Chapter 5: Government

macro intervention
The aims of macroeconomic policy
• The main government macroeconomic policy aims are:
• ■ full employment
• ■ low and stable inflation
• ■ balance of payments equilibrium
• ■ steady and sustained economic growth
• ■ avoidance of exchange rate fluctuations
• ■ sustainable economic development.
Price Stability
• Government seek to achieve price stability (low and stable inflation of 2-
3%, but not a zero inflation) Why?
Aim for zero inflation may result in deflation
Low and stable inflation may be caused by higher spending (AS>AD), which
may encourage firms to increase output, (higher spending, hiring,
employment)
• Government may set an inflation target for the central bank to achieve.
(Set a target of 3-6% to achieve).
• An inflation target makes central banks more accountable, reduce
inflationary expectations (wages, energy, raw materials, rent, interest rate)
Low unemployment

• Benefits of keeping
unemployment low: To know the
benefits of low unemployment,
look at the costs of
unemployment
• High output, GDP
• High tax revenue (more people are
working)
• Low expenditure on
unemployment benefit
High economic growth (GDP)
see the benefits of economic growth

• Higher average incomes.

• Lower unemployment.
• Lower government borrowing.
• Improved public services.
• Increased investment.
• Increased research and
development.
• Economic development, decline
in absolute poverty
Types of policy (tools) used
by governments to reach
macro-economic objectives:

• Fiscal policy/ Budget

• Monetary policy
• Supply side policies
• At any one time, a government may prioritise one objective. For
example, if the inflation rate is at 20% and rising, a government may
decide to concentrate on achieving price stability.
Fiscal policy
Fiscal policy and the budget
• Fiscal policy: the use of taxation and government spending to influence aggregate
demand.
• Budget: an annual statement in which the government outlines plans for its
spending and tax revenue.
• Budget surplus: government revenue exceeding government income.
• Budget deficit: government expenditure exceeding government revenue.
• Balance budget: government revenue equals government income
• Automatic stabilizers: changes in government spending and taxation that occur to
reduce fluctuations in aggregate demand without any alteration in government
policy.
• Cyclical budget deficit: a budget deficit caused by a decline in economic activity.
(Keynesians) Automatic stabilizers
• An automatic stabilizer in economics refers to a fiscal mechanism built into the
government’s budget that demands increased public spending and decreased taxes to
stabilize the economy during a crisis. It activates automatically in the case of economic
turmoil or recession, rather than requiring consent from the government.
• Automatic stabilizers are ongoing government fiscal policies that automatically adjust
tax rates and transfer payments in a manner that is intended to stabilize incomes,
consumption, and business spending over the business cycle.
• They are used as a tool to combat economic slumps and recessions or shocks.
• In 2020, the Coronavirus Aid, Relief, and Economic Security (CARES) Act became the
largest stimulus package in U.S. history. It provided over $2 trillion in government relief
in the form of expanded unemployment benefits, direct payments to families and
adults, loans and grants to small businesses, loans to corporate America, and billions of
dollars to state and local governments.
Structural deficit
• A structural deficit arise when a
government spends too much relative to
its tax revenue.
• Spending is being financed by borrowing
and has become increasingly
unsustainable or expensive.
• A rise in tax revenue and a fall in
government spending will reduce a
budget deficit.
• However, there is a possibility that a rise
in government spending and a cut in tax
rate/ tax base could also reduce a budget
deficit (increases economic activity)
• What would indicate a structural
deficit/debt problem?
• A rise in interest payments as a % of GDP
• The reluctance of markets to buy
government debt causing rising bond
yields.
• High inflation could make the issue more
serious (government cannot increase
liquidity/ print money)
• Pensions, health care and an ageing
population can make a structural deficit
problem more likely.
The national
debt
• National debt is the total
amount of government debt.
• The national debt of a
country is the total that it
owes creditors.
• It is often expressed as a
percentage GDP
 • If a country has a • Problems:
Budget and budget deficit, it will • Cost of interest
national debt add to national debt payments
• A budget surplus can be
• Opportunity cost of
used for paying off interest payments
national debt.
• Difficulty in getting
• National debt tends to
loans from lenders
increase during
economic downturns/ • Large borrowing may
pandemics (govt raise interest
expenditure rises faster • External debt may
than tax revenue) cause BoP deficit
• Case study: Japan, p
223
The 2023 United States debt-ceiling crisis

• On January 19, 2023, the United

States hit its debt ceiling.
• The US has hit its debt limit, with the
Treasury Department now taking
measures to prevent a potentially
devastating default.
• Reaching the debt ceiling means the
government is not allowed to borrow
any more money - unless Congress
agrees to suspend or change the cap,
which currently stands at almost
$31.4tn (£25.4tn).
Taxation p.223
A tax is a charge levied by a government to raise revenue.
The main types of taxes include
• Income tax – a percentage of income.
• Corporation tax – a percentage of a firm’s profit.
• Sales tax/VAT – an indirect tax on the sale of
goods.
• Excise duties – taxes on alcohol, tobacco, petrol.
• Production taxes – taxes on particular
goods/services, e.g. gambling tax, airlines,
insurance.
• Environmental taxes – taxes on carbon, airports
e.t.c.
• Stamp duty – tax on buying a house or shares.
• Tariff – this is a charge levied on the import of
particular goods.
• Inheritance tax – a tax levied on the estate of a
deceased person.
• Wealth tax – a tax levied on wealth, rather
than income.
• Capital gains tax – a tax levied on an increase
in the value of assets/wealth.
• Poll Tax – a tax on individuals. Introduced in
UK as the “Community Charge”
• Windfall taxes – These are a type of
corporation tax levied on companies making
‘excess’ profit. The UK introduced windfall
tax on privatised industries. Also levelled on
particular industries like north sea oil
• Council taxes – taxes collected by local
government, could be a tax on property or
local sales/income tax
Direct and indirect taxes
• A direct tax is a tax that a person or company pays directly. For
example, income tax is taken out of your salary.
• An indirect tax is paid by a third party. For example, when you buy a
TV, there is a VAT charge which is included in the price, the consumer
does not pay, but the firm who sells the good is responsible for paying
the tax to the government on your behalf.
Progressive, proportional and regressive taxes
• A progressive tax takes a higher percentage of tax from people with
higher incomes.
• A proportional tax means different income levels pay the same % of
income in tax.
• A regressive tax takes a higher percentage of tax from people with low
income.
Advalorem vs specific tax
• An ad valorem tax is a certain percentage of the price of the good.
VAT is levied at 20% so the more expensive the good is the more VAT
that is paid.
• A specific tax is a fixed levy whatever the price of the good. For
example, a £20 passenger levy on long-haul flights.
Pigovian tax (or sin tax)
• This is a tax that attempts to place a
charge equal to the external cost of
the tax. A Pigovian tax aims to make
consumers pay the full social cost of
the good. It was named after the
economist Arthur Pigou, who
contributed to the theory of
externalities and social efficiency.
• The tax has shifted supply to S2. This
makes consumers pay the full social
marginal cost and leads to greater
efficiency.
Income tax
• Income tax is a common form of tax which takes a percentage of
income. Income tax makes use of the concept of marginal tax rates
Tax revenue Vs government spending
Which Country Has the Highest Income
Taxes? (and the lowest)
• Ivory Coast - 60%
• Finland - 56.95%
• Japan - 55.97%
• Denmark - 55.90%
• Austria - 55.00%
• Sweden - 52.90%
• Aruba - 52.00%
• Belgium - 50.00% (tie)
• Israel - 50.00% (tie)
• Slovenia - 50.00% (tie)
• Only a handful of countries have
0% income tax. These include
Saudi Arabia, United Arab
Emirates, Oman, Kuwait, Qatar,
Bahrain, the Bahamas, Bermuda,
and the Cayman Islands. Many of
these are Arab oil-producing
nations that subsidize their
budgets with exports rather than
taxes. These nations also feature
relatively high sales taxes and/or
corporate tax rates.
Reasons Why We Pay Tax
• Taxes are used to raise income for the government of the country.
• To redistribute income between the rich and the poor by introducing a
system of progressive taxation.
• Discouragement of production and consumption of harmful goods (demerit
goods/ negative externalities)
• To control inflation
• To protect (infant) new industries
• To correct balance of payment deficit
• To prevent dumping
• To promote economic growth
Government spending (Budget)
Sources of Government Spending
• 1. Tax collections by the government
• Direct taxes
• Indirect taxes
• 2. Government borrowing
• Borrowing money from its own citizens
• Borrowing money from foreigners
Government spending
• Government spending is divided into • Exhaustive and non-exhaustive
spending on transfer payments (not
included in NI measurements), current
government spending:
and capital spending. • Exhaustive: current and capital
• Transfer payments: welfare payments to spending (counted in AD/ GDP)
unemployed, old, disabled etc.
• Current spending: day to day spending
• Non-exhaustive: spending on
for providing government services (salary transfer payments.
for government employees, teachers,
doctors, nurses, police etc
• Capital spending: Spending on capital
goods (school/ hospital buildings,
infrastructure)
 Is a Key Component of Aggregate
Economic Demand
Importance Has a big Regional Economic
of Impact/ employment

Government Important in providing Public &

Merit Goods
Spending
Can help achieve greater Equity in
Society
How Government Spending can affect
Incomes
• Welfare state transfers
• Universal child benefits /
unemployment benefit
• Public (state) pensions
• Conditional welfare transfers e.g.
Conditional on attending
unemployment programmes
• Targeted welfare payments-
linked to income
• State-provided services (in-kind
benefits)
• Education - reduces inequality of
market incomes
• Health care – state provided
health services
• Social housing e.g. Provided by
local authorities
• Employment training
Automatic stabilisers to influence aggregate demand.

• A government can also allow automatic stabilisers to influence

aggregate demand.
• Automatic stabilisers are forms of government spending and taxation
that change, without any deliberate government action, to off set
fluctuations in GDP.
• For example, during a recession, government spending on
unemployment benefits automatically rises because there are more
unemployed people. Tax revenue from corporation tax, income tax
and indirect taxes will fall automatically as profits, incomes and
expenditure decline.
Expansionary and contractionary fiscal
policies
• Definition of fiscal policy: Fiscal policy involves the government
changing the levels of taxation and government spending in order to
influence aggregate demand (AD) and the level of economic activity.
• The purpose of Fiscal Policy
• Stimulate economic growth in a period of a recession.
• Keep inflation low (the UK government has a target of 2%)
• Fiscal policy aims to stabilise economic growth, avoiding a boom and
bust economic cycle.
• Fiscal policy is often used in conjunction with monetary policy. In fact,
governments often prefer monetary policy for stabilising the economy.
Expansionary (or loose) fiscal policy
• This involves increasing AD.
• Therefore the government will
increase spending (G) and cut
taxes (T). Lower taxes will
increase consumers spending
because they have more
disposable income (C)
• This will tend to worsen the
government budget deficit, and
the government will need to
increase borrowing.
Contractionary/ deflationary (or tight) fiscal
policy
• This involves decreasing AD.
• Therefore the government will
cut government spending (G)
and/or increase taxes. Higher
taxes will reduce consumer
spending (C)
• Tight fiscal policy will tend to
cause an improvement in the
government budget deficit.
Discretionary fiscal policy
• Discretionary fiscal stabilisers – This is a deliberate attempt by the
government to affect AD and stabilise the economy, e.g. in a boom
the government will increase taxes to reduce inflation.
• Fine tuning – fiscal policy involves maintaining a steady rate of
economic growth by using fiscal policy. In theory, the government can
make incremental changes to spending and taxation levels to slow
down or speed up the economy.
HOWEVER: why fiscal policies are not always effective?
criticisms of fiscal policy

• Time lags. It takes several months for government spending to feed its way
into the economy. By the time government spending increases it may be too
late,
• People will not like the idea of higher taxes.
• Difficulty in getting correct information about current state of economy and
likely forecasts of growth.
• Crowding out: government have to borrow from the private sector who will
then have lower funds for private investment.
• Government spending is inefficient: Some economists argue that the
government spending will tend to be wasted on inefficient spending projects.
• Higher borrowing costs:
Automatic stabilization process
• Initially, the economy is
operating below full
employment at Y with a
significant gap between
government spending and
taxation.
• As GDP rises, government
spending on benefits falls while
tax revenue rises with more
people in employment and so
receiving more income.
The budget position
• Budget: an annual statement in which the government outlines plans
for its spending and tax revenue (expenditure and income) for the
year ahead.
• The annual budget is a statement of fiscal policy.
• A budget surplus arises when tax revenue exceeds government
spending. In contrast, a budget deficit occurs when government
spending exceeds tax revenue and a balanced budget is when
government spending matches tax revenue.
Cyclical and structural deficit
• Cyclical budget deficit: a budget deficit caused by changes in economic
activity.
• Structural budget deficit: a budget deficit caused by an imbalance
between government spending and taxation.
• A budget deficit that occurs due to automatic stabilisers is known as a
cyclical deficit. A government is unlikely to be concerned about this?
(temporary)
• A government will, however, be concerned about a structural deficit.
This arises when a government is committed to too much spending
relative to its tax revenue. (the deficit will not disappear when GDP
increases).
Monetary policy
Monetary policy: Interest rates, money
supply, credit regulations
• Monetary policy involves using
interest rates and other
monetary tools (open market
operations and cash reserve
ratios) to influence the levels of
consumer spending and
aggregate demand (AD). In
particular monetary policy aims
to stabilise the economic cycle –
keep inflation low and avoid
recessions.
• Aim of monetary policy
• Low inflation. UK target is CPI 2%
+/-1. Low inflation is considered an
important factor in enabling higher
investment in the long-term.
• Stable economic growth. Monetary
policy is also concerned with
maintaining a sustainable rate of
economic growth and keeping
unemployment low.
 • Quantitative easing (QE) is a form of monetary policy in
Quantitative which a central bank, like the U.S. Federal Reserve,
purchases securities from the open market to reduce
easing interest rates and increase the money supply.
Quantitive tightening
• Quantitative tightening, also
known as balance sheet
normalization, is a type of
monetary policy followed by
central banks. It is the exact
opposite stance of quantitative
easing, which is a type of
monetary expansion followed
after the 2008 Global Financial
Crisis.
Bank’s cash reserve ratio, money supply and
inflation
• When cash reserve ratio is
reduces,a low cash reserve ratio
means the money supply of the
banking system will increase.
Increased money supply means
high inflation.
• When CRR is increased , it
decreases money supply, Increases
interest rates on home loans, car
loans etc. and in inter-bank market,
Increases demand for money and
decreases inflation.
• When the Federal Reserve
decreases the reserve ratio, it
lowers the amount of cash that
banks are required to hold in
reserves, allowing them to make
more loans to consumers and
businesses. This increases the
nation's money supply expands
the economy.
Interest rate and Inflation
Central Bank and the monetary policy
• As the UK’s central bank, Bank of
England use two main monetary
policy tools. First, we set the
interest rate that we charge
banks to borrow money from us
– this is Bank Rate. Second, we
can buy bonds to lower the
interest rates on savings and
loans through quantitative
easing (QE).
How monetary policy works?
• UK monetary policy is set by the Monetary Policy Committee (MPC) of the
Bank of England.
• The Bank of England decides whether inflation is likely to rise or fall.
• If they expect higher inflation and higher growth, they will tend to increase
interest rates.
• If they expect lower growth and a fall in the inflation rate, they will tend to
cut interest rates.
• The Bank of England also used Quantitative Easing as a part of monetary
policy. This involves creating money electronically to buy assets (such as
government bonds from banks). It is hoped by buying illiquid assets there
will be an increase in the money supply and avoid deflationary pressures.
Loose (Expansionary)
monetary policy
• If the Bank of England anticipates
inflation falling below the government’s
target of 2% and economic growth is
sluggish, or the economy is facing a
recession. They are likely to cut interest
rates.
• Lower interest rates, in theory, should
stimulate economic activity. This is
because lower interest rates reduce
borrowing costs. This increases the
disposable income of consumers with
mortgage interest payments and should
encourage spending.
Effect of lower interest rates
• Lower interest rates make it cheaper to borrow. This tends to encourage
spending and investment. This leads to higher aggregate demand (AD) and
economic growth. This increase in AD may also cause inflationary pressures.
• Lower interest rates will reduce the incentive to save. Lower interest rates
give a smaller return from saving. This lower incentive to save will encourage
consumers to spend rather than hold onto money.
• Cheaper borrowing costs. Lower interest rates make the cost of borrowing
cheaper. It will encourage consumers and firms to take out loans to finance
greater spending and investment.
• Lower mortgage interest payments.
• Rising asset prices. Lower interest rates make it more attractive to buy assets
AD/AS diagram showing effect of a cut/
lower interest rates
• If lower interest rates cause a
rise in AD, then it will lead to an
increase in real GDP (higher rate
of economic growth) and an
increase in the inflation rate.
Evaluation points: Why a lower interest rate
will not increase AD?
• If the Central Bank cut the base rate, banks may not pass this base
rate cut onto consumers.
• It depends on other factors in the economy like a global recession.
• Interest rates may be low, but banks may be unwilling to lend.
• If confidence is low, a cut in interest rates may not encourage more
spending.
• Time lag. A cut in interest rates can have up to 18 months to affect the
economy.
Tight (Contractionary)monetary policy
• If the Bank feels the economy is
growing too quickly and inflation is
expected to exceed the
government’s target, then they are
likely to increase interest rates to
reduce the rate of economic
growth and reduce inflationary
pressures.
• In this case, a rise in interest rates
causes a fall in consumer spending
and investment leading to lower
inflation.
 • The Central Bank usually increase interest
Effect of rates when inflation is predicted to rise
significantly above their inflation target.
raising interest Higher interest rates increase the cost of
borrowing, reduce disposable income and
rates therefore limit the growth in consumer
spending. Higher interest rates tend to
reduce inflationary pressures and cause an
appreciation in the exchange rate.
AD/AS diagram showing impact of HIGHER
interest rates on AD
• higher interest rates will tend to
reduce consumer spending and
investment. This will lead to a
fall in Aggregate Demand (AD).
• Lower economic growth
• Higher unemployment.
• Improvement in the current
account.
Evaluation of higher interest
rates
• Increase in debt burden of borrowers
• Time-lags. The effect of rising interest rates can often take
up to 18 months to have an effect.
• It depends whether increases in the interest rate are
passed on to consumers.
• Expectations: people have got used to low rates.
Activity
• Define monetary policy.
• What are the monetary policy tools available to central banks?
• Discuss how a central bank uses expansionary and contractionary
monetary policy to achieve its macro economic objectives.
Supply side policy
• Supply-side policies are
government attempts to increase
productivity and increase efficiency
in the economy. If successful, they
will shift aggregate supply (AS) to
the right and enable higher
economic growth in the long-run.
• In theory, supply-side policies
should increase productivity and
shift long-run aggregate supply
(LRAS) to the right.
Two main types of supply-side policies.
• Free-market supply-side policies • Interventionist supply-side
involve policies to increase policies involve government
competitiveness and free-market intervention to overcome
efficiency. For example, market failure. For example,
privatisation, deregulation, higher government spending on
lower income tax rates, and transport, education and
reduced power of trade unions. communication.
Benefits of Supply-Side Policies
• 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.
• 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.
The effects of supply-side policy
• Successful supply-side policy will
shift the AS curve to the right.
Limitations of supply-side policies
• Productivity growth depends largely on private enterprise and trends in
technological innovation.
• Supply-side policies can be counter-productive. For example, flexible labour markets
may reduce costs for business – but if they cause job-insecurity, workers may
become demotivated and labour productivity stagnates.
• In a recession, (AS>AD) supply-side policies cannot tackle the fundamental problem
which is lack of aggregate demand.
• Time. All supply-side policies take a long time to have an effect. Some policies, such
as education spending may not influence the economy for 20-30 years.
• Supply side policies will not reduce unemployment caused by a fall in aggregate
demand (demand-deficient unemployment) They can only reduce long term
structural unemployment. (natural rate of unemployment).
Supply Side Policies for Reducing
Unemployment
• interventionist supply-side
policies
• Better education and training.
• Training for the unemployed.
• Better job information.
• Employment subsidies for firms
• Geographical subsidies to reuce
occupational immobilities.
• Free market supply-side policies
• Lower unemployment benefits.
• Reduced power of trades unions.
• Increased labour market
flexibility. e.g. make it easier to
hire and fire workers.
• Free trade and free-market
Policies to correct
balance of payments
disequilibrium 118
Policies to reduce a current account deficit
• A current account deficit occurs when the value of imports (of
goods/services/inv. incomes) is greater than the value of exports.
Policies to reduce a current account deficit involve:
• Devaluation of exchange rate (make exports cheaper – imports more
expensive) However it depends on elasticity of demand for exp/imp.
• Reduce domestic consumption and spending on imports, exchange
controls (e.g. tight fiscal policy/higher taxes)
• Supply side policies to improve the competitiveness of domestic
industry and exports.
Devaluation/ Expenditure switching policies
• Devaluation raises the domestic price of imports and reduces the
foreign price of exports of a country devaluing its currency in relation
to the currency of another country. Devaluation is referred to as
expenditure switching policy because it switches expenditure from
imported to domestic goods and services.
• When a country devalues its currency, the price of foreign currency
increases which makes imports dearer and exports cheaper. This
causes expenditures to be switched from foreign to domestic goods
as the country’s exports rise and the country produces more to meet
the domestic and foreign demand for goods with reduction in
imports. Consequently, the balance of payments deficit is eliminated.
Expenditure dampening/ reducing policies
• These are policies designed to
lower real incomes and
aggregate demand and thereby
cut the demand for imports. E.g.
higher direct taxes, cuts in
government spending or an
increase in monetary policy
interest rates.
• Expenditure-reducing policies aim
to reduce demand in the economy,
so spending on imports fall.
• Expenditure-switching policies aim
to switch consumer spending
towards domestic goods, and
away from imports.
• Reducing the growth of the supply
of money in an economy can be
expenditure reducing or
expenditure-switching.
Fiscal policy measures to correct balance of
payment disequilibrium 120
• A fiscal approach to expenditure reduction would involve either
reducing public spending in the economy, or raising direct taxes, such
as income tax, or a combination of both.

• This would create a net withdrawal of expenditure, and, graphically,

cause aggregate demand (AD) to shift to the left, to AD1, as shown.
The new equilibrium level national income, GDP, is now at Y1. If we
then look at a simple cross diagram, we can see that the reduction in
GDP causes imports to fall and moving the economy towards a
balance of payments.
The effectiveness of fiscal policy
Monetary policy measures to correct balance
of payment disequilibrium.
Supply side policies to correct balance of
payment disequilibrium
• 121
The effectiveness of supply side policies
• 122