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 economic growth or restrain it to slow down the economy.
Government intervention to speed up economic growth
The government can stimulate economic growth in the country by increasing its own government spending, through lower TAXes and decreasing interest rates.
Scenario 1: The economy is in recession. Unemployment is high.
Two of the six major macroeconomic objectives are not being met – high economic growth and low unemployment. This is the result of aggregate demand for products in the country dropping below the level of output that the economy is able to produce.
The government and the central bank should act to increase aggregate demand to speed up economic growth.
A. FISCAL POLICY
The government should use expansionary fiscal policy to increase aggregate demand – raise government spending and lower TAX rates. The economy will see increases in output produced and employment. However, using expansionary fiscal policy will lead to a budget deficit.
- Lower Direct TAX rates. Lower Individual Income TAX will increase consumers’ disposable incomes. Higher disposable incomes will increase the demand for products. Also, lower Corporate TAX will increase businesses’ retained earnings. Higher retained earnings will increase business investment.
- Lower Indirect TAX rates. Lower Consumption TAX will decrease retail prices of goods and services. Consequently, lower product prices will increase overall demand.
- Increase government spending. Higher government spending will see an increase in demand. Higher demand will create more 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 decrease interest rates to increase the supply of money.
- Lower interest rates. Lower interest rates will decrease interest payments of highly geared companies. This will make their cash flow position better. Businesses will be more likely to borrow money from the bank to finance further investment because the costs of loans will be lower. Consumers will be more likely to buy products on credit as the interest charges will be lower. Lower interest rates will stimulate demand for expensive consumer goods such as cars, overseas holidays and clothes. The demand for houses will increase as mortgages are the biggest loan most consumers take out. The interest on existing consumer debts will be lower which will most likely increase consumer demand. Lower domestic interest rates may discourage overseas capital to flow into the country. This will to lead to a depreciation of the currency exchange rate which will increase the competitiveness of local exporting businesses.
To speed up economic growth, governments can also support both small businesses and large firms through subsidies to help keep prices down. Governments can prevent a loss-making business from failing by injecting additional capital. Additionally, government grants for businesses may encourage businesses to locate in particular regions, while financial support for consumers will stimulate demand for products such as houses and cars.
