Cambridge International as and a level Economics Ebook

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Chapter 5: Government macro intervention 

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A rise in interest rates may have an adverse eff ect 
on investment. Th
is is because it will increase the cost 
of borrowing funds to invest and will increase the 
opportunity cost of using profi ts to invest. If investment 
falls below depreciation, the capital stock will decline. Th
e 
resulting decrease in aggregate supply can push up the 
price level.
Some countries may face constraints on the fi scal 
and monetary policy measures that they can use to 
correct infl ation. Governments may be worried that if 
they raise income taxes higher than those operating 
in rival countries, some of their skilled workers may 
emigrate. Countries that are members of an economic 
union may operate the same interest rate and the 
same exchange rate as other members and the area’s 
central bank may make the decisions on these areas of 
monetary policy. Another constraint may operate in 
the case of a country operating a fi xed exchange rate. 
In this case, its central bank may be reluctant to raise 
the interest rate as it may put upward pressure on the 
exchange rate.
Supply side policy measures have the potential to 
benefit all of a government’s policy objectives in the 
long term. They can reduce inf lationary pressure, raise 
economic growth, lower unemployment, stabilise an 
exchange rate, reduce a current account deficit and 
promote development. In the short run, however, 
some supply side policy measures may contribute 
to inf lation. For instance, increased government 
spending on education and cuts in income tax may 
increase aggregate demand before they increase 
aggregate supply.
In addition, as previously mentioned, the eff ects of 
supply side policy measures are uncertain. For instance, 
privatised fi rms that have considerable market power may 
raise their prices.