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S13
IGCSE®/O Level Economics
5.1 Government economic
policy
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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
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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
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Why do governments spend money?
A government can use its spending power to:
•
•
•
•
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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
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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
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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)
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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)
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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
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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
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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
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Supply-side policies
Supply-side policies attempt to boost the productive potential of
an economy and increase aggregate supply
Increased growth = more jobs + more incomes + lower inflation
•
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
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Can policy objectives conflict?
Yes
‘Raising public spending,
cutting taxes and interest
rates to boost demand and
employment will increase
inflationary pressures and
spending on imports.’
‘Cutting public spending,
raising taxes and interest
rates to control inflation will
reduce demand and therefore
increase unemployment and
reduce economic growth.’
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No
‘Keeping price inflation low and stable
will make domestic goods and services
more competitive. Demand for them will
rise at home and overseas. This will help
to improve the balance of trade and will
boost jobs, incomes and tax revenues.’
‘If workers expect inflation to remain low
they are less likely to push for big wage
increases. This will boost the demand
for their labour. And if firms are more
confident in the future they are more
likely to invest in new capacity for
growth. In contrast, rising inflation raises
costs and lowers profits.’