Prepared by: Rehab Abdelgawad

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Chapter 26: Government economic objectives and policies

Government economic objectives
Most governments have the following economic objectives:
1. Low inflation
 Inflation: is the increase in the average price level of goods and services over time.
2. Low unemployment
 Unemployment: exists when people who are willing and able to work cannot find a
job
3. Economic growth
 Economic growth: Is when a country’s gross domestic product increases – more goods
and services are produced than in the previous year.
4. Balance of payments
 The balance of payments: records the difference between a country’s exports and
imports.
1. Low inflation
The following problems may result due to rapid inflation:
 People’s real income will fall thus workers will demand higher wages so that their real income
increases.
Real income: is the value of income and it falls when prices rise faster than money income.
 Prices of local goods will be higher than prices of goods abroad so people will buy foreign goods
instead. Jobs in that country will be lost.
 Business will not want to expand and thus will not create more jobs in near future. The living
standards are likely to fall.
Low inflation can encourage businesses to expand and it makes it easier for a country to sell its
goods and services abroad (if inflation rate is lower than that abroad)

2. Low unemployment
Unemployment will result in the following problems:
 The total level of output in a country will be lower than it could be
 A high level of unemployment will cost the government a lot as it will pay more unemployment
benefits. There is an opportunity cost for this money spent on unemployment.
Low unemployment will help increase the output of a country and improve worker’s living
standards.

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3. Economic growth
An economy is said to grow if the GDP in the country increases. Growth will lead to higher living
standard of the population.
Gross domestic product (GDP): is the value of output of goods and services in a country in one
year.
Problems that may arise if the economy is not growing:
 Unemployment as output is falling.
 Decline in the average standard of living of the population; the number of goods and services
they can afford to buy in one year will decline.
 Businesses will not expand as people will have less money to spend on their products.
Economic growth makes a country richer and allows living standards to rise.

The business cycle

Economic growth is not achieved steadily ever year. It follows a pattern which has four main stages;
growth, boom, recession and slump/depression
GDP ($)

Years

Explanation of the trade cycle:

Growth: GDP is rising
Unemployment falling
Higher living standards
Businesses doing well at this time
Boom: cause by too much spending
Prices rise quickly
Shortage of skilled workers
Business costs will be rising
Businesses uncertain about the future

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Recession: caused by too little spending

GDP falls
Businesses experience falling demand and profits
Workers may lose their jobs
Slump: it is a serious and long-drawn-out recession
Unemployment reaches very high levels
Prices may fall
Businesses will fail to survive this period
Governments try to avoid the economy moving towards recession or a slump and reduce the
chances of a boom. A boom with rapid inflation will result in recession.

4. Balance of payments
Government aims to achieve equality or balance between its exports and imports over a period of
time.
Exports: are goods and services sold by one country to people and businesses in another country.
They bring foreign currency into a country.
Imports: are goods bought in from other countries. It leads to foreign currency flowing out of the
country.
A deficit occurs if the value of country’s imports is greater than the value of its exports and would
lead to the following problems:
 Government runs out of foreign currencies and it may have to borrow from abroad.
 The exchange rate depreciates
o Exchange rate: is the price of one currency in terms of another currency.
o Depreciation in exchange rate: is the fall in the value of a currency compared with
other currencies.

Government economic policies

Governments have power to control the economy through raising taxes and spending on a wide
range of services and state benefits. They use their power to achieve their economic objectives. The
economic policies are:
1. Fiscal policy – taxes and government spending
2. Monetary policy – interest rates
3. Supply side policies

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1. Fiscal policy: taxes and government

The government will collect taxes from individuals and businesses to use it on its expenditure on
schools, hospitals, roads, defense, and so on.
There are two main types of taxes:
a. Direct taxes: are paid directly from incomes – for example, income tax or profits tax.
b. Indirect taxes: are added to the prices of goods and taxpayers pay the tax as they purchase
the goods – for example, VAT

a. Income tax
This is a tax on people’s income. Usually the higher the income the greater will be the amount of tax
they have to pay to the government (progressive tax).

How would businesses be affected by an increase in the rate of income tax?

less less businesses businesses

increase in disposable money to unemployment
have falling produce
tax rate income spend rises
sales fewer goods

Which businesses are likely to be most affected by this increase in income tax rates?
Businesses which produce luxury goods are likely to be most affected than those producing essential
goods and services.

b. Profit tax (or corporation tax)

It is a tax on the profits made by businesses usually companies.
How would an increase in the rate of corporation tax affect businesses?

businesses have less money to new projecs

difficult o
lower profits reinvest in the may have to be
expnad
after tax business cancelled

few owners will

businesses have less dividends to
share price want to start
lower profits pay for
could fall their own
afer tax shareholders
business

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c. Indirect taxes
Indirect taxes are added to the prices of products we all buy, such as VAT. They make goods and
services more expensive for consumers. Governments usually avoid putting these taxes on essential
items such as food, as it would be considered unfair to poorer consumers.
How would businesses be affected by an increase in an expenditure tax?

prices of goods consumers buy fewer demand on

would rise fewer items products

businesses
prices of workers' real
may be business cost
goods would income
pressurized to rises
rise declined
raise wages

d. Import tariffs and quotas

Governments reduce the import of products from other countries by putting import tariffs / tax on
them. This also raises money for the government. They may also introduce an import quota which is
a physical limit to the quantity of a product that can be imported.
How would businesses in a country be affected if the government put tariffs on imports into the
country?
increase in sales of local
imported goods will be expensive businesses producing similar
goods

higher costs for

imported raw
businesses using businesses will raise
materials will be
imported raw their prices
expensive
materials

busineses exporting
other countries to these countries
import tariff
retaliate will sell fewer goods
than before

e. Changes in government spending

When governments want to boost economic growth, they can raise their spending on education,
health, defense, law and order and transport. This will create more demand in the economy, more

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jobs and GDP will increase. If the government wants to save money they will cut expenditure on
these programs.
2. Monetary policy – interest rates
Monetary policy: is a change in interest rate by the government or central bank.
In most countries the government through its central bank fixes the interest rates (cost of
borrowing money) to control the economy.

What are the effects of a higher interest rate?

less dividends less retained

more payment to banks by firms reduces their
paid to profits for
with existing variable interest rate profits
shareholders exapansion

delay in expansion plans of existine

reduce investtments few factories and
businesses - enterpreneurs hoping to start
in business activity offices are built
a new business will not be able to borrow

consumers with morgages reduces their available demand for all goods and
will pay more to banks income services could fall

fall on demand for

these businesses reduce workers may be made
expensive products like
output redundant
houses and cars

foreign banks and increasing imported goods will

investors encouraged demand on the exchange rate be cheaper and
to deposit money in country's appreciation exported ones will be
this country currency expensive

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3. Supply side policies

The aim of these policies is to make the country more efficient, increase the competitiveness of a
country’s industries against those from other countries. This would allow their businesses to expand,
produce more and employ more workers. The following supply side policies are trying to improve
the efficient supply of goods and services.
 Privatization: aims at using profit motive to improve efficiency
 Improve training and education: improving the skills of workers especially for important
industries such as computer software which are often very short of skilled staff.
 Increase competition in all industries: this is done by reducing government controls over
industry or by acting against monopolies.

How business might react to changes in economic policy

Government policy change Possible business decision Problems with this decision
Increase income tax Lower prices on existing Less profit on each item sold
products to increase demand which reduces gross profit margin

Produce cheaper products to Brand image of the product may

Increase tariffs on imports
allow for lower prices
Focus on selling in domestic
markets as local goods will
seem to be cheaper
be damaged by using cheaper
versions of the product
It might still be more profitable to
export

Switch from buying imported Foreign materials and components

materials and components to might be of higher quality
locally produced ones
Increase interest rates Reduce investments so future Market share may be lost as other
growth will be less companies may still grow

Develop cheaper products that Consumers may think that quality

consumers will be better able and brand image are lower
to afford

Sell assets for cash to reduce These assets might be needed for
existing loans future expansion