Government macroeconomic intervention (A Level)

10.1 Government macroeconomic policy objectives

Governments pursue growth, low unemployment, price stability, balance of payments equilibrium, income redistribution and sustainability. Targets are set for the objectives (for example a 2% inflation target) and judged over short and long runs.

Costs and benefits of each objective:

Policy instruments: fiscal, monetary, supply-side, exchange rate and direct controls.

10.2 Links between macroeconomic problems and their interrelatedness

Macroeconomic problems are linked:

• Growth and inflation: fast growth with spare capacity exhausted raises inflation.
• Growth and unemployment: growth lowers cyclical unemployment (Okun's law).
• Growth and the current account: growth raises imports (high income elasticity of demand for imports), so the deficit widens.
• Inflation and the current account: higher inflation makes exports uncompetitive.
• Unemployment and inflation: the Phillips curve trade-off.
• Growth and inequality / environment: growth may increase inequality and environmental harm.
• Government budget: recession lowers tax revenue and raises benefit spending, widening the budget deficit; national debt rises.

Government debt

The budget deficit adds to the national debt; debt interest is a burden and may crowd out other spending; sustainability depends on the debt-to-GDP ratio and the growth rate relative to the interest rate. Cyclical (automatic) and structural (underlying) deficits differ.

The internal value of money is its purchasing power at home (inversely related to the price level); the external value is the exchange rate. Higher inflation lowers the internal value and, unless the exchange rate falls, raises the price of exports, worsening the balance of payments. The balance of payments also depends on growth: faster growth sucks in imports. The expectations-augmented Phillips curve shows that the short-run curve shifts up when inflation expectations rise, so the long-run curve is vertical at the natural rate.

10.3 Effectiveness of policy options to meet all macroeconomic objectives

Fiscal policy

Expansionary fiscal policy raises AD: effective for demand-deficient problems; size depends on the multiplier; crowding out; lags; debt concerns. Contractionary policy (austerity) reduces deficits and inflation but can slow growth and raise unemployment. Fiscal rules and independent fiscal bodies may limit deficits.

Structural use of fiscal policy: spending on infrastructure and education supports supply-side growth; taxes shape incentives.

Monetary policy

Interest rate policy by an independent central bank targeting inflation; quick to change but long lags to take effect; transmission works via spending, asset prices, exchange rates. Limits when rates are near zero (the zero lower bound), where QE and forward guidance are used. Exchange rate effects help external balance but hit importers or exporters.

Supply-side policy

Raises potential output, easing the trade-off between growth and inflation; works slowly; may widen inequality or need large spending. Market-based (deregulation, tax cuts, labour reform) and interventionist (education, infrastructure, R&D).

Choosing and combining policies

Factors influencing success

Time lags, accuracy of forecasts, size of multiplier, expectations and confidence, international conditions (world growth, capital flows), political constraints, the state of the economy and the scale of spare capacity. Policy effects are uncertain and depend on the causes of the problem.

Fiscal policy may use the Laffer curve: at very high tax rates, revenue falls because of reduced incentives and avoidance, so cutting rates may increase revenue; but the peak is hard to find. Problems and conflicts arise from the outcomes of policies: reducing unemployment may raise inflation, cutting inflation may cut growth, boosting growth may harm the environment and the current account, and deficit reduction may slow the economy. Government failure in macroeconomic policy includes poor forecasts, time lags, political short-termism, policy mistakes, crowding out and unintended effects on expectations.