Government macroeconomic intervention (AS)

5.1 Government macroeconomic policy objectives

Policies use demand-side tools (fiscal and monetary) to influence AD and supply-side tools to raise AS. Their success is judged against the objectives, time lags and side effects.

5.2 Fiscal policy

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

• Government spending (G): on current items (wages, benefits), capital (roads, schools) and transfers.
• Taxation: direct (income, profit) and indirect (VAT, duties).
• Budget deficit: spending exceeds tax revenue; funded by borrowing (adding to national debt). Budget surplus: the reverse.

Expansionary fiscal policy (higher G, lower taxes) raises AD, increasing growth and employment but risking inflation and a larger deficit. Contractionary policy (lower G, higher taxes) reduces AD to lower inflation or cut the deficit.

Evaluation of fiscal policy:

• Time lags (recognition, decision, impact).
• Crowding out: borrowing may raise interest rates and reduce private investment.
• Size of the multiplier depends on MPC, spare capacity and leakages.
• Political pressure, limited accuracy, debt burden, effects on incentives.
• It can target specific groups or regions.

Automatic stabilisers (income tax and benefits) rise or fall with the cycle without new decisions, dampening fluctuations.

Types of tax: direct taxes are paid straight to the government by the person or firm that bears them (income tax, corporation tax) and indirect taxes are charged on spending (VAT, excise duties). Progressive (average rate rises with income), regressive (average rate falls) and proportional (flat rate).

The national debt is the total accumulated borrowing of the government. Its significance depends on its size relative to GDP, the interest cost (which crowds out other spending), who holds it (domestic or foreign) and whether it funded productive investment; a high debt may force tax rises or spending cuts and reduce confidence.

5.3 Monetary policy

Monetary policy uses the interest rate, the money supply and the exchange rate to influence AD, usually run by the central bank.

• Interest rates: a fall reduces the cost of borrowing and the reward for saving, raising consumption and investment (and AD), and often weakening the currency, which helps exports. A rise does the reverse and reduces inflationary pressure.
• Money supply and quantitative easing (QE): the central bank creates money to buy assets, raising the money supply and lowering long-term rates.
• Exchange rate policy: buying or selling currency (intervention).

Evaluation: time lags, people may not respond (confidence, liquidity trap), banks may not lend, savers lose, impact on different groups differs, conflicts between inflation and growth objectives, and international capital flows. The independence of central banks aims to remove political bias.

Expansionary monetary policy (lower interest rates, higher money supply) increases AD: in AD/AS, AD shifts right, raising real output and employment (and the price level, if near full employment). Contractionary monetary policy (higher rates, lower money supply) shifts AD left, reducing inflationary pressure but also output and employment.

5.4 Supply-side policy

Supply-side policies aim to increase the economy's productive capacity (LRAS), improving growth and reducing inflation without extra demand.

Evaluation: long time lags, expensive, outcomes uncertain, effects may be unequal (job losses), and some policies (tax cuts) widen inequality. Market-based supply-side policies use incentives; interventionist policies use government spending.

Policy mix

Governments use a combination of fiscal, monetary and supply-side policy, judging trade-offs and the state of the economy (recession, boom). Demand-side policies work faster but may be inflationary; supply-side policies work slowly but can raise growth sustainably.

Supply-side policy shifts LRAS to the right (and often SRAS), so real output and employment rise while the price level falls or rises less: this is the AD/AS effect of a successful policy, giving growth without inflation.