Macroeconomic Policy

Government’s macroeconomic objectives

Governments have many objectives that they wish to achieve, which can be political, social, or economic. To accomplish these objectives, a government tends to set policies. This brings us to the term ‘policy objective’.

Some examples of policy objectives include:

• Attain high levels of economic growth
• Maintain low levels of unemployment
• Achieve price stability
• Maintain a satisfactory balance of payments.

Let's take a closer look at each of these objectives.

Economic growth

Economic growth is important as it contributes to a better living standard, a lower rate of unemployment, and higher tax revenues for the government.

To stimulate economic growth, a government can enact policy to increase aggregate demand (national expenditure) or aggregate supply (national output).

Fig. 1 - Long-Run Economic Growth

As you can see in Figure 1, there is an increase in aggregate demand (AD) and long-run aggregate supply (LRAS), which causes the GDP to rise (Y1 to Y2) without increasing the price levels (P1).

Short-run vs long-run economic growth

A production possibility frontier (PPF) gives information on an economy's capacity to produce goods and services given existing resources. It also illustrates the choice of an economy to produce more capital goods or consumer goods. At any given point on the PPF curve, the production of more capital goods will result in fewer consumer goods produced and vice versa.

Suppose more resources are used to produce capital goods. Then, in the short run, the consumption will go down and the economy will suffer a temporary recession. If the investment is successful, then, in the long run, the productive capacity will increase, causing the economy to grow again.

The shift of the PPF curve to the right (or outward) shows this. In both the short and long run, the investment in capital goods comes at the expense of consumer goods. (See Figure 2).

Fig. 2 - Production Possibility Frontier

Full employment

In a perfect world, the unemployment rate would be zero since if you're not looking for work at the going wage rate, you will not be counted as 'unemployed'. Unemployment only takes into account people who are actively seeking jobs but aren't able to find one.

However, in practice, the economy never experiences zero unemployment. This is due to frictional unemployment - the situation where people delay getting a job in search of the best possible employment. The typical rate of frictional unemployment in an economy is around 2-3%.

Another way to define full employment is based on the full capacity of the economy.

Full employment and full capacity

Full employment will happen at output Y2, which is the maximum output of the economy. At this point, the economy cannot produce more goods and services since it has utilised all the resources available. Any increase in aggregate demand (AD) will only cause the price levels to rise without increasing real output. (See Figure 3).

Fig. 3 - Full Employment

Full employment and PPF curve

Any point on the PPF curve represents the maximum output an economy can produce. These are points A and B, as you can see in Figure 4. At point C, the economy is not operating at its full capacity, thus there is unemployment due to resources not utilised. Point D is only feasible if there is an increase in the productive potential of the economy enacted by the supply-side policies.

Fig. 4 - Full Employment PPF Curve

To curb short-run unemployment, the government can increase aggregate demand by enacting fiscal policy (lowering tax and increasing public spending) or providing subsidies in certain industries to encourage firms to hire more people. To increase employment to D, a government can pursue long-term supply-side policies to increase the productive potential of the economy.

Price stability

Price levels are regulated by the supply and demand of goods and services within the economy. A significant surge or fall in the supply/demand can cause the price levels to fluctuate wildly and put the economy at risk. Thus, one of the government's main objectives is to maintain price stability.

Since price levels determine inflation (the general increase in price levels), a government’s price stability methods often involve keeping inflation at a lower rate.

A high inflation rate can result in lower real wages and reduced purchasing power. This means that people are less willing to spend and as a result, production will fall and the economy might undergo a recession.

To fight inflation, the government often adopts a contractionary monetary policy by raising the interest rates. This causes the cost of borrowing money to increase and discourages people from borrowing money to spend on goods and services. As a result, consumption will drop and so will the price levels and inflation.

Balance of payments

A key aspect of the balance of payments is the current account. It consists of the value of exports and the value of imports. If the value of exports exceeds the value of imports there is a balance of payments surplus. Conversely, if the value of imports exceeds the value of exports, there is a balance of payments deficit.

A balance of payments deficit means that the government must borrow money from another source to pay for its imports. The money can come from another component of the balance of payments (like a BOP Financial account) or they can come from public spending. In the short run, a balance of payments deficit can stimulate economic growth.

However, in the long run, the country will struggle to pay off debts if it borrows. So the government needs to balance their policies in order to re-distribute their spending effectively.

Government macroeconomic policies

What tools can the government use to achieve its macroeconomic objectives? There are two main tools to help the government maintain a stable macroeconomic environment: fiscal policy and monetary policy.

Fiscal Policy

The main goals of fiscal policy include:

• Providing public services.

• Redistributing wealth and income.

• Achieving environmental objectives.

• Promoting economic growth.

• Regulating the economic business cycle.

There are two main types of fiscal policy: expansionary and contractionary.

• Expansionary fiscal policy aims to increase aggregate demand and shift the AD curve outwards by reducing taxes and raising government spending. With lower taxes, individuals and households have more income at their disposal to spend on goods and services. This increases production and creates new job opportunities. The increased government spending will also boost economic activities which require workers to be hired, contributing to lower employment levels.

• Contractionary fiscal policy tries to reduce aggregate demand and shift the AD curve inwards by increasing taxes and decreasing public spending. By increasing taxes the government can reduce the budget deficit, fight inflation, and resolve other balance of payment issues.

Monetary Policy

Similar to fiscal policy, there are two types of monetary policy: expansionary and contractionary.

• Expansionary monetary policy aims to boost economic activities by lowering interest rates or increasing the money supply. When the interest rates decrease, the cost of borrowing money is lower. More individuals and firms will be inclined to borrow more money and spend it. This improves the overall production and economic growth.

• Contractionary monetary policy tries to reduce inflation and reduce the size of the budget deficit by increasing interest rates. With higher interest rates, the cost of borrowing money will increase. This discourages individuals and firms from borrowing from the central bank and spending it on goods and services.

Demand-side vs supply-side policies

Overall, the government can regulate the economy through demand-side and supply-side policies. The main difference is that demand-side policies are designed to affect the aggregate demand, whilst supply-side policies are designed to affect the aggregate supply and productivity.

Demand-side policies include:

• Fiscal policies such as tax cuts and increased government spending.

• Monetary policies such as reduced interest rates.

Supply-side policies include:

• Interventionist supply-side policies such as government provision for private sector firms, training, education, and infrastructure. This policy emphasises the role of the government more than the role of the market.

• Non-interventionist supply-side policies such as tax cuts, welfare benefit cuts, privatisation, marketisation, and deregulation. In this policy, the market plays a more important role than the government.

The UK government's macroeconomic policy

Let’s see how the UK government applies what we've just learned to its macroeconomic policies.

Here are the four main macroeconomic objectives in the UK and the tools used to achieve them:

1. Maintain low inflation: since 2009, the UK government has been working on keeping inflation at a low level. The current aim of the UK government is to maintain inflation levels at 2%.¹ This is mainly done through monetary policies set by the bank of England, more specifically through monetary policy.

2. Reduce budget deficit: the UK government aims to reduce the size of the budget deficit with both monetary and fiscal policy, especially the expansionary fiscal and monetary policy.

3. Lower unemployment levels: the UK government utilises the instruments of fiscal and monetary policy to keep unemployment levels at a minimum. The current unemployment rate aim of the country is around 3%.

4. Limit the balance of trade deficit: to accomplish this, the British government has developed a ‘12-point plan’ to help firms based in the UK increase their exports to 1 Trillion pounds.² Some of the 12-point-plan strategies include an internationalisation fund that allows UK businesses, especially small and medium-sized businesses, to grow international sales. Along with this is the Export Support Service that helps UK firms to conduct more productive business in the European Union and North America.

International macroeconomic policy

When looking at macroeconomic policy in an international context, we may consider how the governments utilise macroeconomic instruments such as a fiscal policy to influence the exchange rate of international trade. Fiscal policy may affect the exchange rate through income changes, price changes, and interest rates.

The implementation of fiscal policy also has a general impact on the price levels.

If the government increases its spending, it will have to get that money from somewhere, usually, from borrowing through selling bonds. Selling bonds to its citizens can increase interest rates, which boosts foreign currency inflows as more foreign investors are attracted to high-interest rates. This capital inflow from foreign investors will lead to an appreciation of the exchange rate.