Government Policies Influencing Economic Activity Governments have two broad policies available to affect the level of aggregate demand in the economy.

Fiscal Policy Fiscal policy is defined as the set of a government’s policies relating to its spending and taxation rates. Fiscal policy is defined as the set of a government’s policies relating to its spending and taxation rates.

Fiscal Policy Direct taxes and indirect taxes can be raised or lowered to alter the amount of disposable income consumers have. Direct taxes and indirect taxes can be raised or lowered to alter the amount of disposable income consumers have. Governments use expansionary fiscal policy to increase aggregate demand and contractionary fiscal policy to reduce aggregate demand. Governments use expansionary fiscal policy to increase aggregate demand and contractionary fiscal policy to reduce aggregate demand.

Expansionary fiscal policy If a government would like to encourage greater consumption, then it can lower income taxes to increase disposable income. This is likely to increase AD If a government would like to encourage greater consumption, then it can lower income taxes to increase disposable income. This is likely to increase AD

Expansionary fiscal policy If a government would like to encourage greater investment, then it can lower corporate taxes so that firms enjoy higher after-tax profits that can be used for investment. This is likely to increase AD. If a government would like to encourage greater investment, then it can lower corporate taxes so that firms enjoy higher after-tax profits that can be used for investment. This is likely to increase AD.

Expansionary fiscal policy Governments have major investment projects themselves and may increase their spending in order to improve or increase public services. This directly impacts upon AD. Governments have major investment projects themselves and may increase their spending in order to improve or increase public services. This directly impacts upon AD.

Monetary Policy Monetary policy is defined as the set of official policies governing the supply of money in the economy and the level of interest rates in the economy. Monetary policy is defined as the set of official policies governing the supply of money in the economy and the level of interest rates in the economy.

Monetary Policy The central bank (the Reserve Bank) is the government’s bank, and the ultimate authority in control of the money supply in an economy. The central bank (the Reserve Bank) is the government’s bank, and the ultimate authority in control of the money supply in an economy. Changes in the central bank’s interest rate can affect the level of AD in the economy. Changes in the central bank’s interest rate can affect the level of AD in the economy.

Monetary Policy To increase aggregate demand, the central bank might lower the interest rate. This ultimately reduces the cost of borrowing and can lead to increases in both consumption and investment. This would be known as expansionary monetary policy. To increase aggregate demand, the central bank might lower the interest rate. This ultimately reduces the cost of borrowing and can lead to increases in both consumption and investment. This would be known as expansionary monetary policy.

Monetary Policy To operate contractionary monetary policy to reduce aggregate demand, the central bank would increase the interest rate. To operate contractionary monetary policy to reduce aggregate demand, the central bank would increase the interest rate. Rate % Qty of Money Demand for Money Supply of Money M0M1 r0 r1

References Caves, RE & Krause, LB (eds) The Australian Economy: A view from the north. North Sydney: Allen & Unwin. Caves, RE & Krause, LB (eds) The Australian Economy: A view from the north. North Sydney: Allen & Unwin. Lipsey, RG et al Positive Economics for Australian Students. London: George Weidenfeld & Nicholson Ltd. Lipsey, RG et al Positive Economics for Australian Students. London: George Weidenfeld & Nicholson Ltd. Samuelson, Paul et al Economics. Sydney: McGraw-Hill. Samuelson, Paul et al Economics. Sydney: McGraw-Hill.