What is macroeconomic policy?
A policy is the course of action taken by the government to achieve a macroeconomic objective. The macroeconomic objectives include price stability, low level of unemployment, exchange rate stability, balance of payment equilibrium, economic growth and economic development.
There are two broad categories of policies, namely demand-side and supply-side policies. Demand-side policies are policies that are used to control aggregate demand. The two types of demand-side policies are fiscal policies and monetary policies. Supply-side policies are policies that increase aggregate supply,e.g., education and training.
Content
What is macroeconomic policy?
What is fiscal policy?
Automatic fiscal stabilisers
Discretionary fiscal policies
The usefulness of fiscal policy
The effectiveness of fiscal policies
What is monetary policy?
Monetary policy instrument: interest rate
The effectiveness of interest rate
Monetary policy instrument: money supply
The effectiveness of money supply
Monetary policy instrument: exchange rate
The effectiveness of exchange rate policy
Supply-side policies
Types of supply-side policies
What is fiscal policy?
Fiscal policy is the use of taxes and government spending to influence aggregate demand. An increase in taxes and/or a reduction in government spending will decrease aggregate demand. This is known as contractionary, deflationary or tight fiscal policy. A rise in income taxes reduces disposable income and consumption. A fall in consumption will cause aggregate demand to decline since aggregate demand is a function of consumption, investment, government spending and net exports [AD=C+I+G+(X-M)]. A reduction in government spending on roads, healthcare, defence and welfare benefits will also make aggregate demand to fall.
Taxes could be directly imposed on the incomes of individuals and profits of companies (direct taxes) or on goods and services, such as Value-Added Tax (indirect taxes). A tight fiscal policy is capable of causing revenue from taxes to exceed the expenditure of government- a situation in which there is a budget surplus.
An expansionary, a reflationary or a loose fiscal policy is a decrease in taxes and/or an increase in government spending aimed at increasing aggregate demand. A decrease in income taxes increases people’s disposable income, thereby raising consumption expenditure and aggregate demand. An increase in government spending also increases the aggregate demand. It can result in a situation where government spending exceeds government revenue. This is known as a budget deficit. A budget deficit implies that there is a need for the government to borrow to meet its expenditure. Therefore, a budget deficit increases national or government debt.
Automatic fiscal stabilisers
These are policies that adjust to the economic cycle without any intervention by the government. In a period of recession, the economy’s output is low, there is a rise in unemployment and living standards reduce. Consequently, government revenue from taxes decreases as less taxes are paid. But government expenditure increases since it spends more on welfare and unemployment benefits to cater to those affected by the recession. Aggregate demand is expected to be boosted as a result of the increase in government spending and decrease in tax revenue.
When there is economic growth, there is increasing output and a high level of employment. The government, as a result, obtains more tax revenue and spends less on benefits to cater to the unemployed. A rise in aggregate demand is restrained when tax revenue is rising and government spending is decreasing.
Discretionary fiscal policies
These are fiscal policies that are intentionally altered by the government. Tax rates and/or government spending are changed by the government in order to influence aggregate demand. Automatic fiscal stabilisers cannot have the desired effect when there are major fluctuations in the economy, hence the need for a deliberate effort on the part of the government. Discretionary fiscal policies are also known as active fiscal policies.
The usefulness of fiscal policy
It curbs the rising inflation rate
The government uses a contractionary fiscal policy when there is inflation. A rise in direct tax and/or a fall in government spending will reduce aggregate demand, thereby controlling demand-pull inflation. A rise in tax rate means consumers have less to spend; consumption, a component of aggregate demand, reduces as a result. Also, less government expenditure reduces aggregate demand because it is a component of aggregate demand.
It reduces the production and consumption of demerit goods
Taxes can be imposed on demerit goods to discourage production and consumption. Demerit goods, such as cigarettes, are goods that have negative effects on third parties. They are usually overproduced and overconsumed. Indirect taxes will reduce the supply through a leftward shift of the supply curve. Production will reduce because it adds to the cost of production. Prices will increase to reduce the quantity demanded by consumers.
It boosts economic growth
An expansionary fiscal policy can be used to encourage an increase in production and output (Gross Domestic Product) of the economy. An increase in an economy’s output is called economic growth. A reduction in corporation tax will increase the amount of profit that can be retained in the business for expansion purposes. Thus, businesses can invest in more capital to ensure there is an increase in production. In addition, the government can increase its expenditure on infrastructure or subsidies to aid production in the economy. Increasing the output of the economy is capable of curtailing recession (a situation where there is a decline in output across most sectors of the economy).
It decreases the budget deficit
A budget deficit occurs when the proposed government expenditure is more than its expected revenue. This will necessitate borrowing either from internal or external sources. But an increase in tax rates will boost government revenue and reduce the deficit.
It reduces the inequality of income
A progressive tax system is capable of redistributing income from the rich to the poor in a country. Tax rate increases as income increases in a progressive tax system. In other words, people pay a higher proportion of their incomes as taxes when their incomes are rising. This will make more money available for the government to help the low-income group in the society by providing affordable healthcare, education and welfare benefits.
The effectiveness of fiscal policies
Time lag
It takes time to design and carry out changes to tax or government spending. It even takes time for the changes to have effects on the economy. Before fiscal policy works its way through the economy, economic conditions might have changed, thereby worsening the situation. For example, a contractionary policy meant to reduce the inflation rate may take effect after the economy has already achieved the target rate; it will push the rate well below the target for the economy.
Conflict of objectives
An attempt to use fiscal policy to achieve a particular objective may lead to conflict with another objective. For example, using expansionary fiscal policy to reduce unemployment or increase economic growth will increase the inflation rate. Also, an attempt to reduce inflation using contractionary fiscal policy could lead to an increase in unemployment. A combination of fiscal and monetary policies is usually used in order to reduce conflict.
Unreliable and inadequate data
In formulating policies, data about the economy are needed, e.g., data on current account balance, unemployment and inflation. These data are subject to errors and omissions, which lead to the formulation of wrong policies. The government may also need to forecast the effect of its policies on different economic variables such as Gross Domestic Product, inflation and employment. These predictions may be inaccurate.
Unintended consequences
The economic world is complex with many variables at play simultaneously. Therefore, reducing the economy to an economic model may be unrealistic. The policy decisions taken based on such a model may not produce the expected outcome, thereby rendering policies ineffective. Besides, there are external events that are beyond a country’s control that may cause a sudden change in the economy which was not envisaged by policymakers.
What is monetary policy?
Monetary policy involves the use of interest rate, money supply and exchange rate to regulate aggregate demand. There are two types of monetary policies, namely expansionary and contractionary fiscal policies. Expansionary fiscal policies are used to increase aggregate demand; they involve reducing the interest rate, increasing the money supply and/or devaluing the currency. The reduction of the interest rate will encourage borrowing by households and firms as the cost of borrowing has fallen. Household consumption expenditure and business investment spending, as a result, will increase, thereby expanding aggregate demand. Note that consumption (C) and investment (I) are components of aggregate demand [AD=C+I+G+(X-M)]. When the amount of money in circulation (money supply) is increased, the total spending in the economy will grow and aggregate demand will rise. Devaluing a currency means that it will now have a lower value compared to another currency; consequently, exports will be cheaper while imports will be more expensive. Exports increase and imports decrease, thereby boosting net exports (exports minus imports). A rise in net exports will increase aggregate demand because net exports are one of the components of aggregate demand (X-M). Expansionary monetary policies are also referred to as reflationary or loose monetary policies.
Contractionary monetary policies are utilised in reducing aggregate demand. They involve increasing the interest rate, reducing the money supply and revaluing the currency. High interest rate reduces household consumption, investment spending and, by extension, aggregate demand. A fall in money supply would reduce the availability of money for spending by different economic agents. Besides, there will be a rise in imports (which are cheaper) and a fall in exports (which are more expensive) when the currency’s value is increased by the government (revaluation). This would reduce net exports and result in a fall in aggregate demand. Contractionary monetary policies are also known as deflationary or tight monetary policies.
Monetary policy instrument: Interest rate
Interest rate has become the major instrument of monetary policy and it can be used to achieve a range of macroeconomic objectives. It is the principal instrument for controlling inflation. Interest rate is the price of money; it is the cost that borrowers have to pay for the use of the lenders’ money; it is also the return financial institutions pay to savers as compensation for the use of their money. The government may set a target, such as the inflation rate, and allow the central bank to manipulate interest rate in a bid to meet the target. Alternatively, the central bank may be given the freedom to set the target and decide on the policy to achieve the predetermined target.
The central bank can manipulate the interest rate charged by financial institutions by changing the interest it charges for lending to banks (bank rate). The bank rate determines the interests banks will charge their customers; they will, of course, not charge lower interest than the rate they pay for borrowing from the central bank. A rise in interest rate reduces borrowing by individuals and businesses and curtails consumption and investment. Aggregate demand will fall and the inflation rate will drop.
The effectiveness of interest rate
Conflict with the growth objective
A rise in interest rate to curtail inflation would be counterproductive as it discourages borrowing by businesses. Less borrowing will lead to a fall in investment and an economy’s productive capacity. Consequently, the economic growth rate reduces and jobs are lost. A reduced interest rate, on the other hand, may fuel inflation in an attempt to encourage borrowing and production by businesses.
Liquidity trap
Interest rate will be ineffective in boosting aggregate demand when it is already very low. For example, cutting a 1.5% interest rate may not cause any substantial change in the economy. The government may have to use other means, such as quantitative easing, to boost economic activities. Quantitative easing is the purchase of securities (bonds and treasury bills) by the central bank to increase the money supply and stimulate economic activities.
Inelasticity of demand for credit
If demand for loans or credit facilities is inelastic, a fall in interest rate would only lead to a smaller rise in demand for loans. Therefore, investment would not rise by a significant amount and the effect of investment undertaken on aggregate demand may be insignificant. A rise in interest rate, however, would lead to a smaller percentage fall in demand for loans. This may not be able to reduce aggregate demand to the level desired by monetary authorities.
Difficulty in setting the right interest rate
The monetary authority must make some predictions in order to determine the appropriate interest rate to achieve its objectives, such as an anticipated rise in economic growth, consumer confidence or money supply. There is no central bank or government that can accurately predict future events using past economic data.
Time lags
It takes time for monetary policy to be transmitted through the economy and have the desired effects. An unanticipated change in the economy may render the policy ineffective or inappropriate.
Monetary policy instrument: money supply
Money supply, the total amount of money circulating in an economy, includes cash (currency notes and coins) and deposits in banks. The central bank can control the money supply by influencing the provision of credit by banks. The central bank can sell or buy government securities to influence the ability of banks to give credit facilities to the public. This is referred to as Open Market Operations (OMO). For example, when the central bank sells securities, members of the public will pay through their banks and the banks will have less money to give out as loans. This will reduce the volume of money in circulation. If the central bank buys securities, it will increase the money available for banks to give out as credit facilities since the central bank has to pay.
The rate of interest charged by the central bank on loans given to banks can be raised to discourage banks from borrowing, thereby reducing their ability to grant credit to the public. In addition, by increasing the percentage of the deposits they are required to hold in liquid assets (the reserve ratio), the central bank can curtail their lending activities and reduce the money supply.
The effectiveness of money supply
Conflict with other objectives
The use of money supply as a contractionary policy to reduce the inflation rate can reduce the availability of credit to firms to create investment and increase an economy’s output. This means that the unemployment rate may rise as fewer people would be needed due to a fall in output. An expansionary policy to increase economic growth would, however, increase the money supply and fuel inflation in the economy.
Reluctance to cut credit due to the profit motive
Banks are commercial entities that seek to make profits. The more the loans they grant, the more the possibility of making a profit. Even if the central bank embarks on an action to reduce their ability to grant loans, they will always find a way around it as long as there are credit-worthy customers who demand for loans. For instance, if the central bank charges a high interest rate, banks may still borrow more and pass the high interest rate to their customers. This would defeat the purpose of reducing the money supply by the central bank.
Time lags
It takes time for monetary policy to be transmitted through the economy and have the desired effects. An unanticipated change in the economy may render the policy ineffective or inappropriate. The time taken for the policy to have the desired outcome may be more than a year.
Monetary policy instrument: exchange rate
The exchange rate adopted by the country can also be used to control aggregate demand. The exchange rate affects net exports, a component of aggregate demand. The exchange rate of a currency can be revalued or raised, which makes export prices rise and import prices fall. Exports decline and imports rise, thereby reducing net exports and aggregate demand.
The effectiveness of exchange rate policy
Conflict with other objectives
The devaluation of the exchange would increase the demand for a country’s export since they are cheaper; imports would decline because they become more expensive. High demand for exports could result in demand-pull inflation. This would later reduce the international competitiveness of a country’s exports. In addition, a revaluation of the currency makes imports cheaper and exports dearer, thereby causing a current account deficit due to an excess of imports over exports.
Time lags
It takes time for any type of monetary policy to be transmitted through the economy and have the desired effects. An unanticipated change in the economy may render the policy ineffective or inappropriate.
Elasticity of demand
The elasticity of demand determines whether the change will be large enough to achieve the pre-determined objectives. For example, a devaluation of the exchange rate is used to reduce the deficit by increasing exports and reducing imports. However, if the demand for exports is inelastic, the increase in export revenue may not be large enough to reduce the current account deficit.
Supply-side policies
The supply-side policies are policies that are aimed at increasing aggregate supply (they are not meant to reduce it). They increase the capacity of the economy to produce more output by reducing all hindrances to productivity and effective operations in the economy.
Supply-side policies are long-term policies and they shift the long-run aggregate supply curve rightwards. A rightward shift of the long-run aggregate supply curve means that total output or Gross Domestic Product (GDP) has increased (economic growth). Supply-side policies reduce price level (inflation) because they assure that aggregate supply is not exceeded by aggregate demand. They also ensure that jobs are created to meet up with the increased production. More goods are made and trade deficit is prevented.
Types of supply-side policies
Interventionist supply-side policies
These correct inefficient utilisation of resources by the market (or market failure). When there is inefficiency in a privately-operated economy, the government will need to intervene in order to create socially desirable outcomes. The government directly gets involved through direct provision. For example, If the market is left on its own, there will not be sufficient investment in research and development, technology and education. But because these have benefits to other parties apart from the party spending on them (external benefits), the government would like to get involved to increase their availability.
Infrastructural provisions or improvements
The government can directly provide infrastructure, such as roads and rail systems, to aid productive activities in the country. Easy movement of workers, materials and finished products through transportation is beneficial to firms.
Research and development
Financing research and development (R&D) will encourage innovation and technological development in the country. The private individuals in the market may not be able to afford the R&D costs needed to boost productivity and innovation. The private sector R&D may not be adequate to help innovative products and production methods.
Education and training
The government set up schools, vocational centres and training schemes to help boost the skills of the workforce and its productivity. It may give grants or tax reliefs to firms that set up training schemes.
Nationalisation
The transfer of private businesses to the government may be justified on the basis of the need for increased investment, which may be unaffordable for private businesses, e.g., rail transport, power and electricity generation are undertaken by the government in some countries.
Spending on healthcare
The government spends on the healthcare system to reduce absenteeism and loss of manpower hours due to ill health. This will increase productivity, production and aggregate supply in the economy.
Free market-oriented supply-side policies
Privatisation
Private businesses tend to be more efficient than state-owned enterprises due to their profit motive. This necessitates the sale of some government businesses to private individuals.
Lowering Taxes
A tax cut will increase aggregate supply by boosting economic activities in the country. Low-income taxes increase purchasing power, boost consumption of products, and incentivise firms to increase their investment and output to meet increased demand. If corporation taxes are lowered, firms have more profits for investment, leading to a rise in aggregate supply.
Indirect taxes such as Value-Added Tax (VAT) or General Sales Tax (GST) raise prices, reduce demand and sales revenues and discourage investment. Tax cuts also encourage more people to work.
Reducing the power of trade unions
Weakening the bargaining power of trade unions limits their ability to go on strike and reduces output in the economy. Employers lose a lot of revenue when workers go on strike. For example, many countries have made closed shop illegal; workers do not have to belong to a specific trade union to get hired.
Deregulation
Regulations comprise rules or laws used by the government to intervene in the market to promote market efficiency or protect the consumers,e.g., maximum price, minimum wage and pollution control legislation. Adhering to these rules may involve some costs and discourage investors. Deregulation is the process of reducing or eliminating regulations to encourage investment and boost the productive capacity of the economy.