Unit 10, Government macroeconomic policy objectives, links between macroeconomic problems and their interrelatedness, and effectiveness of policy options to meet all macroeconomic objectives flashcards

government macroeconomic policy objectives

low and stable rate of inflation, balance of payments stability, low and short-term unemployment, economic growth, economic development, sustainability, and equitable income and wealth distribution.

inflation (government macroeconomic policy objective)

governments aim for a low and stable rate of inflation, the rate of inflation is influenced by the inflation rate of other countries, as well as the actions of other governments and central banks

balance of payments stability (government macroeconomic policy objective)

governments usually aim for the total of the credit items in the current account of the balance of payments to equal the total of debit items in the long run, as well as to avoid large changes in the current account balance

unemployment (government macroeconomic policy objective)

governments seek to keep unemployment low and of short duration to reduce output loss and lower government spending on unemployment benefits, as well as to avoid workers’ skill loss

economic growth (government macroeconomic policy objective)

governments aim for economic growth or to increase the rate of economic growth if the economy has been experiencing a negative output gap through the use of expansionary fiscal and/or monetary policy as well as through supply-side policy

economic development (government macroeconomic policy objective)

Governments aim to raise living standards within the country

sustainability (government macroeconomic policy objective)

Governments aim to prevent the current increase in output from harming the needs of future generations

sustainable development

development that ensures that the needs of the present generation can be met without harming the well-being of future generations

redistribution of wealth (government macroeconomic policy objective)

governments take some money from the rich and use it to help those on low incomes in the form of cash benefits or the provison of goods and services, the extent of this depends on the government's different views on how significant the disincentive effect to work and enterprise of the policies enforce are

the relationship between the internal and external value of money

the internal and external value of a country’s money are directly related; a fall in the internal value of money due to inflation, leads to fall in demand for its products and a corresponding depreciation of its external value in foreign exchange markets;

the relationship between the balance of payments and inflation

an increase in inflation leads to a deterioration in the current account balance due to a loss of price competitiveness; an increase in the current account surplus may cause inflation, however this is short-lived as an appreciation of the exchange rate occurs shortly afterward

the relationship between growth and inflation

a high rate of inflation is likely to reduce a country’s economic growth rate as next exports are likely to fall; a rise in economic growth may result in cost-push or demand-pull inflation, however non-inflationary economic growth is possible

the relationship between growth and the balance of payments

An increase in a current account surplus will increase aggregate demand due to an increase in net exports, causing actual economic growth; however this relationship can be inverse in the short-run if raw materials and capital equipment are imported

the relationship between inflation and unemployment

described by the Phillips Curve, which suggests that lower unemployment can lead to higher inflation due to increased demand for goods and services, while higher unemployment tends to reduce inflation.

Phillips curve

a curve that shows the relationship between the unemployment rate and the inflation rate over a period of time

Implications of the Phillips curve

Slope suggests that reducing unemployment from a very high rate may not have much impact on the price level and that a very high rate of unemployment may be accompanied by deflation; as well as that a government can select its best combination of unemployment and inflation and trade off the two

expectations-augmented Phillips curve

a diagram that shows that while there may be a trade-off between unemployment and inflation in the short run, there is no trade-off in the long run

economic growth and low unemployment versus balance of payments stability and price stability (fiscal policy)

expansionary fiscal policy can increase actual economic growth and reduce cyclical unemployment, however it can increase demand-pull inflation an increase a deficit on the current account of the balance of payments; the opposite applies for contractionary fiscal policy

crowding out

the idea that higher public sector spending will just replace private sector spending

crowding in

the idea that higher public sector spending will increase private sector spending

unexpected responses (fiscal policy)

there is no certainty as to how households and firms may respond to changes in fiscal policy, a cut in income and corporate tax rates may not increase consumption and investment if households and firms believe that the tax cuts will soon be reversed

time lags (fiscal policy)

due to the time lags involved in fiscal policy there is a risk that the policy might act to reinforce the business cycle rather than counter it

difficulties of reversing an increase in government spending (fiscal policy)

some forms of government spending can involve a long-term commitment to higher spending and the alternative would be to face considerable unpopularity in no longer financing them

redistribution of income and development versus the incentive to work

An increase in transfer payments may reduce the incentive for the unemployed to seek work, and their children may experience longer poverty in the long run than if they had accepted a low paid job now due to a lack of skills

Laffer curve

a curve showing tax revenue rising at first as the tax rate is increasing and then falling beyond a certain rate

Economic growth and low unemployment versus balance of payments stability and price stability (monetary policy)

Expansionary monetary policy may promote economic growth and may reduce unemployment, but this type of policy can increase demand-pull inflation and increase a deficit on the current account of the balance of payments

Time lag (monetary policy)

Monetary policy tends to have a shorter time lag than fiscal policy, yet it still exists

how commercial banks respond (monetary policy)

commercial banks may not pass on interest rate changes if they think that lending at the current level will generate more profits, and there is no guarantee that quantitative easing will be successful if commercial banks are pessimistic about the future

liquidity trap (monetary policy)

a reduction in the interest rate may have little impact when it is already low and a liquidity trap may occur, leading quantitative easing to be adopted

influence of changes in other countries (monetary policy)

A central bank’s ability to change it’s interest rate is limited by what other central banks are doing, as this will influence where firms decide to borrow from and where foreigners choose to place money

unexpected responses (monetary policy)

it is difficult to predict how households and firms will respond to changes in monetary policy and consumer’s and firm’s views of the future can have a large impact

demand and supply-side shocks (fiscal and monetary policy)

The success of both fiscal and monetary policies depends on the ability of government and central bank officials to assess current macroeconomic performance and future private sector economic activity

mobility of financial investment (monetary policy)

with increasing mobility of financial investment, it can be difficult for a country to operate an interest rate that is significantly different from rival countries

co-ordination (fiscal and monetary policy)

fiscal and monetary policies must be coordinated or they may counteract each other

market based supply-side policy

Includes tools that increase the role or market forces being cuts in direct tax, cuts in unemployment benefit, privatisation, deregulation, and labour market reforms

interventionist supply-side policy

Involves the government taking a larger role in the economy, includes tools such as government spending on education, training, infrastructure and support for technological improvement

balance of payments stability, economic growth and low unemployment versus price stability (exchange rate policy)

a government can lower the exchange rate to improve the current account of the balance of payments, increase economic growth and reduce unemployment, however this may also cause cost-push and demand-pull inflation

price elasticity of demand (exchange rate policy)

The effect of changes in the prices of exports on export revenue and changes in the price of imports on import expenditure will depend on price elasticity of demand

speculation (exchange rate policy)

Using a floating exchange rate system a country may bring about changes in the exchange rate, however strong speculation may counteract any changes made

objectives of other countries (exchange rate policy)

The governments of other countries may object to a government seeking to lower its exchange rate if they think it is doing this to gain a competitive advantage for its products

availability of foreign currency (exchange rate policy)

A central bank may want to raise the exchange rate if inflationary pressure is building up, however this is may be restricted by a lack of foreign currency to purchase the currency

actions of other central banks (exchange rate policy)

A country’s exchange rate is also affected by the actions of the central banks of other countries

the effectiveness of international trade policy in relation to different macroeconomic policy objectives

a government may promote free international trade by removing restrictions of imports and exports which can increase economic growth by allowing greater advantage to be taken of comparative advantage; trade protectionism however can help to protect employment, build up infant industries and discourage dumping

low unemployment and economic growth versus price stability (conflict between policy objectives)

Government expansionary fiscal and monetary policy tools designed to reduce unemployment and / or the economic growth rate increase the rate of inflation

low inflation versus balance of payments stability (conflict between policy objectives)

a central bank may raise the rate of interest to combat inflation, however this could have a knock-on effect, worsening the current account balance but attracting hot money flows, as well as leading to an appreciation in the exchange rate

redistribution of wealth versus economic growth (conflict between policy objectives)

making income taxes more progressive and increasing benefits to low income groups may discourage effort and enterprise and may reduce foreign direct investment, however raising living standards of the poor may improve the labour force and so raise productivity

number of policy tools (conflict between policy objectives)

to avoid conflicts between policy objectives, a government must employ a separate policy tool for each objective, using a combination of fiscal, monetary, and supply-side policies

government macroeconomic failure

government intervention reducing rather than increasing economic performance

Reasons for government failure in macroeconomic policies

miscalculating the size of the multiplier, time lags, desire to win elections, pressure groups and corruption

counter-cyclically

going against the fluctuations in economic activity