Suppose you are an entrepreneur, and you are considering a long-

term expansion of your business. Discuss what kind of fiscal- and

monetary policies that you want the Government and the central
bank to implement.

It is the job of the entrepreneur to organize resources in a

business. There are many reasons as to why an entrepreneur may
wish to expand his business; larger firms enjoy the benefits of
lower average cost of production through greater economies of
scale, as well as a higher market share amongst other benefits. In
the long-term, an economy needs to increase potential output
and term growth and expansion of a business mainly comes
about by increasing the quantity, quality and efficiency of the
factors of production in an economy. However, it is important to
note, that without the assistance of the Government and the
Central bank via their fiscal and monetary policies, this business
expansion may prove to be extremely difficult, if not impossible.

One of the central banks policies is Fiscal policy. Fiscal policy is

the use of the government’s budget to induce an effect in the
total level of economic activity in the country by influencing the
Total Demand (Aggregate Demand) for goods and services. (Total
Demand is a summation of all the demands in the nation’s
individual markets.). The Governments budget depends on the
Governments expenditure and its taxation. Therefore in Fiscal
policy the Government makes use of these two tools to effect AD.

A Governments Fiscal stance refers to wether it is pursuing an

expansionary or contractionary Fiscal policy.

As the questions states, supposing I am the Entrepreneur, I would

want the Government/ Central bank to implement An
Expansionary Fiscal policy, which would means that Government
expenditure (G) will increase and/or Direct Taxes (T) decrease.
For someone who is thinking of a long term expansion of his
business this would be the ideal situation as I am likely to receive
more grants and subsidies from the Government, due to an
increase in G especially when I am undertaking an expansion and
also because an increase in G will lead to a full and multiplied
increase in national income, thereby increasing consumer
spending and thereby increasing AD. At first thought, one would
probably assume that AD will shift exactly by the amount of G.
However as the multiplier affect suggests, this increase will be
much more than just that initial amount. For example the
Government places an order with my business worth £10 million.
Now this increase in G of £10 million initially shifts the AD curve
by the exact amount, however this order of £10 million will make
me increase employment, increase my profits, and thus as
workers see higher earnings ,both will increase spending on
consumer goods which will result in demand for other goods
increasing too and therefore will lead to higher incomes and even
higher demands. If all these increases in demand are added
together it will be realized that it is much more than the initial
increase in demand by the government proving that G has a
multiplier effect on AD which is beneficial for all businesses.
(Multiplier effect diagram)

On the other hand we have a reduction in T as per the

Expansionary Fiscal policy. Along with G, a reduction in T would
further help because this would be mean a lesser tax cut and thus
higher profits for me, of which I can invest a greater part back
into the business. Also a reduction in T will leave consumers with
more disposable income which they can spend which would in
turn induce an increase in AD. This increase in demand will be
coming at the opportune moment of when I am thinking of
expansion as an even further increase in AD will mean higher
profits. The multiplier has its effect with regards to T as well, as
the same process occurs as it did with G. However a very
important determinant with regards to the shift in AD because of
T is what consumers will perceive of this Tax cut. Will they think
of it as long term or as short term? If long term then they would
accordingly adjust their spending patterns. However if they think
of it as temporary, then they will save it. In the first case the tax
cut will have a greater impact as compared to the second case
where spending will not increase by much and therefore neither
will AD.
 The question that now arises is Will changing G or T have the
same effect? Is an increase in G of £10 million the same as
reducing T by the same amount?

The answer is NO. If G is increased by £10 million, this will lead to

a full and multiplied increase in National Income and in turn AD,
because all the money that the Government gives my business
for catering its order will be circulated in the economy. However
the same cannot be said about a reduction in T of £10 million. The
effect will be smaller because of the simple concepts of marginal
propensity to consume (mpc) and marginal propensity to save
(mps). These concepts explain a family is not likely to spend all its
income but save a part of it. What they spend is mpc and what
they save is mps. Therefore a reduction in T will increase their
disposable incomes but not all will be spent. Rather some of it will
be saved and therefore not all of the tax cut will translate into an
increase in AD. This implies that the required tax cut needs to be
bigger than required increase in G to achieve the same increase
in Income (Y) or AD.

However there are certain limitations with Fiscal policies. One of

the main ones being ‘The Crowding-out Effect’, which suggests
that because of an increase in National income (Y) following fiscal
expansion, the demand for money increases and a money
shortage occurs which makes interest rates (r) rise and therefore
tend to reduce interest sensitive expenditure thus partially
offsetting the expansionary effect of the increase in expenditure.
This partially offsetting of expenditure is called the ‘Crowding-Out
Effect’, which could easily be resolved if the money supply was
increased at the same rate as the money demand increased. No
money shortage would me increase in interest rates (r) and
therefore no crowding out effect.
(Crowding out effect diagram)

Another limitation to the Fiscal policy could be the responsiveness

of consumption to tax changes. The theory of consumption
function is the Keynesian theory. An alternative theory to this is
‘The Permanent Income Theory’, which relates consumption to
what people regard as their ‘permanent income’. This states that
people do not let short term fluctuations in their current incomes
affect their consumption rather they do not spend the extra
income but save, it. Thus consumption expenditure will not rise as
much as predicted by the Keynesian theory which relates
consumption to current income.

Just like the central bank’s fiscal policy, there is the monetary
policy. The monetary policy has a connection with the money
supply and interest rates which in turn affect AD and Y.

I as an entrepreneur would definitely want the central bank to

implement an expansionary monetary policy for the reasons
that it is increasing money supply, AD and Y, and at the same
time decreasing interest rates which would make it easier and
less costly for me to borrow.

How this works is the original supply of money sets an

equilibrium interest rate as shown in the diagram below, we
see the supply curve shifting to the left from M to M1, interest
rates reducing from r to r1 so that monetary equilibrium is re-
established at the interest rate r1 and money supply M1. This
was the first link between money supply and interest rates. The
next link is between the interest rate and the investment
expenditure. This relation is also shown in the diagram below.
As the diagram shows that the lower the interest rate the
larger the demand for investment, (the MEI curve is one and
the same as the Demand for investment curve), the larger will
be the number of investment opportunities, thus the larger the
volume of investment expenditure.

In the diagram below, in both cases we have r on the vertical

axis so comparison is easier. In the beginning at the interest
rate of ‘r’ money supply is in equilibrium at M, and investment
expenditure is in equilibrium at ‘I’, but after the shift in money
supply to ‘M1’, r drops to ‘r1’ and thus ‘I’ moves to “ I‘ ”. The
change in investment expenditure has been shown.
 (The effects on changes in money supply on desired
investment expenditure diagram)

Therefore an increase in money supply will cause a fall in

interest rates, which will increase desired investment
expenditure and therefore shift aggregate expenditure by the
amount of shift in the figure above.

This would definitely be beneficial for me because it would

increase expenditure/demand which would aid any growing or
expanding business.

One of the main problems with monetary policy is that if the

economy is in recession and money supply is increased, people
cannot be forced to borrow no matter how low the interest rates
are. Similarly firms may not want to invest by borrowing more if
they feel that recession will be long term.

However changing interest rates is effective because it can be

done quickly without any time lag. Also it sends out a clear
message to people and alters their expectations accordingly.