It is common for governments to intervene in the economy. And, most governments have several policies to do so. Government intervention may either support business activity to speed up the economy or restrain it to slow down economic growth.
Government intervention to slow down the economy
The government can slow down economic growth in the country by decreasing its own government spending, through higher TAXes and increasing interest rates.
Scenario 2: The economy is booming. Inflation is high.
Two of the six major macroeconomic objectives are not being met – low inflation and keeping Balance of Payment at the healthy level. This is the result of aggregate demand for products in the country increasing above the level of output that the economy is able to produce.
The government and the central bank should act to decrease aggregate demand to slow down economic growth.
A. FISCAL POLICY
The government should use contractionary fiscal policy to decrease aggregate demand – reduce government spending and raise TAX rates. The economy will see decreases in output produced and employment. However, using contractionary fiscal policy will lead to a budget surplus.
- Raise Direct TAX rates. Higher Individual Income TAX will decrease consumers’ disposable incomes. Lower disposable incomes will decrease the demand for products. Also, higher Corporate TAX will decrease businesses’ retained earnings. Lower retained earnings will decrease business investment.
- Raise Indirect TAX rates. Higher Consumption TAX will increase retail prices of goods and services. Consequently, higher product prices will decrease overall demand.
- Decrease government spending. Lower government spending will see a decrease in demand. Lower demand will create less jobs in the sectors selling to the government such as construction companies, defense suppliers, military, public schools, public hospitals, etc.Â
B. MONETARY POLICY
The government should increase interest rates to decrease the supply of money.
- Higher interest rates. Higher interest rates will increase interest payments of highly geared companies. This will make their cash flow position worse. Businesses will be less likely to borrow money from the bank to finance further investment because the costs of loans will be higher. Consumers will be less likely to buy products on credit as the interest charges will be higher. Higher interest rates will not stimulate demand for expensive consumer goods such as cars, overseas holidays and clothes. The demand for houses will decrease as mortgages are the biggest loan most consumers take out. The interest on existing consumer debts will be higher which will most likely decrease consumer demand. Higher domestic interest rates may encourage overseas capital to flow into the country. This will to lead to an appreciation of the currency exchange rate which will decrease the competitiveness of local exporting businesses.
To slow down economic growth, governments can also restrain business activity by the use of strict laws and regulation that add unnecessary burdens to daily running of a business. Additionally, governments can also discourage entrepreneurship by imposing unrealistic expectations and bureaucratic requirements.
