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How the macro-economic policies can be used to
achieve the macro-economic objectives
Policies to reduce unemployment.
There are a range of policy measures that a government may use to reduce
unemployment. The choice of measures will be influenced by the cause of the
unemployment, the rate and duration of the unemployment and the state of the other
macro-economic objectives.
Demand-side policies. If the economy is operating below its productive capacity (ie
bellow full employment) then unemployment may be reduced by increases in A.D. In such
a case, expansionary fiscal and/or monetary policy can be used to create jobs. Fiscal
policy would involve cutting direct taxes and/or cutting indirect taxes and/or increasing
government spending. Monetary policy would involve cutting interest rates.
However, these policies could have undesirable side-effects. One consequence of a rise in
A.D. may be a rise in the price level as the economy moves close to full employment. Also,
the higher consumer spending in the economy may lead to an increase in imports, which
could worsen the current account on the Balance of Payments.
In recent years, fiscal and monetary policies have not been used to influence
unemployment directly. Fiscal policy has been used to promote economic stability and
monetary policy has been used to achieve the government’s inflation target. Economic
stability and low inflation will, of course, make low unemployment more likely.
Supply-side policies. Unemployment can exist even when there is not a shortage of A.D.
if there are supply-side problems. Those people who are out of work when the level of A.D.
is high are likely to be in-between jobs, lacking the appropriate skills, geographically or
occupationally immobile, have family circumstances that restrict their ability to work or are
lacking the incentives to move off benefits and find employment.
In these circumstances, it is unlikely that raising A.D. will succeed in reducing
unemployment. What is needed instead is an increase in the attractiveness of work to the
unemployed and an increase in the attractiveness of the unemployed to employers.
Supply-side policies that can be implemented need to improve the quality and quantity of
information available to the unemployed about job vacancies, and also to employers about
those seeking jobs. Examples include education and training, providing work experience,
offering low-cost childcare, a reduction in tax rates, and a reduction in welfare benefits.
Unemployment is often the result of both a lack of A.D. and supply-side problems. In such
a situation, a combination of expansionary demand-side and supply-side policies will be
needed.
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Policies to control inflation.
If a country is experiencing inflation, the measures it implements will be influenced by what
is thought to be causing the inflation.
Cost-push inflation. There are a number of policy measures that a government can take
to try to control cost-push inflation in the short run. If a government believes that inflation is
caused by excessive increases in wage rates then it can try to restrict wage rises. It can
control wages in the public sector directly by restricting increases in government spending
allocated to the pay of public sector workers. It can also restrict wage rises in both the
public and private sectors by introducing an incomes policy. For example, the government
may place a limit on wage increases of 3% or £2,000 per year. This seeks to reduce
inflation without causing unemployment. However, firms wanting to expand will be limited
in how much they can offer to attract new employees.
The government could also reduce corporation tax or give firms subsidies in an attempt to
reduce firms’ costs. Both these methods should enable firms to have more money
available for investment, whilst not raising their prices. The danger here though is that
firms might become reliant on subsidies and not strive to become more efficient and keep
their costs down.
Demand-pull inflation. To reduce demand-pull inflation, a government may use
deflationary fiscal and/or monetary policy. These try to reduce A.D, or reduce the growth in
A.D. Fiscal policy measures would include raising direct tax and/or raising indirect tax
and/or reducing government spending. Monetary policy would involve raising interest
rates.
Inflation Targeting. Inflation targeting can lower the chance of both demand-pull and
cost-push inflation by reducing expectations of inflation. If consumers and firms are
convinced that a central bank has the determination, experience and ability to meet its
inflation target, then they will probably act in a way that does not cause inflation. If a
central bank is successful in keeping inflation low, then it can also set a low interest rate –
this, in turn, is likely to encourage investment and economic growth.
In the long run, a government is likely to seek to reduce the possibility of inflationary
pressure by increasing A.S. If the productive potential of the economy grows in line with
A.D. (ie rightwards shifts in the A.D. curve are being matched by rightward shifts in the
A.S. curve) then the economy can grow without the price level rising. This is shown in the
diagram below :
If A.D. and A.S. increase in line with each-other, then people will be able to enjoy more
goods and services without the economy experiencing inflation and B of P problems.
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Policies to promote economic growth.
A government may use different policies to achieve economic growth in the short and long
run and to make economic growth more stable.
Short-run. Increases in output in the short run can occur due to increases in A.D. if the
economy is initially producing below full capacity. Such an increase may be stimulated by
expansionary fiscal or monetary policy.
Some fiscal and monetary policy instruments have the advantage that they have the
potential to increase both A.D. and A.S. For example, a lower rate of interest is likely to
simulate C and I, which in turn is likely to lead to a boost in A.S.
Long-run. In the long run, increases in the country’s output can continue to be achieved
only if the productive capacity of the economy increases. So, for long run economic growth
to occur, the quality and/or the quantity of resources has to increase. This is exactly what
supply-side policies seek to achieve. Such policies include firms investing in new items of
capital, and education and training to improve workers’ human capital.
In seeking to promote economic growth, most governments aim for stable growth. This
objective is for actual growth to match trend growth and for that trend to rise over time.
Governments try to avoid A.D. increasing faster than the trend growth rate permits, since
this can result in the economy overheating with inflation and balance of payments
problems arising. They also try to prevent A.D. rising more slowly than the trend growth
rate, since this would mean a negative output gap developing with unemployed resources.
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Policies to improve the balance of payments.
As with the other objectives, there are a range of policy instruments that a government can
use to improve its B of P position. The short-run measures tend to concentrate on
demand, while the long-run measures focus on improving the supply-side of the economy.
Short-run. In the short run there are 3 main ways that a government can try to raise
export revenue and/or reduce import expenditure in order to correct a current account
deficit. These 3 ways should cause a fall in the exchange rate, a fall in demand for imports
and an increase in demand for the country’s exports.
1) Exchange rate adjustment. A country may seek to reduce the exchange rate if it
believes that its current level is too high and as a result is causing its products to be
uncompetitive against rival countries’ products. A central bank may seek to lower
the exchange rate by selling its own currency and/or reducing its interest rate. A
lower exchange rate will cause export prices to fall and import prices to rise. This
should cause a rise in A.D., output and employment in the short run, but may also
cause a build up of inflationary pressure.
2) Deflationary demand management. Fiscal policy measures would include raising
direct tax and/or raising indirect tax and/or reducing government spending.
Monetary policy would involve raising interest rates. There is a danger that the
resulting reduction in spending may cause output to fall and unemployment to rise.
3) Import restrictions. A country may seek to reduce expenditure on imports by
imposing import restrictions including TARIFFS and QUOTAS. However, these
measures can have inflationary side-effects (eg imposing tariffs increases the price
of some products bought in the country, raises the cost of imported raw materials
and reduces the competitive pressure on domestic firms to keep costs and prices
low). Placing restrictions also runs the risk of provoking retaliation from other
countries (eg exports to those countries will also fall).
Long-run. If a deficit arises from a lack of quality competitiveness, low labour productivity
or high inflation then reducing the value of the currency, deflationary demand-side policy
instruments and import restrictions will not provide long-run solutions. In such a situation,
the most appropriate approach would be to implement supply-side policies.
A government may give subsidies to infant industries in the belief that they have the
potential to grow and become internationally competitive. It may also increase funds for
R&D at universities to encourage invention and innovation.
How successful supply-side policies are depends on the appropriateness of the policies.
For example, training has to be in the right areas and firms and workers have to respond in
a positive way to any incentives provided. Some supply-side policies can also take a long
time to have an effect and can be very expensive for the government.
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