Chapter 5: Government macro intervention

Macroeconomic Aims

The main government macroeconomic policy are:

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

 

Different Policy

There are different types of macroeconomic policy and they are:

  • Fiscal policy
  • Monetary policy
  • Supply side policy

 

  1. Fiscal Policy

Fiscal policy is use of government funds and taxes to manage aggregate demand in order to achieve government’s macroeconomic aims.

Types of fiscal policy are:

  1. Automatic Stabilizers

Automatic stabilizers are forms of government welfare spending and taxation that change, without any deliberate government action to reduce fluctuations in GDP. Example; during recession, government spending on unemployment benefits automatically rises because there are more unemployed people.

  1. Discretionary fiscal policy

Deliberate changes in government spending and taxation can be referred to as discretionary fiscal policy.

 

  1. Monetary Policy

Monetary policy refers to the policy measures to influence the price or quantity of money. The three instruments of monetary policy are:

  • Money supply
  • Interest rate
  • Exchange rate

Monetary policy are usually implemented by the central bank of the country.

 

  1. Supply-side policy

Supply side policies are all those measures that the government take to increase aggregate supply in order to achieve its macroeconomic aims.

Those measures have the potential to benefit all of the government’s policy aims in long run. This policy can reduce inflationary pressure, lower unemployment, raise economic growth, etc.

Policies to correct current account deficit

There are two broad-based policy approaches that can be used to correct an imbalance in the balance of payments.

  1. Expenditure-switching policies

It is a policy measure designed to encourage people to switch from buying foreign products to buying domestically produced product. It also include policy measure designed to persuade foreign firms to buy more exports from domestic economy.

These policies are not designed to reduce the total amount of spending in a country but to redirect or switch spending to the country’s product rather than those produced in other countries.

 

  1. Expenditure-dampening policies

An expenditure dampening policies are the measures designed to reduce imports and increase exports by reducing demand. This policy measure has two effects; firstly there is reduction in spending and secondly, domestic producers will find their domestic market being “dampened” and as a result they may resort to sales abroad to minimize the decrease in domestic sales.

 

  1. Monetary policy
  2. Fiscal policy
  3. Supply-side policy

 

  1. Monetary policy and its effectiveness

Reducing the growth of the money supply, decreasing interest rate and exchange rate may be used as an expenditure switching measure.

If an economy has a high rate of unemployment and a current account deficit, its central bank may reduce the interest rate in a hope to put downward pressure on the exchange rate. A lower exchange rate may result in the country’s product becoming more internationally competitive, if the demand for export and import is elastic it will improve current account balance, reduce unemployment and accelerate economic growth.

 

  1. Fiscal policy and its effectiveness

Fiscal policy measures can be used to reduce total expenditure and it could increase income tax and reduce government spending.

Fiscal policy measures may have a short-term impact on a country’s current account balance, but they are unlikely to have a long-term impact.

  1. Supply side policy and its effectiveness

Supply-side policy measures may help to minimize the current account and financial account gaps by making the domestic market more appealing to invest in.

Supply-side measures such as deregulation and privatization, spending on education may not be helpful in short-term but they play great role in long-run. Privatization and deregulation may increase inefficiency.

 

 Policies to correct demand-pull inflation

To reduce demand-pull inflation, government employ

  • Deflation fiscal policy
  • Deflation monetary policy
  • Supply-side policy i.e. to reduce the risk of demand pull inflation in longer term.

 

Policies to correct cost-push inflation

In short term, government may instruct its central bank to raise the exchange rate to reduce cost-push inflation. Government may also employ supply-side policy measure to correct cost push inflation.

Its effectiveness

Increased spending on training may be successful in raising the skills of workers but if their pay rises by more than their productivity, cost of production will also rise. A rise in exchange rate may not reduce inflation if foreign producers decide to keep the price of their exports unchanged in the country’s currency.

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