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GOVERNMENT FINANCE AND PUBLIC MONEY
Attempting control
How it works
Economic policy-making has been compared to trying
to operate a finely balanced machine. By adjusting
various policy “dials”, the government aims for the
best combination of key economic variables − usually,
a combination of low inflation and unemployment levels.
However, economists point to a trade-off between
inflation and unemployment, with low unemployment
coming at the cost of high inflation, and vice versa.
More recently, economists have concluded that
economies run best by themselves, with institutions
such as central banks controlling monetary policy,
while the state concentrates on “supply-side policies”
such as making markets more efficient.
Raising interest rates
The government, by setting its
inflation targets, directs the central
bank to change the base rate, which
in turn influences interest rates.
When rates rise, borrowing costs
becomes more expensive, people
spend less money, and businesses
may feel they need to reduce their
prices, so lowering inflation. Cutting
rates has the opposite effect.
Increasing spending
When the economy slows down
and there is a risk of a rising rate of
unemployment, the government
can try to stimulate the economy
through increasing spending. By
encouraging public spending,
the state increases the likelihood
of firms employing more people
to meet the extra demand. Cutting
spending has the opposite effect.
To reduce unemployment, the
government increases spending in
areas such as infrastructure to increase
the number of construction jobs.
Higher spending pumps money into
the economy, raising inflation.
With unemployment low, the
government raises interest rates,
increasing the cost of borrowing and
reducing the amount of money in
circulation to try and lower inflation.
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