management. This means that changes in
government spending, direct and indirect taxation and the budget balance can be used to help smooth out some
of the volatility of real national output particularly when the economy has experienced an external shock.

The fiscal policy transmission mechanism

This simple flow-chart above identifies some of the possible channels involved with the fiscal policy
transmission mechanism. The multiplier effects of an expansionary fiscal policy depend on how much spare
productive capacity the economy has; how much of any increase in disposable income is spent rather than saved
or spent on imports and the effects of fiscal policy on variables such as interest rates

Fiscal Policy and Aggregate Supply

Changes to fiscal policy can affect the supply-side capacity of the economy and therefore contribute to long
term economic growth. The effects tend to be longer term in nature.

Labour market incentives: Cuts in income tax might be used to improve incentives for people to actively seek
work and also as a strategy to boost labour productivity. Some economists argue that welfare benefit reforms
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are more important than tax cuts in improving incentives – in particular to create a gap between the incomes of
those people in work and those who are in voluntary unemployment.

Capital spending. Government capital spending on the national infrastructure (e.g. improvements to our
motorway network or an increase in the building programme for new schools and hospitals) contributes to an
increase in investment across the whole economy. Lower rates of corporation tax and other business taxes might
also be used as a policy to stimulate a higher level of business investment and attract inward investment from
overseas

Entrepreneurship and new business creation: Government spending might be used to fund an expansion in
the rate of new small business start-ups

Research and development and innovation: Government spending, tax credits and other tax allowances could
be used to encourage an increase in private business sector research and development – designed to improve the
international competitiveness of domestic businesses and contribute to a faster pace of innovation and invention

Human capital of the workforce: Higher government spending on education and training (designed to boost
the human capital of the workforce) and increased investment in health and transport can also have important
supply-side economic effects in the long run.

Automatic stabilisers and discretionary changes in fiscal policy

Discretionary fiscal changes are deliberate changes in direct and indirect taxation and govt spending – for
example a decision by the government to increase total capital spending on the road building budget or increase
the allocation of resources going direct into the health and education sector.

Automatic stabilisers include those changes in tax revenues and government spending that come about
automatically as the economy moves through different stages of the business cycle

Tax revenues: When the economy is expanding rapidly the amount of tax revenue increases which takes
money out of the circular flow of income and spending

Welfare spending: A growing economy means that the government does not have to spend as much on means-
tested welfare benefits such as income support and unemployment benefits

Budget balance and the circular flow: A fast-growing economy tends to lead to a net outflow of money from
the circular flow. Conversely during a slowdown or a recession, the government normally ends up running a
larger budget deficit.

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Monetery Policy: It refers to a policy which is adopted by the central bank to control the overall money
supply so that macroeconomic stability can be created. It is also used to promote economic growth,
low inflation and correcting BOP by using tools such interest rates, bank reserve requirements and
open market operations.

Monetery policy can be

➢ contractionary policy: increases interest rates and limits the outstanding money supply to slow
growth and decrease inflation, where the prices of goods and services in an economy rise and
reduce the purchasing power of money.
➢ Expansionary Policy: During times of slowdown or a recession, an expansionary policy grows
economic activity. By lowering interest rates, saving becomes less attractive, and consumer
spending and borrowing increase.

Money: Anything that is generally acceptable as medium of exchange against selling and buying of gods
and services is known as money. In other words, money is what money does.

Functions of money

• Medium of exchange – people are willing to change their goods and services for money

• A store of value – people are willing to hold on the money because it generally keeps its value
(although not with inflation)

• Unit of account – people can measure the value of things in terms of money

• Standard of deferred payment – people are willing to accept money as payment in the future, e.g.
when the work is completed

Central Bank: A national bank that provides financial and banking services for its country's government
and commercial banking system, as well as implementing the government's monetary policy and issuing
currency.

Functions of the central bank

• Banker to the Government – provides an account for the Government. Managers the National Debt
by arranging the sale of bonds. Redeems (buys back) debt when it has matured. Pays interest for the
Government onto debt and actually holds debt itself.
• Controls the country’s currency – sole power to issue bank notes in England. Note; the actual
number of notes and coins is determined by how much people want to hold in bank deposits or as
cash.
• Supports financial institutions – acts as lender of last resort, i.e. will lend to the financial institutions
if necessary.
• Agent for the Government’s exchange rate policy – holds the official currency reserves and will buy
and sell currency for the Government.
• Banker to retail banks – holds deposit of retail banks and will lend funds to them.
• Overseas the financial system – licenses deposit takers in any country; regulates various financial
services.

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Controlling the money supply

• Open market operations – the Central Bank sells Government debt (short term debt is called
Treasury bills; longer term debt is called bonds). The buyer pays for these by writing a cheque on
their banks. The banks honor the cheque by paying the Central Bank and this reduces their reserves
and so reduces their ability to lend.

• Liquidity (or reserve) ratios – by forcing a bank to keep more funds in reserve, a central bank can
restrict the commercial banks’ lending; but banks may find ways around this, e.g. Goodhart’s law (if
the Central Bank tries to control one type of lending, banks will find ways of increasing other types).

• Cut the PSBR – the PSBR increases the money supply if it is financed by selling Treasury bills or
borrowing from the domestic sources. However, cutting the PSRB may be difficult as it involves
cutting public spending and increasing taxes.

• Funding – this involves converting short-term Government debt to long term. By selling longer-term
debt to banks in return for shorter-term debt, the central bank reduces their liquidity and ability to
lend.

• Special directives and special deposits – banks can be forced to deposit a certain percentage of their
liabilities with the Central Bank. Banks had to put a proportion of their deposits at the Central Bank
without interest. The Central Bank can also give directives on how much banks are allowed to lend
(qualitative controls).

• Moral persuasion – the central bank can make it known whether it would like more or less lending;
banks will often listen to the central bank’s advice or wishes

Problems of monetary control

• Banks may hold in excess of the reserve set by the authorities, so a reserve ratio or special deposits
may have no impact.

• Goodhart’s law – attempts to control particular types of lending or lending by certain financial
institutions will lead to more lending of a different type or by different organizations.

• Disintermediation lending continues, but banks are no longer the intermediaries, i.e. it is no longer
officially organized by banks and so the authorities cannot control it.

Controlling interest rates

Open market operations are often conducted to leave the banks short of cash. The banks then borrow
this, which often means they are competing for scarce funds which will make it more expensive to
borrow, i.e. increase interest rates. The Central Bank can also change the interest rate by changing its
discount rate. (This is the rate at which it buys bills.) By influencing the interest rate, the Central Bank
influences the demand for money.

Problems of using interest rates

Changes in interest rates are likely to affect

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• The exchange rate, e.g. using higher interest rates to discourage borrowing may increase the
value of the exchange rate and make country’s firms uncompetitive

• Borrowing by households and firms

• they may take time to have an effect

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Supply side policies

Any policy which is designed to encourage aggregate supply in the economy, in other words it is used to
increase the potential of the economy. with supply side policy PPC shifts outwards in the future, it is
normally a long-term policy. Government invests and encourages private sector investment in
infrastructure, education, health, power generation, communication, transport networks and in real
estates. Basic objective of supply side policy is to trigger economic development so that economic activity
can be increased, employment opportunities can be generated, living standards can be improved and
exports can be increased.

There are two main types of supply-side policies.

1. Free-market supply-side policies involve policies to increase competitiveness and free-

market efficiency. For example, privatization, deregulation, lower income tax rates, and
reduced power of trade unions.

2. Interventionist supply-side policies involve government intervention to overcome

market failure. For example, higher government spending on transport, education and
communication.
Benefits of Supply-Side Policies

In theory, supply-side policies should increase productivity and shift long-run aggregate supply (LRAS) to
the right.

Lower Inflation: Shifting AS to the right will cause a lower price level. By making the economy more
efficient, supply-side policies will help reduce cost-push inflation. For example, if privatization leads to
more efficiency it can lead to lower prices.

Lower Unemployment: Supply-side policies can contribute to reducing structural, frictional and real
wage unemployment and therefore help reduce the natural rate of unemployment.

Improved economic growth: Supply-side policies will increase the sustainable rate of economic growth
by increasing LRAS; this enables a higher rate of economic growth without causing inflation.

Improved trade and Balance of Payments: By making firms more productive and competitive, they will
be able to export more. This is important in light of the increased competition from an increasingly
globalized marketplace.

Tools/instruments of supply side policy

Using the tax system to provide incentives to help stimulate factor output, rather than to alter demand,
is often seen as central to supply-side policy. This commonly means reducing direct tax rates, including
income and corporation tax. Lower income tax will act as an incentive for unemployed workers to join the
labour market, or for existing workers to work harder. Lower corporation tax provides an incentive for
entrepreneurs to start and so increase national output.

Other supply-side policies include the promotion of greater competition in labour markets, through the
removal of restrictive practices, and labour market rigidities, such as the protection of employment and
reducing trade union powers.

Measures to improve labour mobility will also have a positive effect on labour productivity, and on
supply-side performance. This improves labour market flexibility.

Better education and training to improve skills, flexibility, and mobility – also called human capital
development. Spending on education and training is likely to improve labour productivity and is an
essential supply-side policy option.
Exchange rate policy

Exchange rate policy: it is a policy designed by the government mainly to achieve BOP equilibrium but it
can also be used to achieve macro-economic targets. if government wants to encourage exports and to
dampen to imports, it depreciates exchange rate against other currencies.

Depreciation of exchange rate makes the import prices higher and according to economic theory; higher
the prices lower will be the demand so demand for imported goods declines which reduces the import bill
for the country. on the other hand, due to depreciation of exchange rate, prices of domestically produced
goods become cheaper in the foreign market so demand for local goods in the international market goes
up and export bill for the country increases. This increase in exports and decrease in imports helped
government to improve its BOP.

However, it must be remembered that depreciation of exchange rate is going to do the above stated
impact if demand for imports and exports is price elastic. Depreciation of exchange rate may also cause
inflation as value of money decreases along with goods and services less available in the economy which
may trigger cost push inflation.