We will start by considering government’s objectives when they intervene in the macroeconomy (e.g. set policies to tackle inflation and improve balance of payments).
To start thinking about government interventions, let’s try the below task:
- Some key targets of macroeconomic policy can be:
- Price stability – Controlling inflation helps markets operate effectively and encourages investment;
- Full employment – Allows economy to operate on the production possibility curve (also people can suffer from being unemployed);
- Equilibrium on balance of payments – Avoids issues with exchange rate;
- Economic growth – Expanding the productive capacity of an economy ultimately improves the well being of its citizens;
- Lack of environmental impact – The externality of damage to the environment can ultimately damage an economy;
- Income redistribution – Progressive taxation and social security benefits can lead to a more harmonious society.
Which of the policy objectives mentioned above do you consider to warrant the highest priority for a government. Let’s each person in the class rank them in order of importance and then we can compare our rankings.
Which of these policy objectives is the Bank of England trying to juggle in this linked article?
Instruments of macroeconomic policy
- The government has three tools that it can use to implement its macroeconomic policy. These are:
- Fiscal policy – Decisions made by the government on government expenditure, taxation and borrowing (an expansionary fiscal policy seeks to increase aggregate demand by increasing government spending or cutting tax rates). In the UK, fiscal policy is stated in the annual budget. Typically the government seek a balanced budget over time. They may not be too worried about a cyclical deficit due to policy changes, but would be concerned about a structural deficit, where government spending is persistently greater than tax revenue;
- Monetary policy – Decisions made by the government regarding monetary variables such as money supply or interest rates;
Task – Monetary Policy
- Supply-side policy – Measures intended to have an impact on aggregate supply and the potential capacity of the economy to produce. e.g. encouraging investment in physical and human capital.
Task – Supply Side Policy
Task – Distinguishing type of policy
Let’s copy the below diagram as a guide to the different types of policy.
Policies to correct disequilibrium in the balance of payments
We can consider two broad categories of policy: expenditure switching (policies designed to persuade domestic and foreign consumers to purchase more domestic products and less foreign products) and expenditure dampening (policies designed to reduce domestic consumption (with the intention to reduce imports and increase exports)).
To dampen expenditure, fiscal policies such as increasing income tax and reducing government spending can be used. Relevant monetary policy could be to reduce the growth of the money supply. Changing the rate of interest is a little more complicated. If inflation is low and the current account is in deficit, a central bank may reduce the interest rate to put downward pressure on a floating exchange rate, causing increased competitiveness of domestic products, however this also risks inflationary pressures. They could also increase the interest rate to reduce demand for imports and reduce inflation.
To switch expenditure, fiscal policies such as imposing a tariff or increasing an existing tariff can be used. Here also relevant monetary policy could be to reduce the growth of the money supply. Also a government may reduce its exchange rate, or devalue its currency, causing a fall in export prices and a rise in import rises.
Fiscal policies can have a short-term impact on the current account position, but are unlikely to be a long-term solution, as once they are stopped spending on imports and exports will typically revert to their original ratio. Raising taxes ca also lead to lower demand, thus increasing unemployment and slowing economic growth, as well as serving as a disincentive that can reduce aggregate supply. Imposing tariffs also carries the risk of retaliation and can reduce pressure on domestic firms to increase inefficiency.
For an economy in macroeconomic equilibrium, inflation can be due to either a leftward shift in the aggregate supply curve or a rightward shift in the aggregate demand curve. First let’s look at the impact of a “supply shock”:
A supply shock, such as increase in the price of oil leading to firms facing higher costs (such as happened in 1973/74) leads to a one-off increase in price and a reduction in quantity produced, but without a tendency for continued inflation. Thinking in terms of the quantity theory equation, MV=PY, P has increased and Y has decreased, but M or V have not been impacted.
Now let’s look below at the impact of an increase in aggregate demand. As you see, price increases without an increase in output. Moreover, if this shift is caused by an increase in government expenditure, financed by an increase in money supply, the AD curve can continue to move to the right, causing not just a move to a new macroeconomic equilibrium, but inflation.
There are different schools of thought regarding macroeconomic policy.
The Monetarists, such as Milton Friedman, suggest that the root cause of inflation is always money supply rising more rapidly than real output and so it is best fixed by the government restricting money supply. They suggest, in general, that the macroeconomy always adjusts rapidly to the full-employment level of output and that monetary policy should be the main instrument for stabilising the economy.
By contrast, the Keynesians suggest that the economy could settle at an equilibrium that is below full employment and that a more active approach to managing the economy is necessary. Keynesians also point out that deflation (as has been experienced in Japan) can be problematic, as people defer spending plans based on the expectation that products will be cheaper in the future. These viewpoints will be considered in more detail in the A-level part of the course.
Balance of payments
Macroeconomic intervention requires an understanding of the trade-offs between inflation, unemployment, the balance of payments and the exchange rate.
If a country experiences higher inflation than its trading partners, its domestic goods will become less competitive, putting downward pressure on the current account of the balance of payments (and the exchange rate). If the exchange rate is fixed, this will require the government to take steps to maintain the exchange rate, but with finite stocks of foreign exchange this is not possible indefinitely. So the government many need to take measures to contract the economy, called expenditure dampening (i.e. reducing domestic demand for imports), or to redirect foreign consumers towards domestic goods (expenditure switching). The may also use exchange controls, regulating the amount of foreign exchange that is a available for domestic residents.
If the country has a floating exchange rate, high relative levels of domestic inflation will cause the currency to depreciate (if a surplus on the financial account doesn’t cover the deficit in the balance of payments current account). This depreciation will restore the competitiveness of domestic goods (known as the purchasing power parity theory of exchange rates). If the inflation was caused by excess aggregate demand however, this increased foreign demand can worsen the situation, further increasing prices (i.e. if the elasticity of the supply of exports is low).