How can government try to..

How can government try to manage the economy?

There are two main ways: fiscal policy and monetary policy.

Fiscal policy = taxation largely, plus some subsidies. This label also includes government spending these days; once it was separated out in text books as “direct action”, “government spending” or a similar phrase.

Monetary policy = changing the money supply or the rate of interest to alter the level of aggregate demand.

NOTE: Since 1997 this power was removed from government and given to the Monetary Policy Committee of the Bank of England. The government is represented on this and can strongly influence its decisions but not control it.

Both main ways of managing have certain implications attached:

Fiscal policy: tends to have strong resource allocation effects, for example if the government increases the tax on cigarettes, it hits smokers only; if it increase income tax, it ignores those on low incomes who do not pay this tax.

Fiscal changes are usually done in an annual budget in April – so a desired change can be slow to implement, as we may have to wait until April to announce it! Some changes to come might be leaked beforehand. In addition to the budget proper, the country may
have a mini-budget around October. Once a change is announced in the budget, the effect is virtually immediate.

Monetary policy: the government no longer can do this directly – despite its ability to influence the views of the Monetary Policy Committee.

The effects of monetary policy may be slow and it can take between 6 months and 18 months to get the full impact of interest rate changes.

What does government actually do?

1. It may try to increase aggregate demand: it might do this if it feels that unemployment is too high, and inflation is reasonably low; or the standard of living could safely be increased; or economic growth could be higher.

- To increase demand:

- Fiscal policy:
government could decrease some or all (unlikely!) taxes;
and/or spend more government money (the “G” in “C+I+G”
which is the domestic component of aggregate demand).

- Monetary policy: government could lower the rate of interest by persuading the Monetary Policy Committee to act.

2. Alternatively, it may try to reduce aggregate demand: it might do this if it feels that inflation is too high, the employment level is too high, or the balance of payment is poor (imports exceed exports), i.e., we are in the middle of a boom and the government wishes to moderate it.

3. Supply side: the government might try to push the aggregate supply curve out and to the right. This would reduce inflationary pressure.

The government cannot attain all its goals at the same time because

We are not yet smart enough to know how to do this! (And probably never will be.)

Some goals contradict others: to get more of one, we must have less of the other – there is a “trade off” between the two.

Mathematically, it is theoretically not possible to attain ten goals with only two policy instruments.

Examples of what we cannot get at the same time because of conflict
High growth with a good balance of payments (fast growth sucks in imports). Low inflation with low unemployment - but we are better at this than we once
were!

High growth with more equal income distribution. Economic growth naturally causes a widening of income distribution as those who are better, luckier, more intelligent, stronger, better connected, happen to be in the right place at the right time….. pull ahead of the pack. The government may choose to step in to try to equalise it more (New Labour has so far chosen not to do so). It is possible that a wider income distribution actually assists the
attainment of higher economic growth (which is part of the supply side view).

In other words, the goals interact. The pursuit of one goal can harm (or sometimes assist)
the attainment of a different goal. We live in a complex world!

Much of the rest of unit 3 is simply explaining the details of the above. What each item
is; how we define individual items; what the government does with them and how it does this; what diagrams we can draw to illustrate the workings of the economy and then use
them to analyse what is currently happening or what might be done if some other equilibrium position is desired.