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UNIT 10 : Economics
Economic policy
This unit should enable you to understand and explain
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The role of government in the economy
The objectives of macroeconomic policy
Fiscal policy
Monetary policy
Problems of policy implementation
THE ROLE OF GOVERNMENT
In this unit we are going to look at the way government interacts with rest of the
macroeconomy and the effect that it has. We mentioned in unit 7 that government
hasn’t always been interested in trying to achieve change in the economy and thus,
historically, its influence was slight. Even in the past, the mere fact that government
needed to raise money to finance spending in such areas as defence and the up-keep
of a royal family still meant that the actions of government had some effect on the
macroeconomy. Taxation was still a leakage from the circular flow of income and
government spending was still an injection.
Government expenditure to finance expensive wars overseas has affected the national
income since the earliest days of our history and continued to have an effect up to and
including the Falklands campaign 1982 and the Gulf War.
Decisions by government to provide services, such as education and public health in
the nineteenth century, caused government expenditure to increase dramatically.
This century we have seen other major increases in government expenditure to
finance social welfare programmes including the introduction of unemployment
benefits, pensions and a health service. The welfare programme has grown to be the
largest item of government expenditure accounting for approximately one third of all
government spending.
Naturally government expenditure needs to be financed and so we have seen taxes
rise to meet it. New taxes have also been introduced, such as the airport departure tax
imposed recently
Activity:
Try to think of three other taxes that have appeared for the first time in
the last few years.
With taxation as a leakage from the circular flow of income, and expenditure as an
injection, the actions of government have become increasingly important to the
macroeconomy.
Until the 1930’s government saw its role as simply balancing income and
expenditure. Consequently, when the major world depression of the 1920’s resulted in
widespread unemployment and business failure, governments reacted to this loss in
their tax revenues by cutting expenditure and raising taxes in order to balance their
budgets.
By now your understanding of the circular flow of income should tell you that this
action was bound to reduce activity in the economic system still further, leading to
downward spirals of income, output and expenditure, making the situation worse.
Governments of the time found this difficult to comprehend since they didn’t have the
advantage of understanding the macroeconomy in the way that you do. It was the
economist Keynes who tried to point this out to them, a process that took
approximately ten years!
Keynes tried to convince governments that the economy could establish equilibrium
at a very low level of activity (as it had) and would stay there until a favourable
upturn in the business cycle. The point Keynes tried to make was that governments
didn’t have to wait for the business cycle to turn-up and they certainly shouldn’t be
cutting expenditure and raising taxes in time of depression.
The key to the level of activity in the economy, according to Keynes, was
expenditure. If expenditure increased in any part of the economy, through investment,
consumption expenditure, government expenditure or net exports, it would have
multiplier effects that would set in motion an economic recovery. The problem was
that consumption expenditure was depressed by mass unemployment, investment
expenditure was low due to negative expectations about the future and government
expenditure had been cut by governments trying to balance their budgets. As if that
wasn’t bad enough, the period between the two world wars had seen countries
increasing import duties against foreign goods in an attempt to protect their domestic
markets from foreign competition. The result of this was to damage the export
markets of many countries seriously, and so reduce the ability of net exports to
increase aggregate demand.
Against this backdrop, Keynes insisted that governments should take responsibility
for managing the level of demand in their economies. If all other sources of
expenditure were depressed then government should take the initiative, stop worrying
about balancing the budget and increase their expenditure in order to raise demand in
the economy. If government had to increase their borrowing in order to finance this
increase in expenditure, then so be it.
Eventually the logic of what Keynes proposed, backed up by new economic theory
put forward by him, and by a growing number of other economists around the
developed world, gradually became acceptable.
This was the start of a new era in economics. Government now had a new role and
that was to actively manage the economy, using the means at its command, to achieve
objectives that it would set out.
ECONOMIC OBJECTIVES
There are certain economic objectives that are shared by most governments in a
mixed economy, they are:
1.
Stable prices
2.
Low unemployment
3.
Sustainable economic growth
4.
A balance of international payments (balanced net exports)
We examined the major economic problems in unit 9, so you should understand the
origins of these objectives. What we need to do now is to consider the policy
alternatives for government and then move on to see how each of the policies can be
used to help achieve the major economic objectives.
Activity:
What additional objectives would you like to see government adopt
apart from the four outlined above?
ECONOMIC POLICY OPTIONS
Government can employ two broad strategies in dealing directly with the economy,
fiscal policy and monetary policy.
FISCAL POLICY
Fiscal policy involves the management of government spending and taxation. If these
two do not balance, then the way in which government finances the difference is also
considered to be part of fiscal policy.
Let’s look at government spending first.
Government spending
We have mentioned earlier that government expenditure has increased considerably
this century. The major areas of expenditure are social security, health, education,
defence and debt interest. Changes in government spending can have considerable
impact on particular departments and the effects can permeate throughout the
economy. Recent cuts in defence spending have had their effects on the armed
services themselves. They have had secondary effects on the defence supply
industries and their employees. The local economies of towns like Aldershot, with a
traditionally high military presence, have also suffered from a reduction in defence
spending.
Changes in government spending not only affect the macroeconomy but have
microeconomic consequences too.
Taxation
The major taxes levied in the UK can be divided into those collected by the Inland
Revenue and those that are the responsibility of Customs and Excise. The important
taxes collected by the Inland Revenue are income tax, corporation tax, capital gains
tax and inheritance tax. Income tax is by far the most important of these.
Of the taxes collected by Customs and Excise, VAT is easily the most significant in
cash terms, followed by the duties we pay on petrol, alcohol and tobacco.
Direct versus indirect taxes
Taxes collected by the Inland Revenue are known as direct taxes and are broadly
based on the ability to pay. Tax rates for these kinds of taxes, as in the case of income
tax and corporation tax, increase on larger incomes and larger profits respectively.
Taxes collected by Customs and Excise are known as indirect taxes and are not based
on the ability to pay. No matter what their income, all consumers purchasing a good
or service that is ‘vatable’, say a video recorder, will pay the same amount in tax.
Everyone buying a litre of petrol pays the same duty regardless of their ability to pay.
Over the last twenty years in the UK there has been a significant shift in the balance
of direct and indirect taxation. The proportion of total tax revenue gathered from
indirect taxation has increased, whilst the proportion from direct taxes has reduced.
Governments have preferred indirect taxes since they are cheap to levy and difficult to
avoid, casting a wide net over society. Whether it would be fairer to levy taxes with
more regard for the ability to pay is a difficult issue. Certainly the introduction of a
poll tax in the UK, which completely disregarded the ability to pay, was not very
popular with a large number of people yet, by the same token, there is relatively little
reaction to increases in VAT and duties.
Taxation as a weapon
Within overall fiscal policy, taxation may be used to achieve a variety of qualitative
changes in the economy. Income tax is the most potent weapon that government
possesses and has the capacity to bring about far-reaching changes in the nature of
society.
High marginal rates of income tax will hit high income-earners. Such taxes could
drive high income-earners abroad, or act as a disincentive to enterprise and effort.
Low tax thresholds and high initial tax rates on low incomes will affect those on low
wages and will discourage those on unemployment benefits from joining the labour
force.
Other taxes could also achieve dramatic effects. Punitive inheritance taxes could
virtually wipe-out inherited wealth. High taxes on investment income, or savings,
could discourage saving and lead to a spendthrift society that thinks only of today and
not of tomorrow. High allowances for married couples could increase the popularity
of marriage. Smoking could be virtually eliminated if a £20 tax per pack of cigarettes
was introduced. Generous tax allowances for child-care could encourage more women
into work.
Activity:
Try to list three other changes in taxation that would have profound
effects on the economy. Outline the effects you think would occur.
It is abundantly clear that the tax system can be used to achieve major economic and
social change in society and, consequently, fiscal policy is a very powerful weapon in
the hands of government.
THE BUDGET
The major instrument of fiscal policy is the annual budget at which government
announces its spending plans for each government department and its taxation plans
for the coming year. The current Chancellor now proposes a three year period. Most
of the business of a budget is trying to balance income with expenditure, raising taxes
to meet increasing expenditure, or trimming expenditure to meet expected income
from current taxes.
A budget that is close to balanced would be described as ‘fiscally neutral’. It will
neither increase economic activity nor decrease it.
If planned expenditure exceeds planned income, then the budget could be
expansionary, depending on how the overspend is financed.
If planned income exceeds planned expenditure, then the budget could be
contractionary, depending on what government does with the surplus.
This is where the issue of financing must be analysed in more detail.
If a government plans to spend more than its income, it has to find the money from
somewhere, just like you or I would. We would borrow to cover our overspending or
use our savings (if we have any). Government is just the same except that
governments rarely build up savings! Consequently, when a government plans to
overspend it creates a need to borrow which is called the Public Sector Borrowing
Requirement (PSBR). History tells us that, more often than not, governments incur a
PSBR which builds up a growing debt over time. This is not just government in the
UK, but it happens in most parts of the world. Perhaps this tells us a little about what
governments like to do most....spend other people’s money!
Debt isn’t necessarily a problem and governments shouldn’t be blamed just for
incurring debts, providing that they can finance their repayments adequately.
Governments, once again, have something in common with individuals in that they
must be able to finance their debts if they incur them, or face undesirable
consequences.
FINANCING THE PSBR
Governments can finance their PSBR in the following ways.
1.
Print money
Governments have control over the printing presses that create money and are often
tempted to use it to finance their debts. The problem with printing money is that it
will increase the money supply and that is inevitably inflationary. This financing
option is not a realistic one unless government wants to create even more problems
for the future.
2.
Borrow from the Bank of England
Since government has its own bank, it would seem reasonable to borrow money from
that bank when it was necessary. Unfortunately, this is also likely to be inflationary
since money will be taken from the Bank of England and put into circulation in the
economy, again increasing the money supply and leading to inflation.
3.
Borrow from abroad
If the government borrows from overseas banks or institutions it again brings money
into circulation in the country which wasn’t there before. This increases the money
supply and is inflationary. In addition, conditions may be applied to the loans and
interest rates may be high.
4.
Borrow from the domestic banking system
Banks are there to lend money, so it would seem reasonable for government to seek
this option if it needs to finance the PSBR. However, there is a problem with this
alternative too. You will recall from unit 8 that when banks lend they create new
money. If government borrows from banks, then new money will be created and you
know that this will be inflationary.
Activity:
5.
Check back in unit 8 and trace the credit creation process to verify how
it creates new deposits in the system.
Borrow from the non-banking sector
This is more promising. If government borrows from the public by attracting money
into National Savings, or by selling government stock and other financial instruments
to individuals, pension companies, insurance companies and other ‘non-banks’, it
attracts money that was already in circulation into the hands of government. When
government then spends this as part of its overspending plans, the money just reenters the system from which it was taken. This does not increase the money supply,
it leaves it unaffected and is not therefore inflationary.
This final alternative is the preferred method of financing a PSBR.
That brings us to the end of the section on fiscal policy. However, you will recognise
in our next section that the issue of financing a government overspend has strong links
to monetary policy.
MONETARY POLICY
Monetary policy deals with the supply and the price of money in the economy.
There is widespread agreement amongst economists that too much money in the
economy is a dangerous thing. The quantity theory of money, which we saw in unit 8,
underlined the theoretical basis for this belief. Keeping control of the money supply
has been an important economic consideration for centuries and continues to be one.
In most developed economies, control of the money supply means control of credit in
the economy, principally bank lending. In the UK, the Bank of England has played an
important role in assisting the government with monetary policy since its creation in
the 17th century. Any analysis of monetary policy is sure to include an analysis of the
role of the Bank of England in our monetary system, its relationship with the
institutions that make-up the financial markets and with government itself.
We saw in unit 8 that the supply of money, which we define as M4, consists mostly of
bank and building society liabilities, in other words, bank and building society
deposits. Control of the money supply logically means the control of the creation of
those deposits thereby maintaining control of the creation of new money.
Where does new money come from?
The answer to this question is simple if we use the ‘counterparts to M4 growth’ tables
published by the Central Statistical Office. These tables show the sources of money
supply increase on a monthly basis and so we need to look at these ‘counterparts’
closely.
The major cause of money supply growth is increases in bank and building society
lending. The ability of these institutions to create credit in the economy has been
investigated previously so this should come as no great surprise.
A second cause of money supply growth derives from government’s fiscal policy. If
government plans to spend more this year than it anticipates in revenue, then this has
the potential to increase the supply of money depending on how that overspend is
financed. Here you see the bridge between fiscal policy and monetary policy, that is to
say, the financing of budget deficits (and surpluses for that matter).
A third cause of money supply growth results from movements of money between our
economy and the rest of the world. If more money is flowing into our economy than is
flowing out of it, the result will be an increase in our money supply. In previous units
we have referred to these flows as ‘net exports’. The paradox here is that strong
export performances by UK businesses may result in increased money supply growth
causing inflationary pressures and another headache for government to deal with.
Economic objectives are not always consistent with each other, so that successful
economic management is bound to involve trade-offs and compromises.
The final part in the ‘counterparts’ jig-saw is the role of government debt sales. As we
established earlier in this unit, the government’s preferred method of financing a
deficit in its budget is to raise money from the non-bank/building society sector. Sales
of government debt to this sector have a neutral effect on the supply of money in the
economy. If government sold less debt than was necessary to cover its overspending,
underfunding as it is called, the result would be to increase the money supply. If
government sold more debt than was necessary to finance its overspending,
overfunding this time, money supply would decrease.
These are the four big influences at work changing the quantity of money in our
economy from month to month.
Activity:
Money supply figures are released every month. Note the latest figures
and when they appear in the media. Consider what the figures tell you
about the economy and about government’s management of the
economy.
Having seen the causes of money supply growth, the main thrust of monetary policy
should be clear.
1.
As part of the overall policy, governments should try not to overspend too
much, they should endeavour to reduce their PSBRs and also ensure that any
remaining borrowing is undertaken in a non-inflationary way.
2.
Governments may also need to keep an eye on their exchange rate since
movements could stimulate net exports and increase money supply growth, or
reduce net exports, decreasing money supply growth.
3.
Most of all, governments need to control bank and building society lending.
The Bank of England and the Treasury have historically been responsible for
monetary policy. The Bank has the power to authorise banks and to take their licences
away. It has, over the years, tried a number of different approaches designed to
control bank lending but is faced with a dilemma. Banks make the bulk of their profits
for their shareholders by lending. Attempts to control the most profitable part of their
operations are strongly resisted or even circumnavigated. The Bank of England now
concentrates on trying to control the demand for money using interest rate policy,
since this seems to be the most effective weapon for achieving its ends.
INTEREST RATE POLICY
The Bank of England has traditionally been responsible for implementing changes in
interest rates on the instruction of the Chancellor of the Exchequer. Since May 1997,
it is now responsible for setting interest rates. The Bank is perfectly placed to
implement changes in interest rates because of its role and relationships with the
financial markets. Below is a summary of a typical day’s activities within those
markets.
Each day there are huge flows of money from the public sector into the private sector.
These represent payments by government of social security cheques and all the other
items of expenditure undertaken by government departments. Money moves out of the
government accounts at the Bank of England and enters circulation. These funds will
find their way into the banking system very quickly as cheques are deposited and
transfers made directly into accounts. There has been an increase in liquidity in the
banking system and with more money around there will be a tendency for the price of
money, i.e. interest rates, to fall.
There are also huge flows of money moving from the private sector to the public
sector on a daily basis. These mostly represent payments of tax by firms and
individuals. Money moves out of private sector bank accounts and into the
government’s accounts at the Bank of England, leaving circulation. There has been a
decrease in liquidity in the banking system and with less money around there will be a
tendency for the price of it, interest rates, to rise.
The objective of the Bank of England is to stabilise interest rates on a day-to-day
basis and so it must intervene in the markets to relieve cash shortages when they
occur and ‘mop-up’ surpluses. If the Bank wishes to push interest rates a little higher
it is in the perfect position to achieve it. It can create a shortage of cash in the market
by selling attractive financial assets to the banks (usually in the form of Treasury
Bills) and it can then provide the liquidity to relieve the shortage on its own terms. If
this involves charging the banks 1% more than they charged them yesterday, we will
eventually see interest rates rising throughout the whole economy. If the Bank thinks
it is time for lower interest rates, then it can charge the banks 1% less when relieving
cash shortages. This will enable banks to lower their rates and interest rates will
eventually fall throughout the economy.
THE EFFECTIVENESS OF MONETARY POLICY
There is some disagreement between economists as to just how effective interest rate
changes are in managing the macroeconomy. Monetarists believe that interest rate
changes can exert a powerful influence on the level of activity in the economy as a
whole. Others believe that the influence of interest rate changes on many economies is
slight, causing minor changes in investment behaviour and not much else.
The effectiveness of interest rate policy rests, essentially, on the interest elasticity of
demand for loans. If demand for loans is sensitive to a change in interest rates, then
small changes in interest rates will lead to significant changes in borrowing
behaviour, making monetary policy a particularly potent weapon.
Of course higher interest rates will discourage some individuals from borrowing to
buy a new house or a car, but interest rate increases have more significance than that
in the UK economy. The reason for this is that a large number of people have variable
rate mortgages.
Higher interest rates mean higher mortgage repayments and a reduced disposable
income. Higher rates therefore, will not only affect future borrowing, they will have
an effect on current consumption too.
Activity:
If you have a mortgage, you might like to consider what effect a one
percent change in interest rates has on your monthly payments.
Higher interest rates will also affect business. As consumers adjust their spending to
cope with reduced disposable incomes, businesses will notice falling sales and a
worsening of their position. Higher interest rates will affect the cost of overdrafts and
other variable rate loans that businesses may have. Firms considering new investment
spending or expansion plans may postpone them if interest rates are high.
The combined effect of higher interest rates on individuals and firms will mean
reduced borrowing and spending throughout the economy. Increases in interest rates
are likely to be used to slow the economy down and to ensure that inflation is kept at
acceptable low levels.
A reduction in interest rates will have the opposite effect. Individuals will be more
likely to borrow to buy the new house or car. People with variable rate mortgages will
enjoy an increase in their disposable incomes, leading to increased spending.
Businesses will experience increasing sales and their own financing costs will be
reduced. Some businesses will decide to invest in new buildings and equipment as
interest rates are now lower.
POLICIES AND OBJECTIVES
Earlier in this unit we saw the major economic objectives of governments. Here they
are once again.
1.
2.
3.
4.
Stable prices
Low unemployment
Sustainable economic growth
A balance of international payments
We have now seen the major policies at government’s disposal, namely fiscal policy
and monetary policy. We must now consider appropriate policies for achieving the
economic objectives above.
1.
Stable prices
To ensure that inflation does not take a grip on the economy government needs to
keep control of money supply growth. In the UK this will involve the use of interest
rate policy. Fiscal policy may be used to back-up monetary policy. If demand is
growing too fast in the economy, putting upward pressure on prices, then it is likely
that government will consider increasing taxation and introducing a contractionary
budget.
2.
Low unemployment
Jobs are created when the economy grows, so low unemployment could be achieved
by a combination of monetary and fiscal policies. Interest rates will have to be low
enough to encourage spending and investment. Taxes will need to be set at a level that
does not damage consumption and encourages enterprise.
3.
Sustainable economic growth
As we mentioned above, low unemployment and growth go hand-in-hand so
appropriate measures have already been covered. Interest rates must be low enough to
encourage spending and investment, whilst taxes should not be set at levels which
would damage consumption and investment. However, if we want controlled growth,
then interest rates should not be too low or the tax system too generous!
4.
A balance of international payments
Some countries have chronic problems in this area and we will look at the issues in
detail in unit 11. As far as the UK is concerned, our performance in this area is largely
determined by the way in which the economy is growing. Strong economic growth
usually produces increased imports and a worsening of the ‘net exports’ situation. To
avoid this problem it will be necessary to ensure that economic growth is controlled.
Interest rates should not be so low as to cause a consumer ‘boom’ and fiscal policy
must not be too ‘loose’. Another major factor at work on net exports is the exchange
rate, which we will discuss in unit 11.
CONFLICT AND COMPROMISE
You will have noticed the difficulty with achieving all of our four objectives at once.
Economic management is a juggling act involving conflicting objectives. Encouraging
growth and employment will worsen net exports and perhaps stimulate inflation.
Keeping prices stable may mean more unemployment than you would wish and lower
economic growth. Problems with international payments will lead to policies that
restrict economic growth and harm employment prospects.
Since it is very difficult to achieve all of our goals at the same time, there have to be
priorities. In the UK for the past twenty years, the priority has been stable prices. In
fact, the battle against inflation is a major concern of most of the world’s developed,
and developing, nations.
Activity:
If your number one priority was to reduce unemployment, what would
be the appropriate economic policy measures to implement?
CONCLUSION
In this unit we have explored the area of economic policy. We began by tracing the
historical development of government’s role in the economy and went on to identify
four traditional economic objectives. We saw how government uses combinations of
taxation, government spending and funding strategies to manipulate the economy.
These tools were referred to as fiscal policy. The control of the money supply was
shown to be another key area of government economic activity, particularly the use of
interest rate policy. Interest rate control is the main weapon of monetary policy. We
saw how government can use its powers to move the economy towards its economic
objectives, but concluded that it may be very difficult to achieve all of the objectives
simultaneously.
REFERENCES FOR UNIT 10
Begg, D et al, Economics, McGraw-Hill, 1997, 5th edition, Ch 16 and Ch 25
Economist, ‘Disappearing Taxes’, May 31st 1997
Economist, ‘On Target’, Sept 6th 1997
Foley, Patrick, ‘Public Finance priorities for a new government’, Lloyds Bank
Economic Bulletin, June 1977
Parkin, M et al, Economics, Addison Wesley Longman, 1997, 3rd edition, Ch 29 and
Ch31
Rodgers, Peter, ‘The new monetary policy and the Bank of England’, The Economic
Review, April 1998
Sloman, John, The Essentials of Economics, Prentice Hall, 1998, Ch 8 and Ch 9