Government's economic role, the national budget, direct and indirect taxes, fiscal policy tools, monetary policy instruments, and government approaches to correcting macroeconomic problems.
Governments do not just let markets run freely — they intervene to correct failures, reduce inequality, and stabilise the economy. The two main instruments are fiscal policy (taxes and spending) and monetary policy (money supply and interest rates).
Governments pursue several macroeconomic objectives:
To pursue these goals, government uses taxation, public expenditure, and transfer payments (welfare benefits, pensions).
The national budget is the government's annual statement of planned revenue and planned expenditure for the coming year.
| Budget position | Meaning | Consequence |
|---|---|---|
| Balanced budget | Revenue = expenditure | National debt unchanged |
| Budget surplus | Revenue > expenditure | Government can repay debt |
| Budget deficit | Revenue < expenditure | Government must borrow; national debt rises |
National debt is the accumulated total of all past government borrowing that has not yet been repaid. A persistent deficit adds to national debt year after year.
A direct tax is levied on the income or wealth of an individual or company. The burden falls directly on the person paying it and cannot easily be passed on.
Examples: income tax, corporation tax, capital gains tax, wealth tax.
Direct taxes are usually progressive — the percentage of income paid in tax rises as income rises, thereby reducing inequality.
An indirect tax is levied on the sale of goods and services. The seller pays the tax to the government but typically passes some or all of the burden to the consumer through higher prices.
Examples: value added tax (VAT), excise duties on alcohol and tobacco, customs duties (tariffs), stamp duty.
Indirect taxes are often regressive — lower-income households spend a higher proportion of their income on taxed goods than higher-income households, so the tax takes a larger share of poor households' income.
Fiscal policy refers to government decisions about taxation and expenditure used to influence the level of aggregate demand, output, and employment.
Used to stimulate the economy during a recession or high unemployment:
Aim: Boost output and reduce unemployment.
Used to cool the economy during inflation:
Aim: Reduce inflationary pressure by lowering aggregate demand.
Transfer payments (unemployment benefits, pensions, child support grants) redistribute income from higher-income to lower-income households. They act as automatic stabilisers — in a recession, welfare payments rise automatically without new policy decisions, supporting demand; in a boom, they fall as fewer people claim them, moderating demand.
Monetary policy refers to the central bank's use of tools to influence the money supply, interest rates, and credit conditions in the economy.
1. Interest rate (discount rate)
The central bank sets the rate at which it lends to commercial banks. Commercial banks then set their own lending rates above this floor.
2. Reserve requirement
Commercial banks must keep a minimum fraction of deposits as reserves. Raising the requirement reduces the funds available for lending, contracting the money supply. Lowering it allows banks to lend more, expanding money supply.
3. Open market operations (OMO)
The central bank buys or sells government securities in the open market.
4. Moral suasion
The central bank issues guidance, recommendations, or public statements to persuade banks to change their lending behaviour — without formal enforcement. Effective when banks trust and cooperate with the central bank.
| Objective | Policy action | Effect |
|---|---|---|
| Stimulate growth, reduce unemployment | Lower interest rates, buy securities, lower reserve requirement | More lending, more spending, more output |
| Reduce inflation | Raise interest rates, sell securities, raise reserve requirement | Less lending, less spending, lower price pressure |
| Problem | Fiscal response | Monetary response |
|---|---|---|
| Unemployment / recession | Increase G, cut taxes | Lower interest rates, buy securities |
| Inflation | Cut G, raise taxes | Raise interest rates, sell securities |
| Balance of payments deficit | Reduce G to limit imports | Raise interest rates to attract capital inflows |
Paper 02 questions often ask you to recommend a policy and justify it. State which policy (fiscal or monetary), name the specific tool used, explain the transmission mechanism (how the tool changes behaviour and then output), and acknowledge a limitation — for example, that fiscal policy takes time to implement, or that monetary policy may be ineffective when interest rates are already near zero.