Macroeconomic Objectives and Policies

The objectives

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Fiscal policy

Fiscal policy is the use of government spending and taxation to influence AD.

Expansionary: higher G and/or lower T

AD right. Used to close a negative output gap.

Contractionary: lower G and/or higher T

AD left. Used against a positive output gap or a large deficit.

Automatic stabilisers work without any decision: in a recession, tax revenue falls and benefit spending rises automatically, cushioning the fall in AD. Discretionary policy is a deliberate change in rates or spending.

Strengths: it can be targeted at specific regions, sectors or income groups; it works directly on demand; and spending on infrastructure, education and skills also shifts LRAS right, so fiscal policy is the only instrument that acts on both AD and capacity.

Limitations: time lags (recognition, decision, implementation, impact); crowding out; a debt burden and rising interest payments; political constraints; and the uncertain size of the multiplier.

Monetary policy

Monetary policy is the manipulation of interest rates, the money supply and the exchange rate, set by the Monetary Policy Committee of the Bank of England, operationally independent since 1997. The government sets the 2% CPI symmetric target; the Bank decides how to meet it.

The transmission mechanism, the analytical core, and Edexcel expects the chain:

1. **Bank Rate falls
2. market rates fall
3. (1) borrowing cheaper and saving less rewarding, so C rises; (2) cheaper finance, so I rises; (3) asset prices rise, generating a wealth effect; (4) lower returns reduce capital inflows, so the currency depreciates and net exports rise
4. AD shifts right.**

The exchange rate channel has a second effect: a depreciation raises imported input costs, shifting SRAS left and adding cost-push inflation.

Quantitative easing is used at the zero lower bound: the central bank creates reserves and buys government bonds → bond prices rise, so yields fall → borrowing costs fall across the economy and asset prices rise → AD rises. Criticisms: it works through asset prices, so it widens wealth inequality; banks may hold rather than lend; and it risks asset bubbles.

Limitations: long and variable lags (roughly 18 months to two years); the zero lower bound and liquidity trap; banks may not pass on cuts; it is a blunt instrument hitting mortgaged households hardest; and it is ineffective against cost-push inflation.

Supply-side policies

Supply-side policies raise productive potential, shifting LRAS right. Uniquely; they can raise output and reduce inflation at the same time.

Market-based, remove obstacles and sharpen incentives:

• Cutting income tax and national insurance to raise the return to work.
• Reducing out-of-work benefits to sharpen incentives.
• Reducing trade union power and employment protection for labour market flexibility.
• Privatisation and deregulation, making markets more contestable.
• Trade liberalisation; cutting corporation tax.

Interventionist, the government acts directly where markets under-provide:

• Education and training: the most important, raising human capital and occupational mobility.
• Infrastructure investment: transport, energy, broadband.
• R&D subsidies and tax credits.
• Regional policy and relocation assistance for geographical immobility.
• Industrial strategy; childcare provision to raise participation.

The ideological divide: market-based measures rely on incentives and tend to increase inequality; interventionist measures cost money, carry an opportunity cost and risk government failure, but tend to reduce inequality.

Limitations of both: very long time lags; cost; uncertain effectiveness; and, most importantly; they are no help against a demand-deficient recession, because raising capacity is pointless when existing capacity is idle.

Conflicts and trade-offs

1. Growth versus inflation. Raising AD beyond capacity produces a positive output gap and demand-pull inflation.

2. Unemployment versus inflation, the Phillips curve. The short-run Phillips curve shows an inverse relationship: lower unemployment tightens the labour market, so wages and prices rise faster. The long-run Phillips curve is vertical at the natural rate, once inflation is anticipated, workers secure compensating nominal wage rises and unemployment returns to the natural rate at a higher rate of inflation. The trade-off exists only in the short run, and only supply-side policy lowers the natural rate.

3. Growth versus the current account. Rising incomes pull in imports.

4. Growth versus the environment. Higher output raises emissions and resource use.

5. Growth versus equity. Gains may accrue to capital owners and the skilled.

6. Unemployment versus sound public finances. Stimulus widens the deficit; consolidation raises unemployment.

7. Inflation versus competitiveness. Raising rates to curb inflation appreciates the currency, damaging exporters.

Complementarities are worth stating too: supply-side policy can improve growth, inflation, unemployment and competitiveness simultaneously; growth raises tax revenue, helping the public finances; and falling unemployment cuts benefit spending.

Worked example

An economy has inflation at 6%, unemployment at 3% against an estimated natural rate of 4.5%, and a widening current account deficit.

1. Unemployment below the natural rate with inflation well above target indicates a positive output gap
2. the economy is overheating
3. demand-pull inflation
4. and strong domestic demand is pulling in imports, worsening the current account.

The demand-side response, raise Bank Rate:

1. Higher rates raise the cost of borrowing and the return to saving
2. C and I fall
3. asset prices fall, reversing the wealth effect
4. higher returns attract capital inflows, appreciating the currency
5. AD shifts left
6. the positive output gap closes and inflation falls back towards target. The appreciation also makes imports cheaper, shifting SRAS right and reinforcing the disinflation.

The conflicts this creates:

• Unemployment rises: the short-run Phillips curve trade-off in reverse.
• Growth slows, and excessive tightening risks recession.
• The appreciation damages exporters and partly offsets the current account improvement.
• Mortgaged households bear far more of the adjustment than savers, a distributional effect.

The supply-side alternative: investment in skills, infrastructure and competition shifts LRAS right, raising capacity so the same demand no longer generates inflation, while improving competitiveness. It avoids every conflict above, but takes years, and does nothing about 6% inflation today.

Evaluation.

• The two are complements, not substitutes.
• The natural rate is an estimate; if it is really 3%, the economy is not overheating and tightening would be an error.
• Time lags of 18 months to two years mean the tightening bites after conditions have changed.
• If the inflation is partly cost-push, raising rates reduces output without addressing the cause.

Judgement: with clear evidence of a positive output gap, monetary tightening is the correct immediate instrument despite the unemployment and exchange rate costs, and it should be paired with supply-side reform to raise the capacity ceiling that created the conflict.

Common exam mistakes

• Listing objectives without identifying a conflict.
• Drawing the long-run Phillips curve as downward-sloping; it is vertical.
• Recommending demand-side policy for structural unemployment.
• Confusing fiscal with supply-side policy, both involve tax, but the target differs (AD versus LRAS).
• Giving only the consumption channel of monetary policy; there are four, plus the exchange rate.
• Forgetting that supply-side policy relaxes several conflicts at once.
• Claiming crowding out unconditionally, regardless of the state of the economy.

Exam technique

Diagnose before prescribing. Identify the output gap and the type of inflation or unemployment from the extract, then choose the instrument. Answers that recommend a policy before diagnosing lose the KAA marks.

Use AD/AS for demand-side policy and shift LRAS for supply-side, commenting on the different effect on the price level.

Conclude by noting that supply-side policy relaxes several conflicts simultaneously but works only over years, so it complements rather than replaces demand management.

Quick revision

• Objectives: growth, 2% inflation, low unemployment, balance of payments, plus sound public finances, equity, environment.
• Fiscal: G and T → AD; also shifts LRAS when spent on capacity. Automatic stabilisers work without a decision.
• Monetary: MPC, independent since 1997, 2% CPI symmetric. Transmission via C, I, wealth, and the exchange rate.
• QE at the zero lower bound: buy bonds → yields fall → AD rises; widens wealth inequality.
• Supply-side: market-based (tax cuts, deregulation, privatisation) vs interventionist (education, infrastructure, R&D).
• Supply-side uniquely raises output and lowers inflation, but is very slow.
• Short-run Phillips curve slopes down; the long run is vertical at the natural rate.
• Conflicts: growth/inflation, unemployment/inflation, growth/current account, growth/environment, growth/equity, unemployment/public finances.

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