Expenditure reducing policies

An expenditure dampening or reducing policy is any action taken by a government that is designed to reduce the total level of spending in an economy.

Deflationary Monetary policy

An increase in interest rates is thought to reduce the money supply through demand for credit in the economy, thereby reducing the level of effective demand. This will, in turn, decrease inflation and improve the balance of payments (the latter by lowering the price of exports, increasing demand for them and simultaneously increasing the relative price of imports, reducing demand for them, and freeing more domestic output for sale abroad).

Limitation

Using interest rates is not without problems.

Time lag

There is a time lag between changing interest rates and the full effect being transmitted to the macroeconomy.

Adverse effect

A higher interest rate may also have an adverse effect on unemployment and economic growth.

Discourage foreign direct investment

A rise in the rate of interest may discourage foreign direct investment as it would raise foreign fi rms’ costs and the firms may expect demand to fall in the country.