Role and Effects of Government in Economic Policy - Case Study Example

Economic Policy/Role and effects of Government Introduction The government of any country has a key role in steering the economy. It is precisely for this that the central banks of each country have been entrusted with the task of raising key rates – whether they are the prime lending rate or the interest and yields on government securities – or the cash reserve ratio (the amount of central government securities that any bank must hold which is a measure of the liquidity of the bank). As the world economy becomes tightly integrated and there is more complexity in the financial system with greater interconnectedness, it becomes imperative for any central banker to walk a tightrope when it comes to monetary policy. One of the most keenly watched events in the financial world is the quarterly interest rate hike/decrease and the credit policy that is announced by the central bank. Whether it was Alan Greenspan or Ben Bernanke in the US or the Bank of England’s governor Mervyn King, they are like the “conductors” to the orchestra of the economy. In this essay, we explore the linkages of the macro policies to the micro components of the economy. This is done by taking the examples of three variables of the macroeconomic policy and their effect on three different actors. As we shall see, the linkages go deep. To put the essay in context, we are primarily dealing with three types of economic policy change namely: - The government makes a substantial rise in interest rates. - The government makes a substantial rise in income tax rates at all levels. - The local government, Birmingham, makes a substantial rise in its tax on business. All the three cases are instances of economic decisions that would be unpopular with business and industry but may have to be implemented nonetheless to contain inflation and prevent an upward spiral in the prices. In all the scenarios and for each business situation, the effects of the policy changes are felt in varying degrees. If, for a particular economic change, a business situation is affected badly, for another situation the effect may not pinch that much but would affect it nonetheless. Economic change 1: The government makes a substantial rise in interest rates Business Situation One: A large retailer of electrical goods like TVs and Computers The central bank raises interest rates whenever there is a threat of inflation or there is an overheating in the economy. Whenever interest rates are raised, there is a decrease in the available credit leading to a credit crunch and decrease in liquidity. As the interest rates on the government bonds and other indices are raised, there is a corresponding In the case of the retailer, increase in interest rates would mean that he might not be able raise capital from the banks and other lending institutions as easily as he was doing earlier. This means a general decrease in available credit and hindering of expansion plans of the retailer. The retailer also may not be able to offer the lines of credit to his suppliers as generously as before. He may have to recall the payments receivable or receivables earlier than the terms stated before. He can employ the capital earned elsewhere. In parallel, he may not be able to raise capital at the lower rates of interest. So in a way, he loses out on easy credit. The main effect of this would be on his expansion plans. Business situation two: A newly set up sole trader in Birmingham selling relatively expensive skin and health care products An increase in interest rates would mean that this trader would not be avail of cheap credit for his expansion plans. If he has to raise additional capital, he would be forced to do so at higher rates which may lead to some of his expansion plans being shelved. There might be liquidity problems on the cash flow front. He may have to manage his short term finances more prudently as he would not be able to access the short term credit needed for working capital at favourable rates. Thus, the outlook on the short term does not appear bright for him. Assuming that his customers also face a tightening of money in their hands for expensive purchases with the increase in interest rates, they may not be able to splurge on their purchases of expensive items. The only positive thing that might come out of this would be a reining in of inflation and thus more buyers flocking to his store over the longer term. This is part of the cyclic nature of the economy that goes through periodic ups and downs. Business situation three: A builder of houses operating mainly across the West Midlands. An increase in interest rates usually leads to a corresponding increase in the lending rates for borrowers. This includes the home loans as well and any potential buyers would have to contend with the fact of increased rates for home loans. This would shrink the pool of potential borrowers and thus impact the builder in terms of having fewer customers for his business. Also, the increase in interest rates would mean that his access to cheap capital would be curtailed. This would hit his expansion plans substantially. Thus he would be hit at both ends in terms of home loans being costlier making customers shy away from purchase of new houses and his expansion plans of building more and more houses taking a hit due to capital becoming costlier. A possible way to alleviate this would be to lower the prices on houses as there are fewer buyers and consequently lesser inflation. This would lead to some kind of stabilisation in the property market. Economic Change 2: The government makes a substantial rise in income tax rates at all levels. Business Situation One: A large retailer of electrical goods like TVs and Computers If the income tax rates are raised, this would mean lower “disposable” incomes in the hands of consumers as they have to pay a higher rate of tax on their incomes. This leads to lower purchasing power as they have less money in their hands. So for our retailer, this would mean lower sales and lower profits as the consumers would splurge less. Plus, the retailer may have to pay more on his pre-tax profits. The raise of income tax rates is a business unfriendly move and may result in lower sales as well as lower post-tax profits. Assuming that the retailer’s income is in the higher levels and the income tax rate is more at the higher levels of income, this would mean that the retailer would face a liquidity crunch in terms of his available income. Business situation two: A newly set up sole trader in Birmingham selling relatively expensive skin and health care products The raise in income tax rates would hit this trader the most among the three given scenarios. This is because the trader deals with high-end customers and operates in an essentially niche market. The likely customers for this trader would be upwardly mobile individuals and high net worth individuals. The increase in income tax rates would mean that the high end customers will have to pay more as income tax. This has cascading effects on their spending habits with the cut most likely to be in high value purchases or splurging on expensive facials involving skin and health care products etc. Assuming that the income tax rates are higher at higher levels of income, this would mean a higher payout for the high end customers for this trader. Business situation three: A builder of houses operating mainly across the West Midlands. Buyers of homes in any area are hit by the rise in income tax rates at all levels. Assuming that the tax rates have been increased more at higher levels of income, it would be natural for the home buyers to postpone their purchase of homes and that too in the expensive segment. Further, the builder has to pay more tax on his income and this would eat into his profit margins. Economic change 3: The local government, Birmingham, makes a substantial rise in its tax on business. Business situation one: A large retailer of electrical goods like TVs and Computers Whenever local government raises taxes on business, it usually raises the costs of doing business in that particular area. For a larger retailer, this means that he may not be able to diversify or expand his business in that area. He may, instead choose to expand his businesses in other areas that are more investment friendly. The retailer would have to handle his inventory in such a way that his working capital needs are adequately taken care of. Business situation two: A newly set up sole trader in Birmingham selling relatively expensive skin and health care products A raise in tax on business in the Birmingham area would mean that this trader would think twice before opening another store. And the given the fact that he has setup the business recently, he may have to take a hit on his profit margins as the tax on business is a major component of his overall tax burden. Assuming that the service tax or the value added tax increase is higher at the upper end of the business products, this trader may have to shell out more as he deals in products that attract more of the value added tax. Business situation three: A builder of houses operating mainly across the West Midlands. An increase in tax on business in Birmingham by the local government would affect the cost of doing business in that area. Since this builder operates in the West Midlands area, his level of exposure to the Birmingham area would determine the range of the effect on his business. An increase in the tax on business would mean that the builder would have to pay more for the services that he provides. This would affect the money available with him either for his expansion plans or for his ability to offer value added services to his clients. There would be an effect on the potential home buyers who have their own businesses and consequently would be affected by the increase in tax on businesses in the Birmingham area. Also, the builder would be at greater risk compared to the rest of the businesses described above as he operates primarily in the West Midlands area and consequently his exposure to the risk of increased tax is more. Conclusion In conclusion, we have seen that all the three economic changes impose their own financial costs on the three business situations in different ways and to varying degree. The economic changes given in the essay are all measures to control inflation and rein in excess liquidity while netting more resources for the government. This typically happens in an economic scenario where reining in inflation is the priority and also getting resources for governmental projects in the social sectors. Usually these kinds of measures are short term in nature and happen during a boom in the economy when there is increased spending by all and sundry. Typically, once these measures yield results, the economy stabilises after over-heating and then the government would go in for a more investment friendly policy. Sources: 1. Samuelson, Paul A.; William D Nordhaus (2004). Economics. McGraw-Hill. New York 2. "Monetary Policy Framework", Bank Of England, 2006. Read More