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5. Government macroeconomic interventions (AS Level)

5.1 Government macroeconomic policy objectives

Government intervenes in the macro economy to achieve different macroeconomic objectives.

Government intervenes in the macro economy using different macroeconomic policies like fiscal policy,
monetary policy and supply side policies. Macroeconomic policies are the policies designed to achieve
the macroeconomic objectives.

The main objectives of government macroeconomic policies are:

• Achieving full employment
• Achieving low and stable inflation
• Correcting Balance of Payment (BOP) disequilibrium
• Avoiding fluctuations in exchange rate
• Achieving steady and sustained economic growth
• Achieving sustainable economic development

5.2 Fiscal policy

Fiscal policy is the use of Government spending and taxation to influence the Aggregate Demand (AD)
so as to achieve the macroeconomic objectives.

Expansionary fiscal policy (Reflationary fiscal policy) involves increasing the government spending and
reducing the tax rate to increase the AD. For example, if the government aims at achieving the
objective of full employment and high economic growth, it should use the expansionary fiscal policy.

Contractionary fiscal policy (Deflationary fiscal policy) involves reducing the government spending and
increasing the tax rate to reduce the AD. For example, if the government aims at achieving the
objective of low and stable inflation and equilibrium in the BOP position, it should use contractionary
fiscal policy.

If the government deliberately (intentionally) changes its spending and taxation, it is referred to as
discretionary fiscal policy. A government may also allow the automatic stabilizers to work into the
economy. They are the forms of government spending and taxation (tax revenue) that change without
any deliberate action taken by the government to influence the AD. For example, during recession,
government spending on unemployment benefits automatically increases as there is large number of
unemployed people while the tax revenue from direct and indirect taxes falls automatically as income,
profit and expenditure decreases.
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Fig: Automatic stabilizers

In the figure, the economy is operating below full employment at Y with a huge gap between
government spending and taxation. As GDP rises, government spending on unemployment benefits falls
while tax revenue rises with more people in employment and so receiving more income.

Meaning of government budget

The annual budget of a country is the statement of fiscal policy. In a budget, government outlines its
spending and taxation plans for a fiscal year.

Distinction between a government budget deficit and a government budget surplus

A budget surplus arises when the tax revenue exceeds the government spending. That is, budget surplus
occurs when a government reduces its spending. Balanced budget is where the government spending
and tax revenue are equalized. Budget deficit arises when the government spending exceeds the tax
revenue. That is, budget deficit occurs when a government increases its spending. The budget deficit
that arises due to automatic stabilizers is called cyclical deficit. The budget deficit that arises when the
government is committed to spend more than its tax revenue is called structural deficit.

Structural deficits will eventually pose a problem for any government. Deficits are financed by
borrowing, and continued borrowing leads to an accumulation of debt. The ability to pay off this debt is
measured by a country's debt relative to its GDP, referred to as its debt-to-GDP ratio.
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Meaning and significance of the national debt

National debt is the total amount of money which a country's government has borrowed. It is the
financial obligations of a national government resulting from deficit spending.

The national debt level is one of the most important public policy issues. When debt is used
appropriately, it can be used to foster the long-term growth and prosperity of a country.

Consequences of national debt

 Lower national savings and income

With the government borrowing more, a higher percentage of the savings available for investment
would go towards government securities. This, in turn, would decrease the amount invested in private
ventures such as factories and industries, making the workforce less productive. This would have a
negative effect on wages. Because wages are determined mainly by workers' productivity, the reduction
in investment would reduce wages as well, lessening people's incentive to work.

 Interest Payments Creating Pressure on Other Spending

High government debt reduces the amount of tax revenue available to spend on other governmental
services because more tax revenue will have to be paid out as interest on the national debt. Over time,
this will cause people to pay more for goods and services, resulting in inflation.

As the government debt mounts, the government will spend more of its budget on interest costs,
reducing the public investments.

 Decreased Ability to Respond to Problems

Governments often borrow to address unexpected events, like wars, financial crises, and natural
disasters. This is relatively easy to do when the national debt is small. However, with a large and growing
national debt, government has fewer options available.

 Greater Risk of a Fiscal Crisis

If the debt continues to climb, at some point investors will lose confidence in the government's ability to
pay back borrowed funds. Investors would demand higher interest rates on the debt, and at some point
interest rates could rise sharply and suddenly, creating broader economic consequences.
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 Taxation

 Types of taxes: direct/indirect, progressive/regressive/proportional

Direct and indirect taxes

Direct taxes are those whose burden cannot be shifted from one person to another. The impact (initial
burden) and incidence (ultimate burden) of direct taxes fall on the same person. Some examples of
direct taxes are income tax, wealth tax, inheritance tax, gift tax, road tax, capital gain tax etc.

Indirect taxes are those whose burden can be shifted from one person to another. These are the taxes
imposed on the producers which are shifted to the consumers by adding them to the prices of the
products. That is the impact (initial burden) of indirect taxes is borne by the producers while the
incidence (ultimate burden) is borne by the consumers. Some examples of indirect taxes are VAT, GST,
tariff, excise tax, custom tax etc.

Types of Indirect taxes

Indirect taxes are of two types- specific and ad valorem.

Specific tax is imposed per unit of any good produced or consumed. For example, $2 per unit of good x
produced or consumed. Specific tax causes a parallel shift in the supply curve to the left. Examples
include excise duties. They are the taxes on particular products. Some excise duties are sometimes
referred to as sin tax. Sin taxes are imposed to discourage people from buying products that are not
good for their health.

Ad valorem tax is imposed as a percentage of prices of the goods produced and consumed. For
example, 20% of the price of any good produced or consumed. Ad valorem tax causes a pivotal (non-
parallel) shift of the supply curve towards the left.

Fig: Effect of specific and ad valorem tax

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Progressive, regressive and proportional

 Progressive tax system

It is where the tax rate (% of income paid in tax) increases with an increase in income and vice versa.

Calculation:

Individual ‘A’ lives in a hypothetical economy with the tax rates shown in the table and his annual
income is $80,000. The following table shows the calculation of the tax paid by individual ‘A’.

Individual A’S taxable Income Marginal rate of Calculation Tax paid

($80,000) taxation
Up to $10,000 0%
Income between $10,000 and 30%
$25,000
Income between $25,000 and 40%
$50,000
Income above $50,000 ($30,000) 50%
Total income $80,000

 Proportional tax system

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It is where the same tax rate is imposed on all levels of income. For example, a 20% income tax.

 Regressive tax system

It is where the tax rate decreases with an increase in income and vice versa. That is, those on lower
incomes pay higher proportion of their income in tax to the government than those on higher incomes.
For example, the indirect taxes imposed on goods / services are regressive in nature

Example:
A’s income=$100
B’s income =$200
Tax paid on purchase of good x = $5
% of income paid in tax by A = 5%
% income paid in tax by B =2.5%

Fig: Progressive, proportional and regressive tax system

Rates of tax: marginal and average rates of taxation (mrt, art)

The marginal rate of taxation (mrt) is the proportion of extra/increased income paid in tax.
Mathematically,

Change∈tax Δt
Marginal rate of taxation (mrt) = =
Change∈income Δy

Example, if a person earns an extra income of $100 and $30 is paid in tax then, the marginal rate of
$ 30
taxation is = 0.3 (30%)
$ 100

That is, 30 % of the extra income of $100 is paid in tax.

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The average rate of taxation is the proportion of a person’s total income that is paid in tax.
Mathematically,

Amount paid ∈tax t

Average rate of taxation (art) = =
Total income y

$ 10,000
Example, if a person earns $50,000 and $10,000 is paid in tax then, average rate of taxation is
$ 50,000
= 0.2 or 20%.

That is, 20% of the person’s total income of $50,000 is paid in tax.

Reasons for taxation

 To raise revenue to finance government spending on merit goods such as education, health care
services and public goods.
 The government also imposes taxes to influence aggregate demand. If the government wants to
reduce the aggregate demand it will raise the tax rates. For example, if the government aims at
achieving the objective of low and stable inflation, it will raise the tax rate to reduce the
aggregate demand.

On the other hand, if the government wants to increase the aggregate demand, it will reduce
the tax rates. For example, if the government aims at achieving the objective of full
employment, it will reduce the tax rate to increase the aggregate demand.

 A government may use progressive income tax to reduce income inequalities. Progressive
income tax narrows the gap between the disposable income of the rich and people on low
incomes. The gap could be further narrowed by the government using some of the tax revenue
to provide monetary benefits to those on low incomes.

 Taxes are also imposed to discourage the consumption of certain products. For example, taxes
are imposed on demerit goods in order to improve people’s health and environment.

 Taxes are also imposed on imports to discourage imports and switch the consumer spending
from foreign goods to domestic goods.
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Types of government spending

Government spending can be divided into the following types:

 Transfer payments

A transfer payment is a payment of money for which there are no goods or services produced and
exchanged. Transfer payments commonly refer to efforts by the governments to redistribute money to
those in need. Government spending on transfer payments includes spending on unemployment
benefits, state pensions, interest payments on national debt etc.

 Current spending

Current government spending is spending on goods and services to provide state-financed services.
Current government spending covers, for instance, the spending on wages of teachers employed in state
schools and medicines used in state hospitals.

 Capital government spending

Capital government spending is the spending on capital goods used in the public sector. Capital
government spending includes, for instance, spending on building state schools and hospitals.

Government spending can also be divided into exhaustive and non-exhaustive spending. Exhaustive
government spending covers current and capital spending. It is the spending which uses resources and
is counted in aggregate demand and GDP.

Non-exhaustive government spending is spending on transfer payments. This spending does not
involve the government deciding how resources are used. The people who receive the payments make
the decision about how to use the resources.

Reasons for government spending

 To influence the aggregate demand

 To influence the aggregate supply
 To avoid poverty and reduce income inequality
 To provide merit goods and public goods and overcome the problem of market failure
 To gain political popularity
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AD/AS analysis of the impact of expansionary and contractionary fiscal policy on the
equilibrium level of national income and the level of real output, the price level and
employment

Expansionary fiscal policy involves increasing government spending and/or decreasing taxes.
Doing any of these things will increase aggregate demand, leading to a higher output, higher
employment, and a higher price level.

On the other hand contractionary fiscal policy involves reducing government spending and
increasing tax rates. It reduces the level of AD. This fall in AD leads to a lower output, lower
employment and a lower price level.

Fig: Effect of expansionary and contractionary fiscal policy on AD/AS model

5.3 Monetary policy

Monetary policy is the use of money supply and interest rate to influence the AD so as to achieve the
macroeconomic objectives.

Expansionary monetary policy (reflationary monetary policy) involves increasing money supply and
reducing interest rate to increase the AD. For example, if a government aims at achieving the objective
of full employment and high economic growth, it should use expansionary monetary policy.

Contractionary monetary policy (deflationary monetary policy) involves reducing money supply and
increasing interest rate to reduce the AD. For example, if a government aims at achieving the objective
of low and stable inflation and equilibrium in the current account of BOP, it should use deflationary
monetary policy.
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AD/AS analysis of the impact of expansionary and contractionary monetary policy on the
equilibrium national income and the level of real output, the price level and employment

Expansionary monetary policy involves increasing money supply and reducing interest. Doing any of
these things will increase aggregate demand, leading to a higher output, higher employment, and a
higher price level.

On the other hand contractionary monetary policy involves reducing money supply and increasing
interest rate. It reduces the level of aggregate demand leading to lower output, lower employment and
a lower price level.

Fig: Effect of expansionary and contractionary monetary policy on AD/AS model

5.4 Supply-side policy

Supply side policy is the policy designed to increase the Aggregate Supply (AS) by improving the
workings of product market and factor market. It may increase or reduce the government intervention
in the price system.

Market-based supply side policies limit the intervention of the government and allow the free market
to eliminate imbalances. The forces of supply and demand are used to eliminate the imbalances.
 Privatisation and deregulation
 Reducing income tax rates.
 Deregulating Labour Markets.
 Reducing the power of trades unions.
 Reducing unemployment benefits.
 Deregulate financial markets.
 Increase free-trade.

Interventionist supply side policies rely on the government intervention in the market.
•increasing spending on the education and training of workers
•increasing spending on infrastructures
•provision of subsidies to private producers
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AD/AS analysis of the impact of supply-side policy on the equilibrium national income and the
level of real output, the price level and employment

Supply-side policies have the ability to increase labor productivity through decreasing income taxes,
increasing the mobility of labor, and through various training programs. This, in total, increases the real
output of the economy.

Supply-side policies can help reduce inflationary pressure in the long term because of efficiency and
productivity gains in the product and labor markets. They can also help create real jobs and sustainable
growth through their positive effect on labor productivity and competitiveness.

Fig: Effect of supply side policy