Macroeconomic objectives and fiscal, monetary and supply-side policy

Last time

Before we start: last time, in The circular flow of income, aggregate demand and aggregate supply, you learned these points. Here they are again on one card. Keep them in mind, because today builds on them.

The policy toolkit

Governments aim for growth, low unemployment, stable prices and a stable balance of payments. They use three kinds of policy: fiscal, monetary and supply-side. This lesson covers the objectives, each policy, and their limits.

The objectives

Steady economic growth, low unemployment, low and stable inflation, and a stable balance of payments. Some also aim for a fairer distribution of income, and a sustainable environment. These can conflict: faster growth may raise inflation and widen a current account deficit.

Should a balanced budget be a main objective?

A balanced budget avoids rising debt and interest costs, and may build confidence. But in a recession, deficits can support AD and jobs; insisting on balance could deepen the downturn. Many economists see it as a medium-term goal, not one for every year.

Fiscal policy

Fiscal policy uses government spending and taxation to influence AD. Expansionary fiscal policy, raising spending or cutting taxes, increases AD: useful against unemployment. Contractionary fiscal policy reduces AD: useful against demand-pull inflation.

Limits of fiscal policy

Time lags: it takes time to plan, approve and feel the effects. Higher deficits raise debt, and government borrowing may raise interest rates, crowding out private investment. Its effect depends on the multiplier and on spare capacity.

Monetary policy

Monetary policy uses interest rates, the money supply and the exchange rate, usually run by the central bank. Lower interest rates make borrowing cheaper and saving less attractive, raising consumption and investment, so AD rises. Higher rates reduce AD and inflation, and may strengthen the currency.

Monetary policy against deflation

Expansionary monetary policy should raise AD and prices, helping to end deflation. But if interest rates are already near zero, they cannot fall much further: a liquidity trap. And if confidence is low, people may not borrow even at low rates. So fiscal policy may also be needed.

Supply-side policy

Supply-side policies aim to increase LRAS: productive capacity and efficiency. Market-based: lower taxes, deregulation, privatisation, and labour market reforms. Interventionist: spending on education, training, infrastructure, and research.

Evaluating supply-side policy

It can raise growth without inflation, and reduce structural unemployment. But it takes a long time, can be costly, and some market-based measures may widen inequality. So it is best combined with demand-side policies.

Mistakes that lose marks

Mistake one: saying the government sets interest rates. Usually the central bank does. Mistake two: suggesting fiscal policy for structural problems only. Mistake three: no evaluation of time lags and side effects. The fix: the right tool, the mechanism, and the limits.

The full-marks tip

The full-marks tip: for each policy, explain the mechanism step by step to AD or LRAS. Evaluate with time lags, side effects and conflicts between objectives.

On one card

So, on one card: macroeconomic policy. Keep it for revision.