Government Economic Policy - Essay Example

Objectives of Government Economic Policy and the Instruments It Uses To Carry Them Out: Introduction: Economic policies are measures taken by the government to influence the behaviour of an economy, there exist two types of policies that government use to influence the economy and they include the fiscal policy and the monetary policies. Fiscal policies include taxation and government spending; the monetary policy will include money supply and other measures that influence the amount of money circulating in an economy. These two policies may sometimes prove to be harmful to an economy in that many scholars argue that an economy should be left at a state of laissez faire. This is to say that a government should not interfere with the working of an economy. These policies however have proved to be useful in the case where an economy is faced by high inflation or a recession; in this case the government will use an expansion ally or a contraction ally monetary or fiscal policy. Governments main objectives of using this type of policies is to stimulate the aggregate demand, reduce inflation, improve a recession, collection of revenue to provide public goods, improve on market failure caused by externalities or even steer the economy to achieve higher growth. Objectives of government economic policies: as earlier discussed the main objectives of government policies is to improve on a recession, depression, inflation, solve on market failure caused by positive and negative externalities, collection of government revenue to provide public goods and to stimulate aggregate demand. These policies will also be used in case of a boom in the economy. The policies can be used together to improve a situation or one of them used. (a)Inflation: Inflation can be defined as the consistent rise in the general prices of goods for a fairly long period of time, the most used indicator of inflation is the consumer price index. Inflation is caused by demand push according to Keynes; he argued that inflation will exist when the aggregate demand exceeds aggregate supply. The excess demand can be from the real sector or the monetary sector. The real sector consist of the model that is used to calculate the national output, Y = consumption + government spending + investment + exports - imports. if marginal propensity to consume increases then aggregate demand will increase leading to inflation, if government spending increases then this will increase aggregate demand also if the level of investment increases this will cause an increase in the aggregate demand and finally if the exports increase then aggregate demand increases and this can be seen when there is a boom caused by increased exports. The monetary sector means that in the case where the money supply in an economy increases this triggers inflation. The other type of inflation is the cost push inflation caused by an increase in the cost of production due to an increase in the price levels of Raw materials. an increase in the cost of production will lead to high unit cost of production, these high prices are passed on to the consumers, therefore their real wages decreases and trade unions come in and fight for high wages and if they are granted higher wages the cost of production further increases. In case of inflation the government will come in and interfere with the economy, in this case the government will simply use monetary policies to improve the situation, they will increase the rate of interests so that the amount of money in circulation in the economy reduces, the government will also improve this by reducing the supply of money in the economy, this can be achieved through increasing the bank reserve ratio held by a central bank. This can be diagrammatically shown as follows; When inflation increases from 0 to 1 then the real GDP falls from y0 to y1, if y0 was the potential output then the economy is operating below potential output, to improve this government will reduce the interest rates the interest rates so that the level of real GDP level gets back to the potential level. (Snowdon (1997)) (b) Policies used in a Recession: In case of a recession in an economy caused by a stock market crash that causes a demand shock, monetary policies will be used is to lower the level of interest rates in order to increase the level of spending which will in turn increase the level of aggregate demand. The role of the government in this case is to maintain economic stability and achieve long term objectives. When the level of spending in an economy goes down then the level of output of an economy is lower than the level of potential output. More severe recessions are known as depressions like the great depression of 1930's. The government will choose to reduce interest rates to increase spending, the aggregate demand will shift outward and the real output will increase up to the potential output The aggregate demand curve shifts from AD1 to AD2 due to the decrease in the level of interest rates, therefore the real output shifts from Y0 to Y1 which is the potential output. (Bach (1971)) (c) Policies used in a boom: when the level of government spending increases or the level of export value increases this causes what is known as a boom, monetary policies must be applied to improve this situation, in case of a boom the central bank will try to move the economy to the new potential level of output of the economy, this is done through increasing the level of interest rates. An increase in government spending that does not affect the level of national output is inflation ally and therefore the central bank will respond by increasing the level of interest rates as shown below; When there is a boom in an economy as shown in diagram A, the aggregate demand shifts outward, but does not affect the level of output, inflation will rise gradually and because of this the will increase interest rates to lower the level of aggregate demand as shown in diagram B where aggregate demand shifts from AD1 to AD2. In the case where a boom changes the level of output to a higher level the central bank increases the level of interest by a small portion so as to achieve the high levels real output in the economy. (Bach (1971)) (d) Policies in a depression: The great depression that lasted from the year 1929 to 1939 was one that was characterised by low production, low sales, high business failure and high levels of unemployment. In these years every nation was affected and therefore the government has to apply its policies to improve this situation. Less severe depressions are known as recessions, if an economy is in depression then the rates of interest are very low, the level of output is low and therefore no way to stimulate aggregate demand. An economy however can further reduce the interest rates and increase government spending to improve the situation. (e) Policies to provide public goods: The government will collect taxes from the public in order to provide public goods, the government therefore needs to acquire revenue in order to provide this goods and services, the government therefore will use taxation as a source of revenue to finance this projects, it will use direct or indirect taxes. United Kingdom policy objective: According to the 1999 UK policy report the government fiscal objective was to maintaining sound public finance, budgets taken on taxation and government spending had the following objective: Ensure sound public finance and that spending and taxation impact fairy within and across generations. The government meets its key taxation and spending priorities while avoiding unsustainable debts. The generation that benefits from public debts also meets the costs of services they consume. Allowing the automatic stabiliser to play its role in smoothing the path of the economy Providing support to the monetary policies through the use fiscal policies (www.hm-treasury.gov.uk) There are four principles that govern fiscal policies and they include: Transparency in the setting of public policies whereby there is the publication of public accounts Stability in fiscal policy making process and the way they impact on the economy Responsibility in the management of public finances Fairness across and between generations Efficiency in designing and implementation of fiscal policies (www.hm-treasury.gov.uk ) Conclusion: From the above discussion government has a major role to play in determining the outcome of an economy, the major objectives for a government economic policy is to maintain stability and enabling macro economic environment. Governments will aim at achieving higher levels of output using its policies. Many governments use their policies to maintain a certain level of inflation; governments will also try to improve on a recession or a depression when such a phenomenon occurs in the economy using policies. however many scholars argue that an economy should be left at a state of laissez faire where the free market will automatically adjust itself, during the 1930's great depression economies were unable to apply the policies to bring back the economy to normal, however this policies are used in our day to day life by the government to maintain stability. References: Brian Snowdon (1997) Macroeconomics, Rout ledge publishers, UK George Leland Bach (1971) Making Monetary and Fiscal Policy, Heinemann publishers USA Philippe Burger (2003) Sustainable Fiscal Policy and Economic Stability: theory and practice, Edward Edgar Publishing, UK The Way Forward: Framework for Economic Development in Scotland (2006) retrieved on 11th December 2006, available at www.scotland.gov.uk UK Fiscal Policy (1999) retrieved on 11th December 2006 available at www.hm-treasury.gov.uk Read More