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Spring 2022 Final Exam on Predicting the Effects of Government Policies from the University of Toronto.

This blog presents the solution to a micro-economics question most students encounter in the exam room. It involves predicting the effects of government policies, examined in a spring 2022 final exam at the University of Toronto. We offer a valid solution for a competitive advantage for students of all levels. Nevertheless, we offer economics exam help services, including major topics like predicting the effects of government policies. Hire us today to take your microeconomics exam.
Exam Question:
The government has established objectives to direct crucial economic activities. Using examples and illustrations from macro and micro-economic policies, explain how the Keynesian model and other investigated predictions serve the country's economic needs.
Exam Answer:
We use the dynamic Keynesian model built up in Chapter 10 and some knowledge acquired by investigations over the years to predict the effects of certain policies on certain firms. So we first look at the kind of objectives governments have and then at the policy instruments they use to achieve them. We divide them into macroeconomic policies dealing with the economy as a whole and microeconomic policy dealing with particular markets or regions of the country.

Government Objectives

Governments have many objectives, but it can be instructive to divide them into six main ones.
  1. Incomes or Growth are probably the main targets of many economic policies. This is not to suggest that economic growth is desirable for any particular country or the world; that is another book! However, most governments have one of three attitudes: to reduce poverty on a national scale by 'development', to provide a higher standard of living in an already prosperous country, or to prevent living standards from falling. In each case, we can call their aim related to incomes, if not in all cases, to economic growth.
  2. Prices at their general level, usually termed the 'cost-of-living or inflation is another major concern. Historically, the inflation rate was high during the 1970s, and its reduction has been a major objective of nearly all governments worldwide.
  3. Employment of those wishing to work has been an aim of many governments since about 1940. The definition of full employment varies, but there is a general commitment to it. This is a notable example of the effect of theories on people's lives. Before Keynes, there was a general belief that either unemployment was caused by people demanding too high wages or that certain levels of unemployment were inevitable and government intervention would only make matters worse. After Keynes, and of course, the demonstration of 'full employment during World War II, people demanded that governments provide full employment.
  4. Social Reform is another aim common to many governments. Often it takes the form of 'redistribution of income, sometimes from the richer to the poorer by using taxation to pay for pensions and sometimes shifting the burden to poorer people by lowering income tax and in- creasing health charges. In either case, the policy involves a view about a 'just' distribution of income and a wish to change the present position for a 'better' one. At irregular intervals, the social reform policies may be more extreme and involve changes in land ownership, nationalization, setting up (or dismantling) a health service or part of the education system. Forecasting the effect of social reform policies is often difficult; as we have seen earlier, the initial, 'short-run effects are often different from the eventual, 'long-run' effects.
  5. External payment balance has usually been the concern of UK governments, although North Sea Oil has (temporarily) removed this problem. However, although the balance of payments does not worry us as much as in the 1950s and 79, we are still affected by the exchange rate, which now concerns UK governments as much as the balance of payments formerly did. The UK trades about 25% of its national income, one of the highest proportions in the world, and thus is affected by world prices, booms and slumps. These world effects are transmitted in the UK economy through the exchange rate. If the pound's value falls, it makes our goods cheaper to foreigners, their goods more expensive to us, and brings more world inflation into the UK economy, and vice versa. Thus the exchange rate level may be an objective of the government for this, and other even less understandable reasons
  6. Political Survival is the final objective of governments which it would be wrong to ignore. We can expect any government, particularly if susceptible to democratic pressure, to do popular things to continue in office. We expect this motive to be strongest for governments that rely on other parties for support or near election time. It is as important in other countries (export markets) as in the UK.

Trading-off Objectives

Keynes's thesis was that the economy was controlled by demand. Thus controlling demand would control the economy. This idea of demand management is central to how the UK (and many other) governments think when running the economy. What effect does change the level of demand have on the objectives? Figure 11.1 summarizes generally held views. Suppose the linkages are as we have shown them. In that case, governments will want to increase demand if they are interested in employment and (perhaps) to create social reform and ensure political survival. However, they would need to cut demand to prevent excess inflation and ensure the right effects externally. If this is true, objectives must be traded against each other. So, to cut inflation, we may have less employment, at least in the short run. We discuss below whether the monetary policy offers a way out of this dilemma.
Demand and government objectives

Fig 11.1 Demand and government objectives

The net result seems governments will be balancing various objectives and changing the balance from time to time. We can expect them to attempt to carry out their 'manifesto' at first and, subsequently, perhaps to move towards compromises as the next election approaches. We now look at the different instruments or policies available for achieving the objectives and some of their likely effects on particular firms.

Macroeconomic Policy Instruments

The government can influence the economy in five main ways: fiscal policy, monetary policy, direct controls, nationalized industries and 'persuasion.

Fiscal policy

Fiscal policy strictly means taxation, but it is usually used to include government expenditure. The government's budget affects firms by its overall surplus or deficit, as discussed in Chapter 10, and by the particular ways it raises revenue and spends it. First, we can look at the effects of raising revenue through taxes on personal income, company income and goods and services.

Personal income tax

What effect do personal income taxes have? What would affect firms if the government were to increase personal taxes? Suppose we assume income taxes of a conventional kind. In that case, lower incomes are exempt through a system of allowances for family members, and the tax then takes a proportion of income above that level. Raising tax rates will reduce disposable (after-tax) income, which should cut demand for consumer goods. This, in turn, will reduce employment, and the multiplier effect will continue for some time. Reduced income will cause consumers to turn away from superior goods.

Reducing demand for goods reduces pressure on prices, making it harder to put prices up. This competition may help to mitigate inflation when demand is reduced. Whether reducing demand reduces inflation may be difficult to accept in some circumstances, but that reduced personal income that will reduce imports is more certain, particularly in the UK. We can support this case with direct evidence or by assuming that imports are a proportion of consumers' expenditure. The only case where reductions would not reduce imports in consumer expenditure would be if imports were, as a group, inferior goods. Income taxes also change the distribution of income as well as its level. So there will be effects on the demand for certain industries.

The effect of income tax on willingness to work has been the subject of lengthy controversy. We only offer some simple ideas. In the long run, people may refuse to take higher-paid jobs if they involve more work but, because of tax, little extra pay. They might also emigrate if their skills are more highly rewarded elsewhere. The country is attractive on other grounds as well. In the short run, the result is likely to be protests at higher taxation, but people may try to earn more money to have the same amount of "disposable income with which to pay fixed commitments. Income tax stimulates the tax-avoidance industry. Taxation into account affects investment in decision-taking, as the investment is concerned with generating the future by changing the rate of profit tax, which have an almost immediate effect on investment. If the profit tax rises, it can cause the cancellation of investments, but a fall in profit tax will take longer to stimulate investment because projects take time to get organized. (For this reason, policies to stimulate investment are often concentrated in the public sector, e.g. the US has a programme of 'public works' which is ready to be started when the unemployment rate rises above a certain level. Thus the firms likely to be involved can take them into account in their planning.)

Apart from the effect on investment, we can look at the effect of profits taxes on the owners' income. In the short term, profits taxes can affect the owners' income, but we expect the firm to earn 'normal profit' in the long run. Thus increases or decreases in profits taxes would eventually be 'passed on' to the customers. This theoretical prediction appears to be borne out by studies in the US. The UK has shown declining profit rates for firms recently, but this is not mainly because of higher profits taxes but rather the inability to raise prices because of foreign competition and government price restraint policies

Taxes on goods and services

The main tax on goods and services in the UK (VAT) has some peculiarities, but all taxes on goods and services have the kind of effects listed here. In the short term, taxes on goods and services raise prices, and the effect this has depends on people's views of the future. If they see the price rise as temporary, they will continue to buy consumer goods such as food but postpone the purchase of consumer durable such as household appliances. If the tax rise is seen as part of general inflation, consumer durables might be bought now rather than later, and consumers might start to switch away from non-durables on which the tax has been raised. The expectations about inflation are crucial in forecasting the result of tax changes on goods and services.

Taxes on company income

Taxes on company income take longer, in general, to have an effect than most other taxes. This is because they are usually taxes on profits and are thus levied about a year after the profit is made. The exception to this statement is in the effect of taxation on investment-that is, if the company takes. As in other cases, we must distinguish short-run or impact effects from long-run adjustments. This is particularly important with tax reductions, where there may be sudden, almost irrational increases in demand in the short run. In the long run, we can expect the price changes caused by tax changes to cause a shift away from the goods whose price has risen. This might lead to more price competition and price reductions depending on suppliers' costs. Extra taxes will almost always lead to less demand for imports, as for home-produced goods, and may lead to some firms attempting to export more to make up for lost home-market sales. This factor can be important in assessing the impact of increased taxes on goods and services in other countries: not only will it be harder to sell in the other country, but some of their products might also start to invade your home market.

Government spending

We shall look at three types of government spending which affect firms differently. These are defence spending, transfer payments and social security, and spending on 'economic services.

Defence expenditure

There is, of course, a major issue about the role defence expenditure plays in 'capitalist' economies and in 'communist' ones, too, for that matter. However, it is possible to make some statements about its effect on individual firms, which are fairly well supported by evidence. The first effect is that of stimulating high-technology industries. If some objective (defence in this case, or the race to the moon) has to be achieved regardless of the cost, then the results may be impressive. Thus the US and USSR are leaders in rocket technology: this gives them leadership in developing satellites, which gives private firms in the US access to ideas as diverse as metallurgy, microelectronics and solar power. Thus consumer products such as calculators, electronic games and solar heating will be produced more cheaply due to defence expenditure. A similar link between nuclear engineering in submarines and power stations can be shown. The point is not that the new products are beneficial- the nuclear reactors may malfunction, and the defoliants may have side effects. Still, that technology may be invented faster under the imperatives of defence expenditure.

The second aspect of defence expenditure is that it almost always harms the balance of payments. Many countries do not produce the arms they wish to buy and thus have to accept a lower standard of living to export to pay for them or become linked somehow to an arms supplier. Countries that produce arms have a different dilemma: overseas arms sales are needed to pay for expenditures on bases and navy costs. However, many countries cannot afford arms without subsidies or special bilateral trading agreements, and the relations with the arms supplier can cause domestic political problems. Thus the foreign exchange aspects of defence spending make it vulnerable to sudden changes in policy, which may make defiance-related industries risky, and the problem of paying for arms may disrupt the foreign trade of small countries.

Transfer payments

All governments have some element of transfer payments in their budgets. Essentially, they tax the income receivers and spenders and provide payments (or services) to 'deserving' cases. What is considered a deserving case differs, of course, from country to country and from time to time? Major programmers exist in most countries to make education less costly, cushion people against the effects of not-earning (for reasons of old age, illness, disability, unemployment, maternity, injury at work, widowhood, etc.) and mitigate the effects of large families and low wages. When an actual income transfer takes place, the effect stimulates demand because the transfer is financed by people who would probably have saved some of this amount. The receivers will usually spend almost all of it. Thus increases in transfer payments, such as old-age pensions, can be expected to boost demand even if they are financed by extra taxes or contributions rather than borrowing. They also change the direction of demand in an obvious way which affects particular firms.

Economic services

Economic services have been used to describe items in the UK budget that essentially encourage or make business activities affordable. Under this heading would come road-building, subsidies to other transport areas such as railways and buses, investment grants and tax reductions, and services to exporters and firms wishing to locate in the country from abroad. The ability to forecast some of these expenditures would be particularly useful to some firms, whether as suppliers of services or users.

Direct controls

Direct controls are used when the government decides on individual cases submitted to a higher power. Depending on the particular control, the control may be delegated to a department, a body such as the Price Commission, the Bank of England, or local authorities. The controls are thus detailed interventions in particular markets and thus matters of ideological controversy. This means that they may be changed, abolished or extended at changes of government and are thus difficult to predict for more than a short period ahead. We now look at the effects of three direct controls, which have been important in recent years.

The first is control over the location of new factories and offices. There are incentives and assistance for location in areas of high unemployment, but these do not involve decisions on individual cases in the control sense. Civil servants who have to decide whether a project receives assistance interpret rules rather than make decisions. However, local authorities have the right to control and use it. Regional offices of the central government department responsible for granting permission to build or extend premises (the name of the department changes regularly) can exercise discretion. This means that permission to extend factories and offices in London and Birmingham is much harder to get than in Glasgow and Liverpool, and this has been an important factor that firms have to consider.

The next direct control is over prices, and the effect of price control legislation has almost always been to slow down price increases. Price 'freezes' have tended to distort relative prices by holding prices constant rather than letting them reflect cost and demand changes. This has meant that the ending of price controls has usually meant an apparent 'price explosion'. Like location controls, price controls mean firms have to learn new skills to cope with a new constraint on their profitable operation. Thus some firms have learned to anticipate the effect of future price controls, argue cases for price increases, and exploit loopholes in the legislation. The firms 'caught by price control have, conversely, been unable to generate enough profit to carry on successfully and have thus cut back on advertising, dividends, research and investment.

The third control that has been important is exchange control, which limits access to foreign currency. Banks administer the control for the Bank of England and seldom affect trade when it is in operation-it was removed in late 1979- the main effect is to limit the firm's ability to invest in other countries. However, the details of exchange control will repay study by firms exporting and importing, although its overall intention- to help the balance of payments is easy to understand.

Monetary measures

The extent to which governments use monetary controls varies from time to time, but all governments use their powers to control the cost and availability of credit. Usually, the central bank formally exercises the powers (in the US, the Federal Reserve, the UK, and the Bank of England). Still, the government retains ultimate power to vary policy. The central bank's monetary measures may differ from the government's policy in some details or emphasis but seldom be opposed to it.

The cost of credit

Financial markets relate rates or interest to the MLR or minimum lending rate of the Bank of England. When MLR is raised, other rates will usually follow, and vice versa. Higher rates seem to affect the demand for consumer durables, such as cars, furniture and electrical appliances, and houses, all items largely bought on credit. Many regular purchases, however, such as groceries, are not affected by the cost of credit. Similarly, some of the expenditures of businesses will not be affected, but many will be. Firms are likely to look more carefully at investments in stocks, aiming to reduce money 'tied up' in them, and they may reappraise capital investments. However, long-term investment sally based on a view of the future, which may be very sensitive to present interest rates. Firms using modern discounting methods will be more responsive to interest rate changes because the higher interest rates represent an attractive alternative use of their funds (see Chapter 17). Higher rates will raise the cost of borrowing by the government, and this will tend to cause two results, a desire by the government to keep rates as low as possible for as long as possible and cuts in expenditure to pay the higher interest costs if high rates are thought necessary for any length of time. High rates also attract foreign investment, at least temporarily, and thus may alleviate balance of payments or exchange rate problems.

Like other policies, monetary policy's effects on business behaviour are harder to predict than its effects on business costs. Most policies aimed at reducing demand, or cutting inflation, put up costs. Still, this depressing effect on business may easily be effective in some circumstances by increasing confidence if the policy is seen to be contributing to prospects.

The supply of credit restrictions on credit availability is often associated with high-interest rates, but not always. Thus we separate the two aspects of monetary policy. We can look at the effect of credit restriction, or relaxation, on consumers and small and large businesses. Consumers' purchases of durable goods are affected more by the supply of credit than its cost. This is particularly seen in the demand for new housing and housing for new families. Large businesses are not so much affected by credit restrictions, mainly because of the government's inability, in most countries, to control much more than the orthodox banking sources of finance. Thus large firms can still use their profits, use shares, borrow from non-bank financial institutions, and from abroad.

Small firms, however, are much more limited in their finance sources and suffer when credit restrictions are applied. The report of the Wilson Committee on the financial services provided by the City of London' (Cmnd 7937, 1980) gives further insight into this problem.

Thus we have various effects of monetary policy on firms, and knowledge of these effects is important if they survive. Often the sudden application of monetary restraint on an economy, Failure to deal adequately with credit problems, for instance, can lead to cash flow problems and, in some cases, bankruptcy. Credit squeezes almost always lead to a higher bankruptcy rate in small businesses. Avoiding this may be as unpalatable. Some firms surrender control or make disadvantageous arrangements to sell assets when faced with cash flow problems. No doubt readers can supply their recent examples.

Nationalized industries

The large public sector in the UK makes it possible for the government to carry out some of its macroeconomic policies directly and use the public sector to influence the private sector. Again, the topic is enormous, but we can illustrate some of the possibilities and limitations of this approach.

Public sector purchasing policies can be used in various ways to help specific objectives. One of the most politically popular is to help balance payments by 'buying British' (or American). Less popular is not buying from firms that do not carry out "voluntary" anti-inflation policies. Another purchasing policy which might have results for the whole economy is favouring small suppliers. Governments generally tend to buy from large firms, but deliberately buying from small firms could help to keep prices down and perhaps create more employment.

The employment policies of the public sector can also aid some macroeconomic policies, notably anti-inflationary and employment policies. However, asking government employees to accept low wage increases is not likely to be popular, and employing more workers is always expensive.

Public sector investment policy can be used counter-cyclically, but it can cause problems if public sector projects are cut back when tax revenues fall (during a recession).

Similarly, it is possible to successfully use the public sector's pricing policies to carry out macroeconomic policies. Still, the effects could be disastrous, for instance, keeping prices frozen during inflation while not investing in extra capacity.

However, despite the problems and dangers of using the operation of the public sector as an instrument of macroeconomic policy, it is likely to be used at times in many countries because it is easier to use than some of the other policies, at least at first. Thus firms must be prepared for the "non-commercial operation of the public sector in many countries at times of macroeconomic problems.


Persuasion is like the public sector: it will sometimes be a very attractive policy for a limited period. By persuasion, we mean the government trying to persuade the public and firms to carry out some policy which is to some extent against their selfish short-term interest. This can be done by an appeal to any motive other than short-term gain, for instance, to buy US (or UK) cars rather than Japanese, either for patriotic (or chauvinistic) reasons or long-term national prosperity. Similarly, voluntary' wage and price restraint can be popular if it promises to reduce inflation. Much of our behaviour is already not governed by short-term self-interest; persuasion attempts to extend this slightly. Its main merits are that it is cheap and, as it is voluntary, may be extremely effective. For instance, voluntary conservation may create savings that would be hopelessly expensive to achieve by legal sanctions.

Microeconomic policies

Microeconomic policies are concerned with individual firms, markets and areas of the country and tend to work more slowly than macroeconomic policies. All countries have some of these policies, but the UK is a good case study for nearly all of them.

Regional policy

Regional policy is the attempt of the government to influence the location of industry. Its history is long and interesting, and there has been some limited degree of success. Regional income disparities are less in the UK than in some other countries despite a general lack of economic growth. The policy has been mainly aimed at creating and retaining jobs in areas of big unemployment by providing incentives such as grants, loans and tax breaks. Land use planning controls restrict location in more prosperous areas, and knowledge of incentives and restrictions is essential for fem locating in the UK. For example, if we embark on aid, the government can supply a large part of the cash flow needed to set up a new factory.

Monopoly policy

This is an area where the firm can easily fall foul of government action even though the number of instances where anti-monopoly policy is enforced is very small. The emphases vary from time to time and country to country; for instance, resale price maintenance is allowed for some goods but not others in the UK. The law is often defined in ways that do not make 'economic sense, penalizing small firms but not large ones and national monopolies but not multi-national firms, which means that knowledge of the particular country's system is very important. As for all the material in this chapter, further reading provides a valuable summary of the UK policy and some of its recent history.

Industry policy

This is the term commonly used in the UK to describe an interest of the government, in the 1960s and 1970s, in fostering the merger of small firms into more 'economic production and selling units. In the 1960s, the IRC (Industrial Reorganisation Corporation) and in the 1970s, the NEB (National Enterprise Board) were set up to assist firms in merging and investing. Political controversy surrounds this policy as it may conflict with both monopoly policy and an ideological belief in "free enterprise". Thus it has been pursued by Labour governments and eschewed, in the main, by Conservative governments. However, the Conservative governments created mergers in nuclear engineering and aerospace.

Small business policy

Assistance to small businesses in the UK is much smaller, more recent, and less formal than in the US. Still, the importance of small businesses for innovation and employment growth is recognized. Thus there is an increased willingness to remove obstacles to the operation of small businesses. The recent growth of this policy makes the study of its detailed operation useful for those responsible for advising small firms. In turn, the government provides financial assistance to firms wishing to use consultants to solve particular problems.

Export policy

UK export policy is similar to its policy on small businesses, without major financial incentives. In the case of exports, this is because international trade agreements forbid export subsidies. Some more general government policies help exports, such as membership in the Common Market and the workings of VAT. Still, the most common assistance is the advice provided by ECGD and financial institutions. As its name implies, ECGD (Export Credit Guarantees Department) also guarantees that exporters be paid by their overseas customers; in effect, it insures the credit.

However, it is possible to use credit to subsidize exports. There are various ways in which this can be done, but the most common is to make low-interest loans to a 'poor' country on the understanding that it will be spent in the country providing the loan. This is an important and difficult-to-prevent method of distorting competition, particularly for large capital projects. Thus covert government assistance is often important in obtaining foreign contracts. Books on the 'multi-national firm' explore this relationship between governments and firms further.

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