Economics | Government policies

Welcome to Government Policies!

Hi future Economist! This chapter is incredibly important because it moves us from understanding how markets work to understanding how the government tries to fix them and manage the entire national economy.

Think of the government as the chief mechanic for the economy. They have a specific set of goals (what they want the economy to look like) and a toolbox full of policies (the actions they take). By the end of these notes, you’ll know their main goals and the three big tools they use: Fiscal Policy, Monetary Policy, and Supply-Side Policies.

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Section 1: The Aims of Government Policy

Why does the government interfere? To achieve certain macroeconomic objectives. While different countries prioritize different things, IGCSE Economics requires you to know the 'Big Four'.

The Four Key Objectives (P.E.G.B.)

It’s helpful to remember these four goals, sometimes called the "Magic Square" of economic policy.

1. Price Stability (Controlling Inflation)

The government aims for low and stable inflation (usually around 2% to 3% in developed economies).

• What it means: Prices shouldn't rise too quickly.
• Why it matters: High inflation reduces the purchasing power of money and creates uncertainty for businesses and consumers.
• Key Term: Inflation is the sustained rise in the general price level.

2. High and Stable Employment

A key goal is to minimize unemployment and ensure that most people who want a job can find one.

• What it means: Getting as close as possible to full employment (recognizing that some unavoidable, temporary unemployment—like people changing jobs—is normal).
• Why it matters: Unemployment wastes productive resources (human capital), reduces national output (GDP), and requires the government to pay more in welfare benefits.

3. Sustainable Economic Growth

The government wants the economy to grow, meaning the total output of goods and services (Gross Domestic Product, or GDP) increases year after year.

• What it means: A sustained increase in the potential output of the economy.
• Why it matters: Growth increases national income, raises living standards, and provides the government with more tax revenue to fund public services (like schools and hospitals).

4. Balance of Payments (BOP) Stability

This relates to the country's transactions with the rest of the world.

• What it means: The country’s income from exports and investments should roughly balance its spending on imports and foreign payments.
• Key Issue: A persistent Balance of Payments deficit (importing much more than exporting) can lead to problems with the value of the country’s currency and may require excessive borrowing. The goal is long-term stability.

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Section 2: The Government Policy Toolbox

To achieve the goals above, governments use three main types of policy. We categorize them based on who controls them and how quickly they take effect.

The Three Main Policy Types

1. Fiscal Policy (Managed by the Treasury/Government)

Involves adjusting government spending and taxation to influence aggregate demand (total spending in the economy).

2. Monetary Policy (Managed by the Central Bank)

Involves adjusting the cost of borrowing, primarily through changes to interest rates.

3. Supply-Side Policies (Long-term, structural changes)

Policies designed to increase the productive capacity and efficiency of the economy in the long run.

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Section 3: Fiscal Policy in Detail

Fiscal policy is the deliberate manipulation of government spending and taxation to influence the economy.

Analogy: Fiscal policy is like managing your own bank account. You decide how much money to spend (\(G\)) and how much the government takes from your salary (\(T\)).

The Tools of Fiscal Policy

1. Government Spending (\(G\))

This includes spending on public services (health, education), infrastructure (roads, railways), and welfare payments.

• Increasing \(G\): Directly increases demand. If the government builds a new hospital, it spends money, hires workers, and stimulates economic activity.
• Decreasing \(G\): Reduces demand and can help reduce national debt.

2. Taxation (\(T\))

Taxes can be direct (on income/profits) or indirect (on goods/services, like VAT or sales tax).

• Increasing \(T\): Decreases the disposable income of consumers, leading to less spending and lower demand. This is often used to cool down an economy and fight inflation.
• Decreasing \(T\): Increases disposable income, leading to more spending and increased demand, stimulating growth.

Expansionary vs. Contractionary Fiscal Policy

Governments use different strategies depending on the economic situation:

Policy Type	Action Taken	Goal
Expansionary (or 'Loose')	Increase \(G\) and/or Decrease \(T\)	Stimulate economic growth, reduce unemployment.
Contractionary (or 'Tight')	Decrease \(G\) and/or Increase \(T\)	Slow down the economy, reduce inflation.

Did you know? When a government increases spending without raising taxes, or cuts taxes without cutting spending, it creates a budget deficit, which must be financed by borrowing (increasing the national debt).

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Section 4: Monetary Policy in Detail

Monetary policy is the manipulation of the money supply and credit conditions, usually carried out by the nation's Central Bank (e.g., the Bank of England or the Federal Reserve).

The Main Tool: Interest Rates

The primary tool is setting the base interest rate. This rate influences all other borrowing and lending rates in the economy (mortgages, loans, savings accounts).

Analogy: Think of interest rates as the 'price of money'. If the price is high, people buy (borrow) less. If the price is low, people buy (borrow) more.

How Changing Interest Rates Affects the Economy

1. To Fight Inflation (Contractionary Monetary Policy)

Action: Raise Interest Rates

1. Borrowing becomes expensive: Businesses and consumers delay investment and large purchases (like cars or houses).
2. Saving increases: Higher returns incentivize consumers to save money rather than spend it.
3. Mortgage repayments rise: Homeowners have less disposable income left to spend.
4. Result: Total spending (Aggregate Demand) falls, easing pressure on prices and reducing inflation.

2. To Stimulate Growth (Expansionary Monetary Policy)

Action: Lower Interest Rates

1. Borrowing becomes cheaper: Businesses borrow to invest in new equipment; consumers take out cheaper loans.
2. Saving decreases: People are less incentivized to save, choosing instead to spend or invest.
3. Result: Total spending (Aggregate Demand) rises, stimulating production, growth, and employment.

Common Mistake to Avoid: Students sometimes confuse the government (Treasury) with the Central Bank. Fiscal Policy is Government/Treasury. Monetary Policy is the independent Central Bank.

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Section 5: Supply-Side Policies

Unlike Fiscal and Monetary policies which focus on managing demand (short-term fixes), Supply-Side Policies focus on improving the long-term efficiency and capacity of the economy (increasing Aggregate Supply).

The goal is to increase the amount an economy can produce without generating inflation.

Key Areas of Supply-Side Policy

These policies often involve structural changes and take a long time to work.

1. Improving Labour Market Efficiency

• Education and Training: Investing in skills makes the workforce more productive.
• Reducing Income Taxes: Lower taxes can act as an incentive for people to work harder or longer (as they keep more of their earnings).
• Reducing Trade Union Power: Makes the labour market more flexible for businesses, potentially lowering costs.

2. Improving Competition and Efficiency

• Deregulation: Removing unnecessary rules and restrictions on businesses reduces costs and encourages investment.
• Privatisation: Selling state-owned enterprises to the private sector, hoping that the profit motive will lead to greater efficiency.

3. Improving Infrastructure and Capital

• Investment in Infrastructure: Better roads, faster broadband, and reliable energy supplies reduce transport and communication costs for businesses.

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Section 6: Conflicts Between Government Objectives

Don't worry if this seems tricky—it's a high-level concept! Governments cannot achieve all four P.E.G.B. goals at the same time. Achieving one objective often makes it harder to achieve another. This is known as a policy conflict or trade-off.

The Main Conflicts

1. Economic Growth vs. Price Stability (Inflation)

If the government uses expansionary policies (e.g., lower interest rates or increased spending) to boost growth, total demand rises. If the economy is already near full capacity, this increased demand puts pressure on resources, causing prices to rise (demand-pull inflation).

2. Unemployment vs. Inflation (The Phillips Curve Concept)

This is perhaps the most famous trade-off.

• Action to reduce unemployment: Government stimulates demand.
• Result: Higher demand means businesses hire more workers (lower unemployment), but also leads to higher prices (higher inflation).
• In simple terms: When the economy is growing rapidly and unemployment is very low, inflation often starts to increase.

3. Economic Growth vs. Balance of Payments (BOP)

When an economy grows rapidly, incomes rise. As people feel richer, they tend to spend more, especially on imported luxury goods.

• Action: Boost growth.
• Result: Increased demand for imports, leading to a worsening of the Balance of Payments deficit.

The Role of Supply-Side Policies in Conflict Resolution

One of the major benefits of Supply-Side Policies is that they can help resolve these conflicts. If the economy becomes more efficient, we can achieve higher growth without necessarily causing inflation, because output potential has increased.