Download Monetary policy, exchange rate policy and fiscal policy

Macroeconomic Aspects of the Irish Economy
By: Dr. Noel Palmer, PhD., MA, MLitt, BA, B. Comm., Examiner – Economics
and Business Environment.
Objectives of National Economic Policy.
These are the same in every country though the order of priority may vary between
countries and over time in any particular country.
Table A
Economic Growth
Full Employment
Table B
Price Stability
Table C
Balanced
Regional
Development
Equilibrium on Balance of Optimum Distribution of
Payments
National Income
Fiscal Rectitude
Table A. The objectives listed in this table are achieved through a buoyant economy
which is self-evident in respect of the objectives of economic growth and full
employment. Fiscal rectitude basically means keeping our National Debt under
control and it is included in table A on the understanding that when the economy is
performing well tax revenues will be very buoyant so that not only will there be less
need for the government to borrow in order to stimulate the economy but
circumstance may exist that permit a reduction in the level of debt – particularly if the
burden of the debt is expressed as a percentage of GDP. The objectives set out in
table A are achieved through a high level of economic activity and the pursuit of
these objectives entails expansionary macroeconomic policies.
On the other hand, Table B contains a list of objectives that are more likely to be
achieved when there is no overheating in the economy.
Inflation is anathema to the idea of price stability and any threat of an inflationary
nature is more likely to be experienced when an economy is growing and particularly
when the economy is approaching full employment. A threat of inflation is unlikely
when the economy is performing to its trend level of growth and / or is in deflationary
phase.
Similarly, deficits (or the danger of deficits) in the Balance of Payments may occur
when an economy is booming but are less likely to occur when the economy is
performing below capacity. When an economy is not performing well, income in the
community will be at a relatively low level with a consequent depressed demand for
imports. In addition, when an economy is operating below capacity, there will no cost
pressure so that our exports are likely to be price competitive and thus are likely to
experience buoyant demand with a resultant improvement in our Balance of
Payments. From the foregoing it will be realised that if the objectives set out in table
B are top of the macroeconomic priority list then deflationary policies will tend to be
pursued.
Table C is made up of objectives that do not unambiguously lend themselves to
either expansionary or contractionary policies. On the one hand, the objective of
balanced regional development could be seen as being facilitated by high levels of
economic activity and employment. The reasoning to support this being that tight
labour markets may encourage firms to move to areas where a larger pool of labour
is available. On the other hand, if the pursuit of the balanced regional development
objective is perceived as policies to locate industry in areas that are economically
sub-optimal then the subsidisation that this implies impedes the efficient allocation of
funds by markets.
In relation to the objective of improving the distribution of national income implies
polices that entail some form of redistributive taxation. Redistributive taxation refers
to taxing the economically able and redistributing this money among the
economically disadvantaged. Policies of this nature may impede economic growth
through reducing economic incentives to the economically able and also through
lessening the need for economic effort from those at the lower end of the income
scale. Perhaps improving the distribution of national income might be perceived as
an objective that has a better chance of being realised as a by-product of economic
growth; since it is easier to gain acceptance of policies that redistribute of national
income when the economy is buoyant.
Instruments of Macroeconomic Policy
Instruments available to economically independent governments to assist in the
attainment of the macroeconomic objectives are:
•
•
•
Monetary Policy ---- the control of interest rates and the money supply.
Exchange Rate Policy ---- changing (or allowing to change) the foreign
exchange value of our currency.
Fiscal Policy ---- any conscious action by the government which affects the
magnitude, structure, or timing of government revenue (taxation) or
expenditure.
Expansionary Policies.
If the objectives set out in table A are given priority then some or all of the above
instruments of macroeconomic policy would be utilised in an expansionary manner.
In terms of monetary policy interest rates might be lowered. If fiscal policy is being
employed as an instrument for economic growth then a deficit national budget would
be introduced. While if exchange rate policy is being used as an instrument for
economic growth then the currency might be permitted to float downwards.
Deflationary Policies.
A deflationary policy would be appropriate to assist in the achievement of the
objectives outlined in table B. If the government were concerned about a deficit on
the Balance of Payments and/or the threat of inflation then the rectification of these
problems would be given priority and become the focus of national economic policy.
The appropriate policy would be to deflate the economy and to this end, it could
initiate monetary, fiscal and/or exchange rate policies that are the direct opposite to
those introduced in order to stimulate the economy. To this end, the strategy could
be to increase interest rates, and/or allow the foreign exchange value of our currency
to appreciate, and/or introduce a surplus national budget.
Trade-off in attainment of objectives.
From the foregoing, it is obvious that the policies appropriate for the achievement of
the objectives set out in table A are the direct opposite to the policies required in
order to achieve the objectives set out in table B. Thus, there is a trade off in the
achievement of the objectives of national economic policy in the sense that policies
introduced to achieve some objectives will have a detrimental effect on other
objectives. These trade-offs are often illustrated by setting objectives in juxtaposition
with each other for instance:
economic growth v equilibrium on the Balance of Payments;
full employment v price stability;
redistribution of national income v economic growth.
Ireland as a member of the European Union.
Monetary policy, exchange rate policy and fiscal policy are the instruments available
to an economically independent government in pursuit of the objectives of national
economic policy. Since Ireland is a member of the European single currency regime,
the freedom to pursue independent economic policies is not at our discretion. We are
now members of the Euro zone and monetary policy for the entire Euro zone is set
and conducted by the European Central Bank (ECB). The principal objective of the
ECB is the integrity of the currency, which translates into the control of inflation since
inflation erodes the value of the currency. Thus, the general level of interest rates
that pertains in the Irish economy is determined by the ECB and decisions as to the
appropriate levels of interest rates are based on confining movements in the value of
the Euro within non-inflationary limits. Accordingly, in an environment where the Irish
trade cycle may not be synchronised with that of the main countries in the euro zone
it is possible that policies that may be appropriate to the general member states of
the euro zone may not be those most suited to the needs of the Irish economy e.g. if
unemployment was the most pressing macroeconomic problem in the Irish economy
then our requirement would be for lower interest rates in order to stimulate our
economy. However, despite this being an appropriate policy for the Irish economy, if
the ECB perceived inflationary threats within the general Euro zone then its
prescribed monetary policy would be of a deflationary nature – the opposite to what
would be required by our circumstances.
Similarly, it is not possible for the Irish economy to pursue an independent policy in
respect of the exchange rate of our currency; since our currency is the Euro,
decisions in relation to foreign exchange rate of our currency fall within the province
of the ECB. The ECB as the decision-making institution in respect of both monetary
policy and exchange rate policy will ensure that these policies are employed in a
manner that will be in keeping with that institution’s objective of price stability.
However, there remains one instrument of macroeconomic policy that is still at the
discretion of the government of member-states namely fiscal policy. The ECB is
concerned that governments may seek to engage in deficit budgeting in order to
stimulate their economies. This is because of the inherent danger in such policies of
unleashing of inflationary pressures. In an effort to minimise this danger in 1996 at its
meeting in Dublin the European Council adopted a Stability and Growth pact that
commits members of the euro zone to aim for balanced budgets, or even budget
surpluses. The Pact holds that a national budget deficit would be considered
excessive if it exceeds 3% of the country’s gross domestic product (GDP) and
financial penalties may be imposed in the event of a country breaching these
guidelines.
Why did we join the European Union?
Given the economic control that we have ceded to the European Union it raises the
question why did we join? And has membership been beneficial to us?
The main features of an economic union are:
A trading area (or market) within which persons, goods, services and capital can
move without hindrance. This feature is usually referred to as the 'four freedoms'.
In circumstances where these four freedoms exist it is necessary that there be a
common competition policy so that markets may operate in response to unfettered
market signals. This implies that governments should not be directly involved in
trading activities, neither should the State subsidise firms nor should states that are
members of an economic union unilaterally provide aids to industry.
Thus not only is it necessary that states are at similar stages of development in order
to prosper in an economic union (this is the reason why EU Cohesion Funds were
made available to assist the development of the Irish economy) but structural and
regional convergence would be a consequence of the economic union.
Advantages accruing from our of our membership of the EU include:
•
Access to European Markets.
•
A voice in the economic decisions being made by our main trading
partners.
•
Our farming sectors have enjoyed benefits through the Common
Agricultural Programme.
•
Direct foreign investment has increased to take advantage of
economic advantage we enjoy through being a member of the EU.
•
Our financial services sector have benefited from our membership.
•
The development of our economic infrastructure has been assisted
though funds made available from the European Cohesion Fund.
•
Removal of exchange rate uncertainty in foreign trade.
•
Reduction in transaction costs in international trade.
Monetary Union.
While an economic union can exist without a monetary union the opposite does not
hold, this is exemplified in the North American Free Trade Agreement (NAFTA) in
which there is no provision for the creation of a currency union between the US,
Canada and Mexico. That a monetary union constitutes a deeper economic
integration is manifest in the following further conditions that are necessary if a
successful sustainable monetary union is to be created.
The main features of a monetary union are:
The complete liberalisation of capital transactions and full integration of banking
and other financial markets.
The irreversible locking of exchange rates.
Complete convertibility of currencies.
The introduction of a single currency.
The conduct of a uniform monetary and exchange rate policy. Within European
Monetary Union the participating countries surrender control over their monetary
and exchange rates to the European Central Bank (ECB).
Ireland as a small open economy.
One of the implications of the UK not being a member of the monetary union is that
the value of sterling can move in a different way to the value of the Euro. If the value
of the Euro rises relative to the value of sterling then our exports lose
competitiveness on UK markets. Conversely if the value of sterling rises relative to
the value of the Euro then the cost of our imports from the UK rise and we import
inflation. The same line of reasoning applies to our trade with the US. This problem
does not arise in relation to trade with other member states within the monetary zone.
Since, of all the member states within the euro zone, Ireland has the greatest
proportion of trade with non Euro zone countries, this is a problem that affects us to a
greater extent than it does any other member state.