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The Impact of Government Policies on the Economy

1. Introduction

It seems that every time you pick up a newspaper or turn on the TV these days, the global economy is in the headlines. The fact is, the economy affects all of us, from students to housewives to businessmen – and women. We talk about the economy as if it were a living being, with a mind and will of its own. But just what is “the economy”? In essence, it is a way of describing how the people of a country make a living – how they earn, spend, and save money. The word “economy” itself comes from the Greek word “oikonomos” which means “household management”. That is a good illustration of what the economy is. Usually, an economy consists of two elements: human and natural resources and money. The resources are used to produce goods and services, which are then sold for money. The money can be used to buy more resources to make more goods and services, and so on. Of course, it is not just individuals who make up the economy. As we will see later, many countries have “mixed economies” in which the resources are owned and managed by both private individuals and the government. Economists, the people who study and write about the economy, argue that people want more than can be produced and this has always been the case. So choices have to be made about what to produce, how much to produce, and for whom. Just who makes these choices and how the choices are made are very important issues, and the answers to these questions give insight into what is meant by “the economy”. As the world moves into the twenty-first century, it is striking to note that the global economy is ceasing to be a collection of national economies and is becoming a single integrated world economy. Perhaps the best example of this is the European Union (EU), where there is now not only a single European market instead of different country markets but also a single European currency. This is having a profound effect on all those who live and work in Europe. One of the key aspects of the global economy is capitalism. This is the name given to the economic system that exists in the UK and the USA, and it is often referred to as the “free market economy”. In a capitalist or free market economy, goods and services are provided by private enterprise and purchased by consumers. There is little or no control or influence by the state, and the success or failure of someone’s business will depend primarily on their decisions and the demand of the consumers for what they produce. However, it is true to say that there are no pure capitalist or socialist economies in the world. Instead, most countries today have mixed economies that are made up of different combinations of capitalism and socialism.

2. Government Spending and Economic Growth

It is clearly shown that the degree of inflation is led by increased government spending. Inflation will not bring any benefits. The outcomes will include rises in the price level of goods and services, which may cause instability of the exchange rate in accompany with the negative effect toward the balance of payments, as well as reducing the international competitiveness of the UK’s goods and services. This also supports the view that increasing government spending leads to inflation – as mentioned in the Reabus’s article.

Obviously, economic growth cannot be driven in the long term simply by stimulating aggregate demand. This is because the capacity of the economy to produce goods and services would be reached. If government spending is not productive, namely the multiplier effect is zero, the aggregate demand would not shift to the right. In terms of not increasing real GDP, the growth in nominal GDP will probably lead to inflation. This is because the inflated figures of GDP do not reflect actual growth in the economy. On the other hand, what will be seen is just a price increase due to the inflated figures. This will influence the international competitiveness of the UK’s production unit, whereby exports will fall and aggregate demand will be decreased. As a result, the balance of payment will be worsened.

As demonstrated in the article, government expenditure would be changed to a relatively small extent. Apparently, many people reckon that increasing government spending will also increase aggregate demand and that this will boost the pace of economic growth. However, this view is likely to be too much simplified. The truth is that economic growth does not only require an increase in aggregate demand. Instead, economic growth requires growth in supply, namely the potential output.

In fact, deeper analysis in the theoretical world shows that the growth rate of real gross domestic product (GDP) will rise as the growth rate of government expenditure rises. Visual inspection could be carried out on the two data series. By looking at the trends of the movement for both GDP and government spending, the potential growth for the two variables could be observed.

To promote the trend of economic globalization, the proficiency of government spending drives a significant role in promoting economic growth. As explicitly mentioned in the article, “The Impact of Government Policies on the Economy,” “Government Spending and Economic Growth” is being analyzed in detail. Here, the rapid growth of modern public spending can be seen clearly, in terms of increasingly socialized policy areas, namely health, education, and housing. The government has put in more efforts to respond to the needs of the poor and to solve social problems. This will surely lay a good foundation for sustainable economic growth.

3. Taxation and its Effects on the Economy

Taxation refers to compulsory or mandatory payments of money to governments from citizens, households, and businesses. These payments are majorly of two types that are direct taxes and indirect taxes. This section focuses on different debates within the public finance literature regarding the impact of taxation on the economy. It particularly attends to the effects of taxation on levels of national income and economic growth. Governments typically use taxation to generate income for their operations and public service provisions. Income taxes, for example, are the single largest generator of government revenues around the world. In contemporary public finance, the incentive effects of taxes have played a significant role in defining many theoretical debates on the desirability of taxes and different forms of taxes. The key debate about the desirability of different taxes is in terms of their effect on the allocation of resources. The opportunity cost of a tax to an individual is the value of what he or she would have worked for; that is, the net benefit forgone- as a result of the distortion caused by the imposition of the tax. In the case of a given tax, the opportunity cost to an individual will depend crucially on his or her behavioural response to the tax. For instance, if income tax has the effect of reducing an individual’s willingness to work, this may be reflected in the individual taking more leisure and less work. This arises because the cost of earning a given amount of income has risen as a consequence of the imposition of the tax. Such a distortion that taxes introduce into people’s decisions to supply labour or to consume or invest can translate to market inefficiencies in the form of reduced rates of employment, output and national income. The uneconomic devises of resources occurring as a result of taxes have been referred to by economists as deadweight losses or excess burden. This describes the net welfare loss to society as a result of a particular tax over and above the revenue raised. It is argued that the size of the deadweight loss associated with a tax will depend on its elasticity of supply and demand. That is, the more responsive the demand and supply of the taxed good is to price changes, the greater the deadweight loss in welfare. Good examples of taxes that generate relatively large deadweight losses because of their nature of low price elasticity are income and property taxes. Lower elasticity of demand and supply in this context suggests that the imposition of such taxes causes a relatively larger distortion in people’s behaviour to the point where it leads to overproduction or overconsumption of the taxed good. These inefficiencies explain why some theorists and economic observers argue for a switch in tax policies towards the use of more indirect taxes, given that these are often less distortionary on market behaviours and hence welfare.

4. Monetary Policy and its Influence on the Economy

Monetary policy, employed by the central bank in a country, has a great influence on how “healthy” is the country’s economy. In the United States, the main objective of monetary policy is to promote a stable price level and good economic growth. The Federal Reserve Board, which is the main monetary authority in the US, can use three main sets of policy tools to achieve its monetary policy goals: open market operations, changes in the required reserve ratios, and changes in the discount rate. Firstly, the Federal Reserve has the ability to set what is called the discount rate. The discount rate is the interest rate charged to commercial banks and other depository institutions on loans they receive from the regional Federal Reserve Bank’s lending facility. When the Fed lowers the discount rate, it becomes cheaper for banks to borrow from the Fed. As a result, the nation’s money supply would increase and interest rates would fall. With more money in the hand of people, aggregate demand (influenced by consumption and investment) in the economy will increase. This will finally lead to higher real GDP and some inflation. Conversely, when the Fed raises the discount rate, it becomes more expensive for banks to borrow from the Fed. As a result, the nation’s money supply would decrease and interest rates would rise. With less money in the hand of people, aggregate demand will reduce. This will finally lead to lower real GDP and some deflation. Secondly, the Federal Reserve has the authority to alter the required reserve ratio. The required reserve ratio is the percentage of all deposits that the depository institutions are obligated to keep in reserve either in their vaults or on deposit at a Federal Reserve Bank. By changing the reserve ratio, the Federal Reserve is able to influence the ability of the commercial banks in creating loans and thus is able to control the nation’s money supply. When the Federal Reserve lowers the reserve requirement, the nation’s money supply will increase and t…

5. Conclusion

In conclusion, we have discussed in this article the various aspects of government policies that have an impact on the economy. In the first chapter, we concentrate mainly on how and which kind of government spending would affect economic growth. And then the effect of different types of taxation that could be found in an economy is discussed. In the subsequent chapter, the influences of expansionary and contractionary monetary policy on the economy are illustrated. Throughout these chapters, different relevant economic theories are applied to explain the mechanisms of how government policies work. For example, we use the theory of Keynesian Economics that focuses on aggregate demand to explain how output could be affected by different types of government spending. Besides that, the Laffer Curve is introduced when we explain the effects of taxation on the incentives of work and how this will affect economic growth. Last but not least, the most obvious is the monetary policy framework that we still use nowadays in the UK, which is inflation targeting. And what is the use prompt that the Monetary Policy Committee will gain if they are trying to adopt expansionary or contractionary monetary policy. By doing this literature, we learn not only the real effect of government policies but also the limitations and problems that are being faced by the policymakers. For instance, the government may actually find it difficult to decide on what to spend and how to allocate the resources in a way that the objectives are achieved. And as the economic condition is changing from time to time, being in line with where we are on the Laffer Curve is always not an easy task for the policymakers. The relative output level in the different stages of the business cycle would affect the policy effectiveness of applying monetary policy.