Government and the macroeconomy: policies - Business Environment

Governments throughout Europe and beyond play various key roles in their respective economies. These include the following functions:
_ consumer of resources (e.g. employer, landowner);
_ supplier of resources (e.g. infrastructure, information);
_ consumer of goods and services (e.g. government spending);
_ supplier of goods and services (e.g. nationalized industries);
_ regulator of business activity (e.g. employment laws, consumer laws);
_ regulator of the economy (e.g. fiscal and monetary policies); and
_ redistributor of income and wealth (e.g. taxation system).

The extent of these roles, and their impact on the economy in general and on business in particular, varies from country to country as well as over time.

Despite the economic significance of these roles, in most market-based economies democratically elected governments prefer levels and patterns of production and consumption to be determined largely by market forces, with a minimum of government interference. This approach is exemplified by the philosophical stance of the UK and US governments in the 1980s, that became colloquially known as ‘That cherism’ (UK) and ‘Reaganomics’ (USA). At the same time, the recognition that market forces alone are unable to guarantee that an economy will automatically achieve the objectives established by governments has meant that state intervention to curb inflation, encourage growth, reduce unemployment, correct a balance of payments or budgetary problem or restore currency stability invariably occurs to some degree in all countries. In broad terms, this intervention usually takes three main forms, described as fiscal policy, monetary policy and direct controls. These policy instruments or ‘instrumental variables’ and their effects on the business community are discussed below.

Fiscal policy
As indicated above, each year governments raise and spend huge amounts of money. The UK government’s estimates for 2005/6, for example, suggest that government spending will be about £519 billion and is to be allocated in the manner illustrated in Figure. This spending will be funded mainly from taxation (direct and indirect), and national insurance contributions. The PSNB is estimated at £32 billion.

Fiscal policy involves the use of changes in government spending and taxation to influence the level and composition of aggregrate demand in the economy and, given the amounts involved, this clearly has important implications for business. Elementary circular flow analysis suggests, for instance, that reductions in taxation and/or increases in government spending will inject additional income into the economy and will, via the multiplier effect, increase the demand for goods and services, with favourable consequences for business. Reductions in government spending and/or increases in taxation will have the opposite effect, depressing business prospects and probably discouraging investment and causing a rise in unemployment.


sources-of-govt revenue

Apart from their overall impact on aggregate demand, fiscal changes can be used to achieve specific objectives, some of which will be of direct or indirect benefit to the business community. Reductions in taxes on company profits and/or increases in tax allowances for investment in capital equipment can be used to encourage business to increase investment spending, hence boosting the income of firms producing industrial products and causing some additional spending on consumption. Similarly, increased government spending targeted at firms involved in exporting, or at the creation of new business, will encourage increased business activity and additionally may lead to more output and employment in the economy.

In considering the use of fiscal policy to achieve their objectives, governments tend to be faced with a large number of practical problems that generally limit their room for manoeuvre. Boosting the economy through increases in spending or reductions in taxation could cause inflationary pressures, as well as encouraging an inflow of imports and increasing the public sector deficit, none of which would be particularly welcomed by entrepreneurs or by the financial markets. By the same token, fiscal attempts to restrain demand in order to reduce inflation will generally depress the economy, causing a fall in output and employment and encouraging firms to abandon or defer investment projects until business prospects improve.

Added to this, it should not be forgotten that government decision makers are politicians who need to consider the political as well as the economic implications of their chosen courses of action. Thus while cuts in taxation may receive public approval, increases may not, and, if implemented, the latter may encourage higher wage demands. Similarly, the redistribution of government spending from one program area to another is likely to give rise to wide spread protests from those on the receiving end of any cuts; so much so that governments tend to be restricted for the most part to changes at the margin, rather than undertaking a radical reallocation of resources and may be tempted to fix budgetary allocations for a number of years ahead (e.g. the Comprehensive Spending Review in the UK).

Other factors too including changes in economic thinking, self-imposed fiscal rules, external constraints on borrowing and international agreements can also play their part in restraining the use of fiscal policy as an instrument of demand management, whatever a government’s preferred course of action may be. Simple prescriptions to boost the economy through large-scale cuts in taxation or increases in government spending often fail to take into account the political and economic realities of the situation faced by most governments.

Monetary policy
Monetary policy seeks to influence monetary variables such as the money supply or rates of interest in order to regulate the economy. While the supply of money and interest rates (i.e. the cost of borrowing) are interrelated, it is convenient to consider them separately.

As far as changes in interest rates are concerned, these clearly have implications for business activity, as circular flow analysis demonstrates. Lower interest rates not only encourage firms to invest as the cost of borrowing falls, but also encourage consumption as disposable incomes rise (predominantly through the mortgage effect) and as the cost of loans and overdrafts decreases. Such increased consumption tends to be an added spur to investment, particularly if inflation rates (and, therefore ‘real’ interest rates) are low and this can help to boost the economy in the short term, as well as improving the supply side in the longer term.

Raising interest rates tends to have the opposite effect causing a fall in consumption as mortgages and other prices rise, and deferring investment because of the additional cost of borrowing and the decline in business confidence as consumer spending falls. If interest rates remain persistently high, the encouragement given to savers and the discouragement given to borrowers and spenders may help to generate a recession, characterized by falling output, income, spending and employment and by increasing business failure. Changes in the money stock (especially credit) affect the capacity of individuals and firms to borrow and, therefore, to spend. Increases in money supply are generally related to increases in spending and this tends to be good for business prospects, particularly if interest rates are falling as the money supply rises. Restrictions on monetary growth normally work in the opposite direction, especially if such restrictions help to generate increases in interest rates which feed through to both consumption and investment, both of which will tend to decline.

As in the case of fiscal policy, government is usually able to manipulate monetary variables in a variety of ways, including taking action in the money markets to influence interest rates and controlling its own spending to influence monetary growth. Once again, however, circumstances tend to dictate how far and in what way government is free to operate. Attempting to boost the economy by allowing the money supply to grow substantially, for instance, threatens to cause inflationary pressures and to increase spending on imports, both of which run counter to government objectives and do little to assist domestic firms. Similarly, policies to boost consumption and investment through lower interest rates, while welcomed generally by industry, offer no guarantee that any additional spending will be on domestically produced goods and services, and also tend to make the financial markets nervous about government commitments to control inflation in the longer term (see below, ‘The role of the central bank’).

This nervousness among market dealers reflects the fact that in modern market economies a government’s policies on interest rates and monetary growth cannot be taken in isolation from those of its major trading partners and this operates as an important constraint on government action. The fact is that a reduction in interest rates to boost output and growth in an economy also tends to be reflected in the exchange rate; this usually falls as foreign exchange dealers move funds into those currencies which yield a better return and which also appear a safer investment if the market believes a government is abandoning its counter inflationary policy. As the UK government found in the early 1990s, persistently high rates of interest in Germany severely restricted its room for manoeuvre on interest rates for fear of the consequences for sterling if relative interest rates got too far out of line.

Direct controls
Fiscal and monetary policies currently represent the chief policy instruments used in modern market economies and hence they have been discussed in some detail.
Governments, however, also use a number of other weapons from time to time in their attempts to achieve their macroeconomic objectives. Such weapons, which are designed essentially to achieve a specific objective such as limiting imports or controlling wage increases tend to be known as direct controls. Examples of such policies include:
_ Incomes policies, which seek to control inflationary pressures by influencing the
rate at which wages and salaries rise.
Import controls, which attempt to improve a country’s balance of payments situation, by reducing either the supply of, or the demand for, imported goods and services.
_ Regional and urban policies, which are aimed at alleviating urban and regional problems, particularly differences in income, output, employment, and local and regional decline.

A brief discussion of some of these policy instruments is found at various points in the text below. Students wishing to study these in more detail are recommended to consult the books referred to at the end of this chapter.

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