Macroeconomics looks at the whole economy: total output, employment, prices and trade. This chapter covers what governments aim for and the policies they use.
4.1 Government macroeconomic intervention
Macroeconomic aims
| Aim | Meaning |
|---|---|
| Economic growth | an increase in the economy's output (real GDP) over time |
| Full employment / low unemployment | everyone who wants a job can find one |
| Stable prices / low inflation | prices rising slowly and predictably (many governments target about 2%) |
| Balance of payments stability | not a large, persistent deficit (or surplus) in trade with other countries |
| Redistribution of income | a fairer distribution between rich and poor |
| Environmental sustainability | growth that does not damage resources for the future |
Why governments choose these aims: growth raises living standards; low unemployment avoids waste of resources and hardship; stable prices keep savings and wages from losing value and make planning easier; a stable balance of payments avoids debt and currency problems; redistribution reduces poverty and inequality; sustainability protects future generations.
Criteria governments may set (examples): growth of around 2–3% a year, unemployment below 4–5%, inflation of about 2%, a current account close to balance.
Conflicts between aims
| Conflict | Why |
|---|---|
| Full employment and stable prices | low unemployment means high demand, which can pull prices up (inflation) |
| Economic growth and environmental sustainability | more production may mean more pollution and resource use |
| Full employment and balance of payments stability | higher incomes mean more imports, worsening the trade balance |
| Economic growth and redistribution | high taxes to redistribute income may reduce incentives to work and invest |
Governments must therefore prioritise between aims.
4.2 Fiscal policy
The government budget
- The government budget is the plan of government spending and tax revenue for the year.
- Budget deficit: government spending is greater than tax revenue (it must borrow).
- Budget surplus: tax revenue is greater than government spending.
Government spending
Main areas: education, healthcare, defence, social security (benefits and pensions), infrastructure (roads, energy), law and order, debt interest.
Reasons and effects: to provide merit and public goods, to redistribute income, to improve skills and health (raising productivity), to create jobs and boost demand. Effects: higher spending raises demand and employment; but it must be funded by taxes or borrowing, which has an opportunity cost.
Taxation
Reasons for taxation: raise revenue for spending, discourage consumption of demerit goods (tobacco), reduce imports (tariffs), redistribute income (progressive taxes), influence total demand (higher taxes reduce spending), and encourage environmental sustainability (carbon or plastic taxes).
Classification of taxes:
| Meaning | Example | |
|---|---|---|
| Direct tax | paid directly to the government by the person or firm on whom it is levied (on income and wealth) | income tax, corporation tax |
| Indirect tax | tax on spending, collected by sellers and passed on | VAT, sales tax, customs duties, excise duty |
| Progressive | takes a higher percentage of income as income rises | income tax with bands |
| Regressive | takes a higher percentage from low-income people | a flat charge on cigarettes (the poor spend a bigger share of their income on it) |
| Proportional | takes the same percentage from everyone | a flat 10% tax |
Impact of taxation:
| On | Effect |
|---|---|
| Consumers | less disposable income, so lower spending; indirect taxes raise prices |
| Workers | high income tax may reduce the incentive to work |
| Firms | higher costs or lower profit (corporation tax); lower consumer spending reduces sales |
| Government | gains revenue to spend on services |
| Economy | reduces total demand; can redistribute income; very high taxes may reduce growth |
Fiscal policy
Measures: change taxes (rates or types) and change government spending.
| Expansionary (to boost the economy) | Contractionary (to slow it down) | |
|---|---|---|
| Taxes | lower (more spending power) | higher |
| Government spending | increase | cut |
| Effect | demand rises: growth and employment rise, but inflation and a budget deficit may follow | demand falls: inflation falls, but growth and jobs may fall |
Effects on aims: fiscal policy can reduce unemployment (more spending creates jobs), promote growth, control inflation (reduce demand), redistribute income (progressive taxes and benefits) and support sustainability (green taxes and spending).
4.3 Monetary policy
- Money supply is the total amount of money in an economy.
- Monetary policy is the use of interest rates, the money supply and the exchange rate by the central bank to influence the economy.
Measures:
| Measure | Effect |
|---|---|
| Change in the interest rate | higher rate: borrowing and spending fall, saving is encouraged, the exchange rate tends to rise; lower rate: borrowing and spending rise |
| Change in the money supply | less money in circulation reduces spending; more money increases it |
| Change in the foreign exchange rate | a higher exchange rate makes exports dearer and imports cheaper; a lower rate does the reverse |
Effects on aims: raising interest rates helps control inflation (lower demand), but may reduce growth and employment; cutting interest rates boosts growth and employment, may raise inflation and lower the exchange rate; a lower exchange rate can help exports and the balance of payments.
4.4 Supply-side policy
Measures:
| Measure | How it works |
|---|---|
| Education and training | more skilled, productive workers |
| Infrastructure spending | better roads, ports, energy and broadband lower firms' costs |
| Labour market reforms | reduce union power or make hiring easier, increase worker mobility |
| Lower direct taxes | raise incentives to work and to invest |
| Deregulation | removing unnecessary rules, so competition and efficiency increase |
| Improving incentives to work and invest | tax breaks, reducing benefits, grants for investment |
| Privatisation | selling state firms to increase competition and efficiency |
Effects on aims: supply-side policy shifts the PPC outward (long-run growth), lowers costs and inflation, creates jobs (reducing structural unemployment) and improves the balance of payments (more competitive exports). Drawbacks: slow (long-term), expensive, effects uncertain, and some measures (deregulation) may harm workers or the environment.
4.5 Economic growth
Measurement: real GDP is GDP adjusted for inflation; growth is the percentage change in real GDP. (GDP is the total value of goods and services produced in a country in a year.)
Causes of growth
- an increase in total (aggregate) demand (higher consumer spending, investment, government spending or net exports)
- an increase in the quantity of resources (more workers, new land or resources, more capital)
- an increase in the quality of resources (education, training, technology).
Advantages and disadvantages
| Advantages | Disadvantages |
|---|---|
| higher incomes and living standards | pollution and resource depletion |
| more jobs | may widen inequality (the rich gain more) |
| more tax revenue for health and education | may cause inflation if too fast |
| better business confidence and investment | congestion, loss of traditional ways of life |
Recession
A recession is a fall in real GDP for two or more consecutive quarters (6 months).
Causes: a fall in total demand (less consumer spending or investment, a fall in exports), a fall in the quantity or quality of resources (a disaster, war, loss of skills).
Consequences:
| For | Effect |
|---|---|
| Consumers | lower incomes and spending, less confidence |
| Workers | unemployment, lower wages, job insecurity |
| Firms | falling sales and profits, some go bankrupt |
| Government | lower tax revenue and more spending on benefits, so a bigger budget deficit |
Policies to promote growth
Fiscal policy (lower taxes, higher spending), monetary policy (lower interest rates), supply-side policy (education, infrastructure), policies to attract investment, encouraging exports. Their effectiveness differs: demand-side policies work quickly but can cause inflation; supply-side policies are slow but give lasting growth.
4.6 Employment and unemployment
- Employment: people who have a job. Unemployment: people who are able, available and actively looking for work but without a job. Full employment: everyone who wants a job has one (some frictional unemployment still exists).
Measuring unemployment
Unemployment is measured by the labour force survey (a sample of households asked about their work situation) and sometimes by counting those claiming benefits (which may miss some).
Types of unemployment
| Type | Cause |
|---|---|
| Frictional | people between jobs or entering the labour market (short-term) |
| Structural | decline of an industry or change in skills needed: long-term, caused by technology or competition (workers' skills no longer match) |
| Cyclical | a fall in total demand in a recession |
| Seasonal | work is available only in certain seasons (farming, tourism, construction) |
Consequences of unemployment
| For | Effect |
|---|---|
| Individuals | loss of income, stress, loss of skills, poverty |
| Firms | lower demand for their products; but a larger pool of workers |
| Government | lower tax revenue and higher spending on benefits |
| Economy | wasted resources (output below the PPC), lower GDP, more inequality and social problems |
Policies to reduce unemployment
- Fiscal policy (cut taxes, spend more) and monetary policy (lower interest rates) for cyclical unemployment.
- Supply-side policies (education and retraining, labour market reforms, better information about jobs, help with relocation) for structural and frictional unemployment.
- Regional policy (grants for firms in high-unemployment areas).
Effectiveness: demand policies can cause inflation; retraining is slow; policy must fit the type of unemployment.
4.7 Inflation
Measuring inflation
Inflation is measured by the Consumer Prices Index (CPI):
- Surveys find what a typical household buys (a "basket" of goods and services).
- Each item is weighted by the share of spending on it.
- The cost of the basket is tracked over time: the percentage change is the inflation rate.
Causes of inflation
| Cause | Explanation |
|---|---|
| Demand-pull | total demand rises faster than supply: "too much money chasing too few goods" (for example a boom, tax cuts, low interest rates) |
| Cost-push | costs of production rise (wages, raw materials, energy, imports from a weaker currency), so firms raise prices |
Consequences of inflation
| Group | Effect |
|---|---|
| Savers | lose out if interest rates are lower than inflation (real value of savings falls) |
| Borrowers | gain (the real value of what they owe falls) |
| Lenders | lose, if interest is below inflation |
| Consumers | purchasing power falls, especially for those on fixed incomes |
| Workers | real wages fall unless pay rises with prices; may demand higher wages (a wage-price spiral) |
| Firms | higher costs, uncertainty, menu costs; exports become less competitive |
| Economy | lower competitiveness, balance of payments worsens, uncertainty reduces investment |
Policies to control inflation
- Monetary policy: raise interest rates to reduce demand (the central bank's usual tool).
- Fiscal policy: raise taxes or cut government spending to reduce demand.
- Supply-side policy: lower costs and raise productivity (long-term).
- A higher exchange rate lowers import prices.
Effectiveness: policies that reduce demand work for demand-pull inflation but can reduce growth and raise unemployment; supply-side policies deal with cost-push but are slow.
Practise this chapter
Every past-paper question on these topics, with the mark scheme.