Economic policy and

instruments
Why governments use economic policies?

• To achieve their macro economic

objectives and to maintain a better
living standard for their nations.
• By using macroeconomic instruments (also
we can say tools) government try to
influence either demand-side of the
economy OR supply-side of the economy.

PRODUCERS CONSUMERS
Demand-side policies
Demand-side policies try to influence the level of aggregate
demand in an economy using a number of policy instruments.
These instruments are as follows;

• 1. The total amount of government

expenditure Fiscal Policy

• 2. The overall level of taxation

• 3. The rate of interest
• 4. money supply MonetaryPolicy
 The total amount of government expenditure

Government spendings affect total demand and therefore output and employment.
 Government expenditures
• BUDGET: is the revenue and expenses over a specified period of time.
• Total planned expenditure is announced every year in the budget.

• Budget deficit = expenses > revenues

• Budget surplus = revenues > expenses

Government expenditures

Mandatory spending: Discretionary spending:

is government spending on certain Extra or new spending
programs that are required by
existing law. - automatical payments .
/unplanned .
 The rate of interest

Interest rate (Cost of borrowing money) affects decisions of both

producers and consumers and also overseas investments
 Money Supply
The total amount of money in circulation or in existence in a country.
 The overall level of taxation

Taxes affect households’ disposable incomes and profits of

business and also level of import and export .
 Taxation

• It is a resource by which governments finance

their expenditure by imposing charges on
citizens and corporate entities.
• Reasons of taxation:
• To pay for public services
• To discourage certain activities. Such as smoking
• To control Aggregate Demand in the economy.
• To control the distribution of wealth
TYPES OF TAXATION
 In economics there are two main types of
taxes:
• Direct taxes- taken from people or firms.
They are usually linked to their incomes and
wealth

• Indirect taxes- taken only indirectly from

incomes when they are spent on goods and
services.
Types of Direct Tax
• Income tax: it is levied on individual’s earnings.

• National Insurance contributions levied on income of

employees and employers and the collected money is used
specially for pensions and benefits if and when it is needed.

• Corporation tax: a tax on company profits.

• Capital gains tax: tax on profits of selling shares, famous

paintings, jewellery and other valuable assets.

• Inheritance tax: is paid on money that is inherited from

people that die.
Types of Indirect Tax
* called hidden taxes in England
Value added tax: is a tax on goods and services levied as a percentage of their
selling price.

Duties: taxes placed on certain goods based on the quantity of product

purchased.

Vehicle excise duty: is paid by the owners of vehicles every year.

Customs duties and Tariffs: are taxws levied on imports.

Council tax: is paid to local authorities.

User taxes or charges: a kind of excise duty linked to specific goods or

activities. Eg. A tax paid to use a road or bridge, etc.

Stamp duties: are paid when buying certain assets such as houses and shares.
 Environmental taxes
• Landfill tax: imposed on the
disposal of waste in landfill sites.

• The Climate Change Levy (CCL) is

an energy tax to encourage
business users to become more
energy efficient, and to reduce
their carbon dioxide emissions.

• Aggregate levy: is a tax on sand,

gravel and rock that is dug from
the ground.
DEMAND MANAGEMENT
 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
 Expansionary fiscal policy.
• Increasing government spending and/or
cutting taxes to boost aggregate demand,
output and employment in an economy is
known as expansionary fiscal policy.

G or Taxes AD
Contractionary fiscal policy
• A contractionary fiscal policy aims to reduce
AD or pressure on prices in the economy by
spending less and/or by taking more in tax.

G or Taxes AD
WHEN A GOVERNMENT USE
FİSCAL POLİCY?
 Expa
n
fisca sionary
l pol
icy

To achieve economic growth

• Increases in G. spending means more and more people earning incomes.

More and more goods and services will be produced because of higher
demand so economic growth can be achieved.

• Ex. employing more civil servant or builning a new school.

• OR
• Government may reduce income taxes, profit taxes or VAT to make
households and entrepreneurs to have more money to spend.

 Money spent on investment is the key to economic growth.

 Expa
n
fisca sionary

To reduce unemployment
l pol
icy

• Increases in G. expenditure and tax cuts can

help to reduce unemployment by stimulate
demand.
• To meet this extra demand firms will have to
produce more.
• This means more and more workers will be
employed and so unemployment will fall .
 Cont
r
fisca actionar

In inflationary economies
l pol y
icy

• It can be used to reduce inflation, if it is thought that

inflation is being caused by high demand.
• Government may cut back its spending. This will generate
less incomes and lesser consumer demand for goods and
services. At the end price levels go down.
• G less incomes demand for P
goods and services

• Government may raise overall taxes to reduce disposable

income of households and again this will reduce demand
on goods and services.
demand for
• Taxes less incomes P
goods and services
 Cont
r
fisca actionar
l pol y
icy

To correct current account deficit

• if there is a large deficit on the current account,

contractionary fiscal policy will help reduce
aggregate demand so specially demand for
imported goods will be reduced.
• G incomes demand for imported goods
• Taxes incomes demand for imported goods
MONETARY POLICY
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
 Interest rates Simply; price of borrowing or lending money
• It is the rate paid by borrowers for the use of money that they
borrow from a lender.
• If interest rates fall, people and firms find it cheaper to
borrow.
• Other people will be less willing to save money and will spend
it instead.
• That is as interest rates fall more people will want to spend
more money.
 Base rate
• Rate of interest set by government or regional
central banks for lending to other banks,
which in turn influences all other rates in the
economy.
• The rate of interest set by the Bank of
England, being in effect the lowest rate that
lenders will charge interest at.
 Why there are many different interest rate in a
country?
• Different banks charge different rates as they
compete with each other for business.
• Rates are higher if money is borrowed without
security.
• The amount paid to borrowers is higher than
the amount given to savers.
• Credit card users pay the highestr rates.
The role of central banks in setting interest rates

• İmplement the government‘s monetary policy

• regulate the bankıng system.
• Control inflation and stabilise a nation’s currency
• Act as a lender of last resort to commercial banks.

A lender of last resort is whoever you turn to when

you urgently need funds and you’ve exhausted all
your other options. Banks typically turn to their
lender of last resort when they cannot get the
funding they need for their daily business.
 Supply of money

• All notes and coins in the economy +

money held in bank accounts.
WHEN A GOVERNMENT USE
MONETARY POLICY?
 Tigh
t mo
n
polic etary
To reduce inflation y

• Tight monetary policy can be used to bring down inflation.

• High interest rates reduce demand for loans that is used in
consumption or investment and rise savings of households.
Aggregate Demand falls and inflation is been slowed down.
demand for
• Interest rates savings goods and services P
 Loo
se m
o
poli netary
To reduce unemployment cy

• Loose monetary policy, low interest rates and high money

supply will help to solve unemployment in an economy.
• Interest rates savings demand for production
goods and services

• If interest rates are cut, there would be a decrease in

demand for loans and spending increases both by firms and
households.
• Increased aggregate demand helps to create jobs and
reduces unemployment.
 Economic growth

• LooseMonetary policy might be used to help

smooth out the fluctuations in the economic cycle.
• Increased investment and consumption helps to
create economic growth as firms will be able to
produce more output in total.

• Interest rates saving and investment production

 To correct the current balance
• To reduce a deficit, a government uses tighten
monetary policy. This will reduce the overall
demand on goods and services which also
reduce spending on imports.
• Interest rates savings demand for import goods and services

• However, if intest rates are raised, the exchange rate might also increase.
This would make exports more expensive, imports cheaper and worsen
the current balance. This usually depends on:
 The income elasticity of imports.
 The strength of the link between interest rates and exchange rates.
 The price elasticity of demand for impoorts and exports.
 The mechanism by which interest rate changes
affect consumers and firms
o Consumers: when interest rates fall, demand for loans
will rise
• Mortgage payments fall an therefore more money directed
to spending
• Saving decreases.

• Firms: firms using borrowed money to fund their

business activities.
• İnfluence investment
• İnfluence imports and exports
 The use of asset purchasing by central banks

• Quantitive easing: buying of financial assets by the CB which

results in a flow of money from the cental bank to commercial
banks.
• Quantitative easing is an unconventional monetary policy in
which a central bank purchases government securities or other
securities from the market in order to increase the money supply
and encourage lending and investment.
• The main aims of quantitative easing are to support the level of
aggregate demand so that real output can be maintained and
inflation can be kept close to the published target.
• The Bank of England uses QE to increase the supply of money in
the banking system.
 Relationship
between objectives
and policies
Possible positive effects of expansionary
fiscal policy (lower taxes and higher G expenditure)
• Unemployment will fall as firms take
on more workers to meet rising
demand.

• With more spending and investment

the economy will grow- increased
production.

• Increased production may rise tax

revenues and so government will
have more revenue.

• There may be an improvement in

government services and
infrastructure means improvement in
people’s living standards.
Possible negative effects of expansionary
fiscal policy (lower taxes and higher G expenditure)
• The increase in aggregate demand might
cause demand pull inflation especially if
the economy has limited capacity
(producing at a full-employment level) .

• Tax cuts might also cause imports to rise.

If people spend their extra disposable
income on holidays abroad and
imported consumer durables, the
current account will worsen.

• If taxes are lower and government

expenditure is higher there is likely to be
an increase in government dept. This
means that the government will have to
borrow more and pay more interest.
Possible positive effects of contractionary
fiscal policy (higher taxes and lower G expenditure)
• If the economy is overheating and
inflation is raising, contractionary fiscal
policy will help to dampen aggregate
demand in the economy. People will
have less disposable income and
government demand will be lower. This
will relieve inflationary pressures and TAX
economy may grow at a more
sustainable rate.

• Higher tax revenues will improve

government financing.

• Less disposable income let people to

reduce their spending on import. This
will reduce a current deficit.
Possible negative effects of contractionary fiscal policy
(higher taxes and lower G expenditure)

• Higher tax rates and lower

government spending could
result in unemployment.

• The economy may contract as

growth in GDP starts to slow and
may even fall.

• People may suffer as a result of

poorer government services after
the cuts in expenditure.
Government services
Possible positive effects of tight monetary
policy (higher interest rates and lower money supply)
• Higher interest rates will
discourage borrowing by firms
and households. This will reduce INFLATION
aggregate demand and
inflationary pressures will reduce.

• Higher interest rates mean that

the reward to savers will increase.
So it encourages savings.

• Higher interest rates may

strengthen the exchange rate
making imports cheaper.
Possible negative effects of tight monetary
policy (higher interest rates and lower money supply)

• Higher interest rates will discourage

people from borrowing. So
consumption and investment will be
reduced. So there will be lower
economic growth and unemployment.

• Firms will incur higher interest charges.

This will raise their costs and reduce
profits in return. Firms may not be
willing to invest which will reduce total
demand of goods and services in the
economy.

• If higher interest rates result in higher

exchange rates it may be harder for
firms to sell abroad….
Possible positive effects of loose monetary
policy (lower interest rates and higher money supply)
• Lower interest rates will encourage
borrowing by firms and households.
This will increase AD, which will
create jobs.
• Lower interest rates may cause the
exchange rate to fall. This means that
demand for firms’ exports may
increase because they will be
cheaper.
• Lower interest rates will encourage
firms to invest on capital.
• Government debt: if interest rates
are lower the amount of interest paid
on government debt will be lower.
More money will be available for the
government … İnterest
payments
Possible negative effects of loose monetary
policy (lower interest rates and higher money supply)
• If AS is not able to be increased
quickly as AD does, this will bring INFLATION
inflation.

• Higher aggregate demand may

pull imports up and the current
account will worsen.
IMPORT
• Lower interest rates may force
exchange rate down which means
that imports become more
expensive. This may create
imported inflation.
Imported
Supply-side policies
• Supply side policies are used to help
increase aggregate supply in the economy.
• Usually supply side policies aimed to:
- Improve flexibility in labour markets and
restore the incentive to work
- Encourage competition in the market
- Increase investment.
SUPPLY SIDE POLICIES FOR LABOUR
MARKET

Main aim is to improve productivity of labour.

 Labour market reforms
• Legislation can be used to control the power of trade unions to call
strikes and other disruptive industrial actions like forcing up the wages
of members which may reduce the demand for labour and raise
unemployment.

• Minimum wage laws protect low-paid workers from being exploited by

some employers and encourage more people into work. (BUT raising
minimum wages will reduce the demand for labour.)

• High social security benefits may discourage some people from

working. Social security contributions include old-age, unemployment,
and disability insurance.
 Tax incentives

• Cutting taxes on incomes and profits can have a direct impact

on the productive efforts of workers and firms.

• High rates of tax on incomes may reduce incentives to work

hard. Vise versa

• High rates of tax on profits can reduce entrepreneurs’

incentives to start new business. Vise versa
 Improving education and training

• If people receive more education and training the quality of the

workforce will improve.

• A government can assist firms by helping them design and finance

training programs, funding universities and providing access for more
people to attend colleges and higher education.

• A well-educated and trained workforce can raise labour productivity and

will be better able to adapt to new production methods and
technologies.
SUPPLY SIDE POLICIES FOR PRODUCT
MARKETS

Productive potential of an economy can be increased if goods

and services can be produced more efficiently.
 Privatization
• Privatization - the change of ownership of public services
from the state or government to private companies.

• It breaks up state monopolies and promotes competition.

So they cannot rely on public money if they make a loss.

• Competitive pressure should improve quality and reduce

prices.

• Nationalization - Takeover of privately owned corporations,

industries, and resources by a government.
 Competition policy

• Some big firms may control the supply of a particular good or

service to a market.

• They may use this power to restrict competition, charge

consumers high prices and reduce the quality of products.

• Competition policy concerns the removal of barriers to help

stimulate competition, expand output and lower prices.
 Deregulation

• Deregulation involves removing or simplifying old,

unnecessary or over-complex rules and regulations
on what business can or cannot do.
 Helping small firms

• If more businesses set up, or existing small firms expand,

aggregate supply will increase.

• Ways of helping small firms:

- Taxes can be reduced
- Bureaucracy can be reduced
- Tax allowances for firms who invest money in small
businesses.
- Free advisory services.
Selective subsidies grand of money provided by a government

• Subsidies are given to business organizations to

encourage or protect productive activity.
 International trade barriers

• Governments protect their domestic firms and employment

from competition from overseas by using barriers against
free trade.

• A government may puts tax on imports or simply restrict

their entry into a country to protect their national firms
producing the same goods and services.
 SUPPLY SIDE POLICIES FOR CAPITAL
MARKETS

The productive potential of the economy will increase if there

is more investment in the economy.
 Things that public sector can do:
• Investing more in the infrastructure, will improve transport and
communications system, mobility of labour, distribution of goods.

• Investing more in the education and health care will improve the quality
of human capital.

• Availability of funds for investment of firms.

• Availability of capital allowances.

• Tax incentives.