Expenditure, taxes and interest rates are government policy instruments used in fiscal and monetary policies to achieve economic objectives at during different phases in a business cycle.
Expenditure
Government stimulates the economy during slump by increasing expenditure. This will increase demand for goods and services from the private sector, reducing unemployment as more firms need to hire more workers to increase production or output (GDP) - recovery. As more workers are employed, their income increases, further increasing sales and revenue, enabling businesses to profit and grow (growth). To reduce inflation, government may reduce spending to reduce demand for goods and services so that prices will not increase further.
Interest Rate
As economic growth peak (boom) and inflation rate increases, government may increase interest rates to increase cost of borrowing. This will reduce financing demand as firms decide to borrow less from banks and consumer reduce spending - as they have less ability to pay interest, while increasing savings as they may earn more interest. This reduces demand for goods and services, preventing prices from increasing (inflation), discouraging businesses from growing, as profit stagnate or reduce. However, when the economy is in recovery or slump, the government will reduce interest rate to encourage more borrowing to spend and grow business.
Taxes
Government uses taxes to reduce the demand for certain products, through indirect taxes or reduce disposable income to reduce spending through direct taxes.
Direct taxes
Personal income tax
Payroll taxes
Corporation tax
Indirect taxes
Ad-valorem taxes
Excise duties
Import tariffs
Increasing direct taxes will reduce disposable income of consumers and profits of firms. This will reduce demand for goods and services by consumers, retained profits and profits distributed to shareholders. Increase in indirect taxes will increase prices of certain products (demerit goods), reducing its demand.
Direct taxes are also used by government to reduce poverty and inequality by re-distributing wealth, while indirect taxes as protectionism measures to reduce imports or protect local sunset or infant industries. Taxes may also be imposed to discourage the use of unsustainable business practices that may harm the environment.
RELATED CONCEPTS
Government economic objectives
Business cycle
PAST YEAR QUESTIONS
Identify and explain two ways in which an increase in interest rates might affect AHP. (6 marks) Oct/Nov 2018/11