IGCSE®/O Level Economics 5.1 Government economic policy

The public sector in an economy The public sector is a major producer, employer and consumer in many modern economies. Public sector organizations include: central and local government authorities and their administrative departments government agencies responsible for the delivery of public services public corporations In addition to civil servants, public sector employees will usually include members of the armed forces, the police and judiciary, teachers, doctors and nurses

Public expenditure Government spending or public expenditure accounts for a large share of total spending or aggregate demand in many economies: current expenditure: recurring spending including the wages of public sector workers, state pensions, welfare payments and the running costs of government offices capital expenditure: investments in long-lived assets such as computer equipment, roads, dams, airports, schools and hospitals Public expenditure will benefit many private sector firms

Why do governments spend money? A government can use its spending power to: provide goods and services that are in the public and economic interest, such as street lighting, national parks, universal education and health care, affordable housing invest in national infrastructure such as road and railway networks, airports support agriculture and key industries to provide jobs and output, and to invest in staff training, new machinery, and the research and development (R&D) of new products manage the economy, for example to boost total spending during an economic recession to help firms and reduce unemployment reduce inequalities in incomes and help vulnerable people, for example by providing welfare payments to people and families in need

gross domestic product The macroeconomy Total demand and supply in a simple macroeconomy Aggregate demand for goods and services = consumer spending + business investment public spending spending on exports by overseas residents Aggregate supply of goods and services = gross domestic product

Macroeconomic objectives Low and stable price inflation High inflation will: reduce the purchasing power of people’s incomes cause hardship for people on low incomes increase business costs make goods and services produced in the economy less competitive High and stable employment High unemployment will: cause hardship for people who lose their jobs reduce spending on goods and services and cause production to fall increase public spending welfare payments to support the unemployed and their families (other public spending may be cut)

Macroeconomic objectives Economic growth in the national output Growth will: boost firms’ revenues and profits boost output, incomes, jobs and living standards boost investments by firms in new capital and businesses increase tax revenues for government to finance its spending A stable balance of international payments and trade If a country has a deficit on its balance of payments with the rest of the world: it may run out of foreign currency to buy imports the value of its currency may fall against other foreign currencies and make imports more expensive to buy (causing imported inflation)

Fiscal policy Changing the total level of government spending and taxation can have a significant impact on the aggregate demand for goods and services, and therefore on output, employment and prices Contractionary fiscal policy Cut public spending Raise taxes Expansionary fiscal policy Increase public spending Cut taxes

Some problems with fiscal policy Too much public spending can cause inflation Increases in taxes on incomes and profits can reduce incentives to work and enterprise Public spending can crowd out private spending Public spending has to be financed: by raising taxes from household and corporate incomes, or by government borrowing from the private sector (an increase in borrowing will raise interest rates Increased taxes and lending Private sector Public sector

Monetary policy Contractionary monetary policy Increase interest rates to reduce consumer borrowing and increase savings Higher interest rates can also increase the exchange rate and reduce prices of imported products Expansionary monetary policy Reduce interest rates to increase consumer borrowing and reduce saving Lower interest rates can also reduce the exchange rate and reduce prices of exported products

Supply-side policies Supply-side policies attempt to boost the productive potential of an economy and increase aggregate supply selective tax incentives e.g. tax breaks to encourage investment selective subsidies e.g. to support development of new technologies improving education and training to raise skills and productivity labour market reforms to restrict trade union power competition policy to outlaw anti-competitive behaviour removing barriers to trade to increase choice and competition privatization transferring public sector activities to private sector firms better regulation simplifying or removing old and unnecessary regulations that otherwise raise costs and restrict business activity Increased growth = more jobs + more incomes + lower inflation

Can policy objectives conflict? No Yes ‘Keeping price inflation low and stable will make domestic goods and services more competitive. Demand for them will rise at home and overseas. This will help to improve the balance of trade and will boost jobs, incomes and tax revenues.’ ‘Raising public spending, cutting taxes and interest rates to boost demand and employment will increase inflationary pressures and spending on imports.’ ‘If workers expect inflation to remain low they are less likely to push for big wage increases. This will boost the demand for their labour. And if firms are more confident in the future they are more likely to invest in new capacity for growth. In contrast, rising inflation raises costs and lowers profits.’ ‘Cutting public spending, raising taxes and interest rates to control inflation will reduce demand and therefore increase unemployment and reduce economic growth.’