Macroeconomic Objectives and Policies

P2 - Topic 6

Macroeconomic objectives

Economic growth, low and stable inflation, low unemployment, current account equilibrium, balanced government budget, greater income equality

Balanced government budget

Government spending = tax revenue (no deficit)

Budget deficit vs national debt

Deficit = annual shortfall (flow). Debt = accumulated total owed (stock)

Current account equilibrium

Sustainable balance: no large persistent deficit or surplus

Conflict: inflation vs unemployment

Higher AD cuts unemployment but raises inflation

Short-run Phillips curve

Inverse relationship between unemployment and inflation in the short run

Conflict: growth vs environment

More output means more pollution, emissions and resource depletion

Conflict: inflation vs current account

Higher inflation makes exports less competitive, worsening the current account. Raising interest rates to cut inflation can strengthen the currency, also hurting exports

Conflict: growth vs equality

Growth may favour the skilled and capital owners. Redistribution may weaken incentives and growth

Evaluating conflicts

Depends on the cause of the change: supply-side growth (higher LRAS) can achieve several objectives at once

Supply-side policies

Policies to raise LRAS by increasing productivity, competition and incentives

Free-market supply-side policies

Deregulation, privatisation, tax cuts, lower welfare payments, cutting bureaucracy for firms

Deregulation

Removing rules in product and labour markets to increase competition and flexibility

Privatisation

Transferring state-owned firms to the private sector to raise efficiency through the profit motive

Tax cuts as a supply-side policy

Lower income tax raises the incentive to work. Lower corporation tax raises the incentive to invest

Lower welfare payments

Increases the incentive to find work, but may raise poverty and inequality

Interventionist supply-side policies

Education and training, investment incentives (tax relief or subsidies), infrastructure, start-up finance, regional policy

Infrastructure investment

Transport, energy and digital networks cut firms' costs and raise productivity

Regional policy

Incentives that bring jobs and investment to deprived regions

Strengths of supply-side policies

Raise LRAS, so growth without inflation. Can cut structural unemployment. Improve competitiveness

Weaknesses of supply-side policies

Long time lags, expensive (opportunity cost), uncertain effects, free-market versions may raise inequality

Demand-side policies

Policies that change AD: fiscal policy and monetary policy

Fiscal policy

Using government spending and taxation to influence AD

Monetary policy

Using interest rates, money supply and credit conditions to influence AD (usually by the central bank)

Reflationary (expansionary) policy

Raises AD: higher spending, lower taxes, lower interest rates, QE

Deflationary (contractionary) policy

Reduces AD: lower spending, higher taxes, higher interest rates

Monetary policy instruments

Interest rates, quantitative easing, lending criteria, reserve (liquidity) requirements

Quantitative easing (QE)

Central bank creates money to buy assets (mainly government bonds), raising the money supply and lowering long-term interest rates

Lending criteria

Rules on who banks may lend to and how much. Looser criteria raise credit and AD

Reserve (liquidity) requirements

Share of deposits banks must hold as reserves. A higher ratio means less lending

Role of central banks

Implement monetary policy, hit the inflation target, act as banker to the government, act as banker to the banks (lender of last resort)

Lender of last resort

The central bank lends to banks in a crisis to prevent the financial system collapsing

Strengths of fiscal policy

Can target specific sectors or regions. Strong in a deep recession (multiplier)

Weaknesses of fiscal policy

Time lags, budget deficits and debt, crowding out, political influence

Strengths of monetary policy

Quick to change, independent of politics, effective against inflation

Weaknesses of monetary policy

Time lags of 18–24 months, weak when rates are near zero, blunt (affects all regions), may hurt exporters via the exchange rate