Thursday, May 10, 2007

Government Intervention in the Macro Economy.

The government intervenes in the macro economy in various ways including demand and supply side policies.

Macro Economics Objectives of the government include:

1. Low Unemployment
2. High but sustainable economic growth.
3. Low Inflation (inflation target in UK CPI = 2%)
4. Equilibrium on Balance of Payments (e.g. minimising current account deficit)

Less important objectives

5. Reduce Government Deficit (in UK Chancellors Golden rule of Borrowing less than 3% of GDP)
6. Stable Exchange rates

Non Economic Objectives

7. Environment - increasingly important
8. Issues of Equality.

Types of Government Intervention

  1. Supply Side Policies.

These are government policies which aim to increase productivity and efficiency in the economy. If they are successful, they will shift the LRAS to the right and potentially increase the long run trend rate of growth. An increase in productivity can also help to reduce inflation, especially cost push inflation. Improvements in productivity may make UK exports more competitive and, therefore, should help to improve the current account.

Types of Supply Side policies

  1. Interventionist. Government intervention to overcome market failure. For example, spending on education and training to reduce occupational immobilities.
  2. Market Oriented supply side polices : This occurs when the government reduces regulations and enables market to work more freely. For example, reducing the power of trades unions and minimum wages can reduce labour market inflexibility's.

Evaluation of Supply Side policies.

  • They will take a long time, e.g. increasing education standards.
  • May be subject to government failure. e.g. spending on education misplaced.
  • Promoting free markets may increase inequality. E.g. removing trades unions may lead to worker exploitation.
See: Supply Side Policies

Demand Side Policies

Demand side polices to influence the level of AD. It may be to reduce the growth of AD, to prevent inflation. Alternatively, it could be to increase AD in time of a recession.

Types of Demand Side Policies

  1. Fiscal Policy - changing the level of government spending and taxation in the economy. It will effect the government's budget and fiscal position.
  2. Monetary Policy - Influencing the supply and demand for money. In the UK monetary policy revolves around changing interest rates, which are set by the MPC (Bank of England).

If there is inflation:

  • The government could pursue deflationary fiscal policy. This involves increasing tax rate and / or cutting spending.
  • The MPC could increase interest rates. This is known as a tightening of monetary policy. Note, in the UK the government no longer sets monetary policy, the Bof E is independent.

In a recession.

  • Government can introduce Expansionary Fiscal Policy. This involves cutting taxes and / or increasing spending, AD should increase.
  • The MPC can cut interest rates.


  • It is difficult to control predict future economic trends, therefore, it can be difficult to know how much to change tax rates / interest rates.
  • Time Lags, Interest rates can take upto 18 months to have an effects.
  • Crowding out. Expansionary fiscal policy may increase government spending, but, reduce private sector spending.
  • Depends on Confidence. For example, a cut in income tax may not increase AD, if confidence is low.

The aim of Demand side policies is to ensure sustainable growth. The aim is to avoid Boom and Bust economic cycles. In practise, this means that growth will be close to the long run trend rate of growth. This enables economic growth, without inflationary pressures.

See also:

Evaluation of MPC in controlling monetary policy

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