A2 – ECONOMICS (9708)

MACRO
CHAPTER 5
Govt. Macroeconomic Intervention

Topics
Topic 1: Government Macroeconomic Objectives
Topic 2: Fiscal Policy
Topic 3: Monetary Policy
Topic 4: Exchange Rate Policy
Topic 5: Supply Side Polices
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TOPIC 1: GOVT. MACROECONOMIC OBJECTIVES

Lecture 1 1. GOVERNMENT MACROECONOMIC OBJECTIVES
Definition: These are objectives that the government wants to achieve through its policies.
There are several macroeconomic objectives:
Objective Description
1. Redistribution of The government aims to reduce the gap between high and low-
Income income groups by imposing taxes. This can be done using a
progressive tax system in which rich pay a higher percentage on
their income as compared to the poor.
2. Control Inflation Inflation is referred to as the general persistent rise in general
(Price Stability) price level. The plans to keep prices stable by keeping a check on
inflation. Since high rates of inflation reduce international
competitiveness and can cause a loss of trust in investors.
Inflation can be either demand-pull or cost-push.
3. Full employment (or Unemployment is who are able and willing to work but do not
Low Employment) have work. The government aims to reduce unemployment.
4. Economic Growth Economic growth is regarded as the increase in county’s GPD
(Gross Domestic Product). Economic growth increase standard of
living and can achieved by increasing factors of production or by
increasing their efficiency.
5. Balance of Payment The BOP is the record of financial transactions with other nations.
Stability If the outflows are greater than the inflows the BOP is in a deficit.
If the inflows are greater than the outflows BOP is in a surplus.
Deficit drains the money from a country where as surplus can
cause inflation in the long run hence the governments try to keep
an equilibrium.
6. Environmental Government wants sustainable growth and development which
Considerations means that today’s growth does not eliminate the consumption
Reduction in possibilities of future generations and this consideration may act
social as a constraint of the rate of economic growth.
costs7. Correcting Market These objectives that exist at the microeconomic level also affect
Failure the rate of economic growth. Example: Controlling monopoly
power might restrict the level of growth because of lower R&D
spending in the economy.
8. Productivity Governments also want to improve the level of efficiency with
which factors of production are being utilized in the economy.
This is important to check an economy’s performance relative to
that of other countries.

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2. INTERRELATED MACROECONOMIC PROBLEMS

It is not possible to achieve all the five objectives simultaneously. Hence the government has
to face tradeoffs. There are SIX main tradeoffs that the government faces:
1. Unemployment vs. Inflation
There is an inverse relationship between level of unemployment and inflation. This is because when
unemployment rises individuals have less money at their disposal and hence demand less goods. Low demand
leads to low inflation. On the other hand, when unemployment falls, more people have money at their disposal
which increase the demand for goods pushing the prices up. This concept is explained by the Phillips curve

Definition | Stagflation: This occurs when inflation and high unemployment both occur together. This usually
happens in the long-run.

2. Economic Growth vs. Current Account

An increase in economic growth resulting in higher real incomes could lead to an increase in imports of goods
and services. This results in “stop-go” cycle of macroeconomic policy. As every time the growth started to
accelerate the current account went into deficit and policy then had to be adjusted to slow down the growth rate
to deal with the deficit.

3. Inflation vs. Balance of Payment

If the domestic economy enters a period of inflation that is high relative to its trading partners as the price
increase is more in the local economy, leading to expensive exports and reducing international competitiveness,
making it more difficult to export and increase in cheaper imports. This not only puts pressure on the current
account but also the exchange rate will depreciate.

4. Economic Growth vs. Sustainability

Economic growth results in environmental degradation as the process of industrialization requires energy
suppliers to keep pace with demand. These usually come from natural resources like oil and coal which add to
the pollution levels in the country. In order to make it sustainable in the short-run the country should slow down
economic growth and invest in renewable and cleaner energy resources. But only developed countries can do
that.
If we demand side policies for growth then this
problem occurs 5. Economic Growth vs. Low Inflation
If the economy grows due to excessive demand this will increase the prices. If the govt. deflates the economy
using increasing taxes or interest rate to control inflation, it will limit economic growth.

6. Economic Growth vs. Redistribution of Income and Wealth

As the economy grows the gap between the rich and the poor increases. This is because rich invest their money
and are able to multiply their money at a faster rate as compared to the poor.
Usually due to absesne of progressive tax systems

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TOPIC 2: FISCAL POLICY

Definition: Fiscal Policy is a government policy concerned about taxes and government
spending to influence economic activity and macroeconomic objectives such as employment,
economic growth, inflation etc. Government maintains a budget to provide services like
education, health care etc. This is done through borrowing, privatization, and taxes.

Govt. Budget = Expected Revenue – Expected Govt. Spending

Balanced Budget: Revenue = Spending

Budget Deficit: Revenue < Spending
Budget Surplus: Revenue > Spending
1. AUTOMATIC STABILIZERS
Definition: Automatic stabilizers are factors that automatically, without any action by
government authorities, work toward stabilizing the economy by reducing the short-term
fluctuations of the business cycle. Since they are automatic, they represent ‘non-
discretionary’ policy. There are two important stabilizers: progressive income taxes and
unemployment benefits. Example: If the economy enters a period of recession, government
expenditure will rise because of increased payments of unemployment and other social
security benefits and revenues will fall because fewer people are paying income tax. This
helps to offset recession.

2. DISCRETIONARY FISCAL POLICES

Definition: Active and purposeful government intervention in the economy to influence
aggregate demand is termed discretionary policy, meaning that the policy is at the discretion
(or the choice and will) of the government. There are TWO types of fiscal policies:
1. Expansionary Fiscal Policy
2. Contractionary Fiscal Policy

1. Expansionary Fiscal Policy Budget Deficit

Definition: In this the government increases government spending or decreases taxes to
increase the aggregate demand in the economy and reducing unemployment. Expansionary
fiscal policy can be used when there is a recessionary gap, and aims to shift the AD curve to
the right leading to equilibrium at the full employment level of real GDP (potential GDP).

Government Spending OR Taxes

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2. Contractionary Fiscal Policy Budget surplus

Definition: In this the government decreases government spending or increase taxes to
decrease the aggregate demand in the economy and reducing inflation. Contractionary fiscal
policy can be used when there is an inflationary gap, and aims to shift the AD curve to the
left leading to equilibrium at the full employment level of real GDP (potential GDP).
Government Spending OR Taxes

Laffer Curve
Definition: The Laffer curve illustrates a theoretical relationship between rates of taxation and the
resulting levels of government revenue. It illustrates that increasing tax rate may increase tax
revenue only to a certain extent, after that point the increase in tax rate will only decrease the
total tax revenue. As taxes increase from low levels, tax revenue collected by the government also
increases. It also shows that tax rates increasing after a certain point (T* on the diagram below) would
cause people not to work as hard or not at all, thereby reducing tax revenue. Eventually, if tax rates
reached 100 percent, shown as the far right on his curve, all people would choose not to work because
everything they earned would go to the government. Governments would like to be at point T*
because it is the point at which the government collects maximum amount of tax revenue while
people continue to work hard.

Advantages and Disadvantages of Fiscal Policy

Advantages Disadvantages
1. Pulling an economy out of a deep recession. 1. Problems of time lags
2. Dealing with rapid and escalating inflation. 2. Political constraints
3. Ability to target sectors of the economy. 3. Crowding Out
4. Direct impact of government spending on 4. Inability to deal with supply-side causes
aggregate demand. of instability.
5. Ability to affect potential output. 5. In a recession, tax cuts may not be very
effective in increasing aggregate demand.
6. Inability to ‘fine tune’ the economy. Lecture 1

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TOPIC 3: MONETARY POLICY

Definition | Monetary Transmission Mechanism: This shows how changes in money supply or demand can
influence the level of national income. We will have a look from both:
1. Change in the Money Supply
2. Change in the Money Demand

1. MONEY SUPPLY CHANGES

Definition | Monetary Policy: This is government policy that revolves around controlling money supply in the
economy to achieve government objectives like inflation, unemployment, economic growth and balance the
balance of payment. There are TWO types of monetary policies that the government can use:
1. Expansionary Monetary Policy
2. Contractionary Monetary Policy

1. Expansionary Monetary Policy | Increase Ms and Reduce Interest Rates

Definition: These policies are made to remove the deflationary gaps in order words increase prices, create
employment, increase GDP and to accelerate economic activity. In this policy the government tries to increase
the Ms and reduce interest rates to boost the economic growth. [The diagram would be same as expansionary
fiscal]

2. Contractionary Monetary Policy | Decrease Ms and Increase Interest Rates

Definition: These policies are made to remove the inflationary gaps in order words reduce prices to restore full
employment. In this policy the government tries to decrease the Ms and increase interest rates to reduce the
inflation and improve BOP deficit. [The diagram would be same as contractionary fiscal]

3. Liquidity Trap | Ms Increases has NO effect on Interest Rate

Definition: This occurs when an increase in money supply does not affect the interest rate and so does not affect
investment or AD. Keynes thought it could occur when the rate of interest is very low and the price of bonds is
very high. In this case, he thought that speculators would expect the price of bonds to fall in the future, so if the
money supply was to be increased they would hold all the extra money. They would not buy bonds for fear of
making a capital loss and because the return from holding such securities would be low.

Limitations of Monetary Policy/Evaluations

Limitation Description
1. Liquidity Trap Economy might be trapped in a liquidity trap where increase in money supply will lead to
unchanged interest rate and in return no change in the AD and price level.
2. Time Lags Although monetary policy is quicker than fiscal policy but it takes time to impact. Supply
does not affect the real economy instantaneously. It might be slow in the first quarters and
with time create more impact.
3. Uncertainty Policy makers are not aware of sudden unseen events. Example: Oil prices, political
instability etc.
4. Reliability of Economic data is imperfect. This problem is even worse in LEDCs. Hence the policy
Data might be more effective in MEDCs however still even with that policy makers might not
be able to make an appropriate decision.
5. Changes in the — Monetarists view investment is interest elastic and that’s why monetary policy will
interest elasticity have a strong multiplier effect on income, employment and prices.
of investment
— Keynesians view that investment is interest inelastic and that’s why monetary policy
will have a weaker multiplier and smaller effect on income, employment and prices.

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TOPIC 4: EXCHANGE RATE POLICY

Definition | Exchange Rate Polices: It is part of the monetary policy of a country because
the exchange rate, interest rate and money supply are all intimately related. The main purpose
is to build international competitiveness and clear balance of payment stability.

— If interest rates are high relative to the world, they will attack investment from abroad,
increasing the demand for domestic currency and hence leading to an appreciation in the
exchange rate which can lead to increase in imports and less exports and vice versa.

Exchange rate policy and type of exchange rate system

Fixed Exchange Rate Floating Exchange Rate
In a fixed exchange rate system since the In a floating exchange rate system, monetary
govt. is focused on maintaining the exchange policy freed from this role, but even so it
rate at a particular level. In this situation must be used in a way that it does not
monetary policy is powerless to influence the become unsustainable in the long run.
real economy and it must be devoted to
maintaining exchange rate.

— Situation 1 | Overvalue currency: Some countries tend to overvalue their currency in

order to encourage domestic production. This is because the local firms can easily import raw
material from abroad and this would reduce the chances of imported inflation. This helps
correct surpluses in the balance of payments.

— Situation 2 | Undervalue currency: Some countries undervalue their currency in order to

stimulate exports. This is because a weaker currency makes exports cheaper and imports
expensive. This helps the economy correct its deficits in the balance of payments.

Note: Exchange rate is only one factor in determining international competitiveness. Several
other factors must be considered with it like quality of goods, consumers incomes,
preferences etc.

The exchange rate is used to influence the CA ;when the economy is experiencing CA
deficits, they tend to undervalue the currency to boost exports.
When the economy is experiencing CA surplus, they tend to overvalue the currency to
clear out surpluses by decreasing exports

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TOPIC 5: SUPPLY SIDE POLICES

Definition: These are long-term strategies that aim to increase or improve the efficiency of factors of production
to ensure long term growth in the economy. These policies help to control inflation, increase employment,
improve the balance of payment etc. Since they expand the productive capacity they tend to shift the supply
curve to the right.

1. Privatization
Definition: It is a government policy in which state-owned businesses are sold to the private sector. The
objective is that the firms will be more efficient and can generate more profits since they will profit driven.

2. Deregulation
Definition: This policy aims to remove barriers to entry to encourage competition. These can include minimum
wage rates, max price etc. This makes the market more competitive and more productive.

3. Capital investment
Definition: This policy aims to spend funds on research and development and new technologies. This helps in
both product and process innovation which can give the country a competitive advantage in the international
market.

4. Training and Education programs

Definition: This policy aims to increase the quantity and quality of labor in the economy by launching training
and education programs. In order to encourage more workers, the government also lowers taxes to encourage
individuals to join the labor force.

5. Enterprise Zones
Definition: These are areas where there is high unemployment and the government gives incentives like tax
holidays, interest free loans etc. to businesses to locate there. The objective is to boost economic activity in that
area and increase the standard of living of individuals.

Conclusion: Supply side policies take time to reap benefits however they are highly effective when it comes to
achieving government objectives of economic growth, lower inflation, lower unemployment and improved
balance of payments. Lecture 1

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