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Maktab Sains Paduka Seri Begawan Sultan Economics Form 5, Economic Policy Detinition Economic policy refers to the economic objectives of the government and the ways in which it tries to achieve those objectives. Objectives of economic policy: 1. To reduce unemployment ‘To create a situation where people who are willing to work able to find jobs within a reasonable period of time. 2. To achieve low and stable i tion in the general price level ‘This means that, inflation should be brought under control and kept under control. 3. To encourage economic growth People have come to expect thal, as the years go by, they will be able to enjoy such things as higher real wages, better housing, more modem hospitals, improvement in education system and so on. These things are possible when real income per head is, increasing, that is, when there is steady economic growth, 4, To secure a favourable balance of payments. ‘A country which persistently spending more on foreign goods and services than it is earning from its exports will be getting deeper and deeper into debt with the rest of the world, One of the aims of economic policy is to prevent this from happening, ‘This does not mean that balance of payments should never be in deficit. It means that the deficits oF some years should be offset by surpluses in other years. ‘The Instruments of economics policy ‘The methods or techniques which the government uses to try and achieve its economic aims are deseribed as instruments of economic policy. Fiscal Policy ‘A government is using fiscal policy when it involves in changing the level of government ‘spending and/or taxation to affect the level of aggregate demand, So in other words, fiscal policy is a government policy with regard to public spending, taxation land borrowing. Government spending is part of total spending or aggregate demand in the economy; a cut in taxes will effect total spending. If the government cut income tax, workers would have more money in their pockets, thus, increasing the aggregate demand. ‘Most countries, like the UK spends more than it receives. So it has to borrow money. So an, increase in government borrowing will lead to more spending in the economy, A tall in ‘government borrowing (less government spending or higher taxes) will lead to a lower level of aggregate demand. Changing the level of aggregate demand affects the four objectives. More spending in the economy form resulting from increased government borrowing (higher public spending or lower taxes) will have the following effects: + Unemployment wil fall as more jobs are created. + Higher economic growth because national income will increase as a result of increase in spending. + _ Inflation will increase, as higher demand will allow firms to push up prices. + The balance of payment will get worse because part of the extra spending in the economy will go on imported goods. Equally, if the government tightens its fiscal policy by borrowing less, this will tend in the short term to put the economy into recession — raising unemployment, lowering growth, but reducing inflation and the current account deficit. Monetary Policy ‘A government policy with regard to the level of interest rates and the growth of the money supply. ‘There are a large number of different interest rates in the economy. For instance, there are mortgages, interest rates, credit card interest rates, bank rates and interest rates on long-term, government borrowing, The money supply is not made up of just money and coins but of bank deposits and building Society deposits too. The money supply and rate of interest are also linked. Increase in the money supply, all other things remaining the same, will lead to a fallin interest rates. On the other hand, a fall in the money supply will ead to a rise in interest rate. Reasons for Controlling the Money Supply and Interest Rates. ‘There are three main reasons: 1. Monetarists believe that inflation is caused by excessive increases in the money supply. Controlling the money supply is therefore the key to controlling inflation. 2. Changing Interest rates will affect the level the level of total spending or aggregate ‘demand in the economy. if interest rates go up, consumers will borrow less because the repayments on loans will be higher. Firms too will be hit by higher repayments on existing loans and will cut back on investment spending Falling intorest rates will have the opposite effect; consumption and investment will tend to rise. Increase aggregate demand will then lead to a boost in the growth and a reduction in unemployment, 3. Interest rates are a key weapon to stabilize the value of pound against other foreign currencies in the Exchange Rate Mechanism. I the interest rates in London go up, more foreigners will want to save their money in London rather than in other countries. So they buy more pounds than before to invest in London money markets. This greater demand {or the pound pushes the value of the pound up. On the other hand. a fallin interest rates creates selling pressure on the pounds, 80 pound tends to weaken. Techniques of Monetary Policy Government tends to operate monetary policy through the Central Banks. The central bank for UK is the Bank of England. Bank of England operates in different ways to control the money supply and interest rates: 1. Open Market Operations. Here the Bank of England either borrows more money than it needs to finance the PSBR. (government borrowing) or it repays money owed by government to the rest of the economy. Borrowing more money than is needed is called Overfunding. The Bank of England borrowing money and not spending it reduces the money supply, which therefore pushes up the rate of interest. 2. Monetary Directives. Here, the Bank of England would order the banks not to lend out more than a certain ‘amount. Or a limit would be placed on the growth of deposits of the banks. Restricting lending and borrowing by banks should help restrict growth in the money supply, 3. Funding. I is @ process of changing short-term government borrowing to long-term government borrowing. One effect is likely to be a tise in long-term interest rates and a fall in short term interest rates, as demand for long term and short term funds changes. Direct Controls. The government has the power to place legal controls on such things as wages, prices, rents and dividends. it can also uses it power to grant planning permission to control the number, type and location of all kinds of building, Public Ownership government owns several major industries (nationalised industries) it will be able to control the economy much more effectively. it can create more jobs by investing heavily in these industries. It Could also affect the cost of production in other industries by controlling the prices charged by the nationalised industries (electricity). Unemployment: If unemployment is rising because the economy is going into recession, then the government spending can stimulate the economy by: + Cutting the interest rates and encourage a rise in borrowing: + Spending more itself or cutting taxes thus increasing government borrowing: + Devaluing the pound, which should stimulate exports and make it easier for UK firms to ‘compete against foreign imports; + Increasing quotas and tariffs on imported goods to keep out imports and provide more work for UK companies.