5.

1 Government economic
policy

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

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

Why do governments spend money?

A government can use its spending power to:

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

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

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

The 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

Macroeconomic objectives
Low and stable price inflation
High inflation will:

reduce the purchasing power of peoples 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)

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)

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

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
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

Supply-side policies
Supply-side policies attempt to boost the productive potential of
an economy and increase aggregate supply

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

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.

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.