What are government policy instruments

Updated: Jul 9, 2021

The government uses policy instruments to achieve government's economic objectives.


Government policy instruments are;

  1. Government spending

  2. Taxes

  3. Interest rates


Government spending


Also known as public expenditures, they are how the government create jobs directly by creating or expanding more government agencies or indirectly by stimulating economic growth through the private sector with increasing demand of good and services.


Taxes


Taxes are the main source of government revenue which the government uses to finance public goods such as public transportation, health and education. They are an important tool as they can influence consumers to increase or reduce spending on certain goods through indirect taxes (VAT) or overall spending through direct taxes (income taxes). This may help reduce inflation as demand reduces.


Interest rates


This monetary instrument is widely used by the government to increase or reduce borrowing and savings. By increasing interest rates, fewer consumers and business will borrow as the cost of borrowing increases. Consumer will also increase savings as they will earn more, while this will result in lower demand and business growth as there are less financing available. However, should the government reduce interest rates, more consumers will increase spending, as they can afford to borrow more, while businesses may decide to expand as they are able to obtain additional financing at a lower cost. This may stimulate economic growth or increase inflation rate.