Chapter 10: Government Macro Intervention

The aims of government macroeconomic policy are:

  1. Low unemployment
  2. Sustained economic growth
  3. Low inflation
  4. Balance of payments equilibrium

The relationship between the internal and external value of money

The internal value of a country’s currency and its external value may be closely connected. The internal value will fall as a result of inflation. If the internal value of a country’s money falls as a result of a rise in its inflation rate above that of rival countries, demand for its products will fall. A fall in the exchange rate will raise the price of a country’s imports in terms of the home currency.

The relationship between the balance of payments and inflation

If a country’s inflation rate rises above that of its mains competitors, its price competitiveness will fall. An increase in a current account surplus may cause inflation as it will mean that net exports are making an increasing contribution to aggregate demands and more money will be flowing into the country than leaving it.

The relationship between unemployment and inflation

Economists have devoted considerable attention to the relationship between unemployment and inflation. A fall in unemployment may cause higher inflation due to extra aggregate demands and the possible upward pressure on wages. The traditional Phillips curve suggests that a government can select its best combination of unemployment and inflation and can trade off the two. Phillips curve: It is a curve that shows the relationship between the unemployment rate and the inflation rate and the inflation rate over a period of time.

Government failure in macroeconomic policy

There are a number of reasons for government macroeconomic failure- when government macroeconomic policy measures may actually cause a deterioration rather than an improvement in economic performance.

Government macroeconomic failure: It is government intervention reducing rather than increasing economic performance.

Equilibrium and efficiency: the key concept of efficiency is clearly linked to government failure. When a government implements a policy measure, it is seeking to improve economic efficiency but, as explained in this chapter, there are a number of reasons why the measures may worsen rather than improve the economy’s performance.

The Laffer curve

The Laffer curve may be considered to be linked to government failure in two ways. One is that it shows that when tax rates are high, raising them further will be counterproductive.

Laffer curve: It is a curve showing tax revenue rising first as the tax rate is increasing and then falling beyond a certain rate. The curve also suggests that, apart from where tax revenue is maximized, tax revenue is associated with two tax rates.

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