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External environment - Government policy

Explanation

Governments like to try to manage the economy to achieve their objectives. The key objectives are:

  1. Maintaining price stability (keeping inflation low)
  2. Maintaining low unemployment
  3. High economic growth (as fast as the economy can sustain without being inflationary)
  4. Balance in international trade - this is known as a balance in the balance of payments and governments aim to achieve this in the medium term

To achieve these objectives, they need to use the policy tools that they have at their disposal and there are three main types of these.

1. Fiscal policy

Fiscal policy is using the levels of government expenditure and taxation to try to influence the path of the economy. However, this can be a fairly blunt tool as fiscal policy is only changed to any great extent in the Budget given by the Chancellor each year (usually in March). This means that all necessary policy changes have to be squeezed into this one time, although the Pre-Budget Statement given by the Chancellor in December gives some indications of future policy changes and helps businesses to plan ahead. However, changes in the tax system can be useful for promoting medium to long-term change in the economy and will often be used to try to improve incentives for people or firms to change their behaviour. For example, the landfill tax is intended to try to reduce the amount of waste that goes into landfill and encourage recycling.

The government can use fiscal policy to try to boost the economy by either spending more (injecting more money into the economy) or by taxing less (allowing people to keep more of their earnings and therefore spend more). Doing the opposite would help slow the economy down.

2. Monetary policy

Monetary policy is the manipulation of interest rates and the money supply to influence the economy. It is the main tool used for the short to medium-term management of the economy, but interestingly, the government gave away control over monetary policy in 1997. They handed it over to the Bank of England, and through a committee called the Monetary Policy Committee (MPC), the Bank of England is now responsible for keeping inflation within 1% either side of the target set by the Chancellor. This target is currently 2%.

3. Supply-side policies

Supply-side policies are medium to long-term policies that are aimed at improving the potential of the economy to produce. In other words, they are aimed at improving the capacity of the economy. They may include policies to encourage investment, or perhaps policies to improve incentives for people to work harder.

For more detail on these policies, why not have a look at the theories section where you can find out all about the different types of policy and how they may be used.