A2 Economics (Macro)
Chapter 5: Macro Economic Policies of the Government
Macro Stabilization Policies
Any policies aimed at stabilizing National Income at or near full employment level is called
stabilization policies. Moreover, other policy aims might involve other forms of stabilization
such as price stability, BOP and ER stability, economic growth, economic development and full
employment etc.
Sometimes, the government opts for contractionary policies in case of a boom where there
may be an inflationary gap. Similarly, the government of opts expansionary policies in case of a
recession when there is a deflationary gap.
There 3 main policies that we will go through in this chapter are Monetary, Fiscal and Supply
Side Policies
Monetary Policy
It is a government policy which is used to achieve macroeconomic objectives by controlling the
money supply in the economy.
Monetary Transmission Mechanism
We know that the monetary policy influences some important macroeconomic objectives of
the government such as price stability, economic growth and employment level. However,
through the MTM, we will see how monetary policy i.e changes in money supply will affect
prices, GDP and unemployment levels.
There are 3 theories that show how △ in MS affects Ps, GDP and unemployment levels
differently.
1. Quantity Theory of Money (QTM)
The QTM theory states that :
MV = PY
Where M = money supply, V = velocity of money, or the number of times money changes hands
in a year, P = price level and Y = output or real GDP. The monetarist theory states that in the
short run, V and RGDP (Y) are constant, hence △ in MS only causes △ in Ps, or inflation. Thus
they conclude by stating that inflation is always a monetary phenomenon.
However, Keynesians argue that △ in MS can change Y and V even in the short run and hence
this equation can’t be used as a theory.
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2. Direct Monetary Transmission Mechanism
It states that the impact of change in MS is directly transmitted onto Ps, GDP and
unemployment levels through AD AS
CPIA
Increase in MS leads to more cash in
the hand of people. This causes an
increase in spending i.e C,I and G ↑
which leads to an increase in AD. This Pzq
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OF INCREASE IN AD
leads to an increase in Ps and GDP
while a decrease in unemployment
AD
levels. .
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3. Indirect Monetary Transmission Mechanism
It states that changes in MS affects Ps, GDP and unemployment levels indirectly through
Interest Rates.
Increase in MS caused the IR to decrease to IR2 which resulted in an increase in investment as
indicated by the MEC curve. An increase in investment resulted in an increase in AE causing the
NI to increase by K (multiplier). Increase in Y led to an increase in AD resulting in an increase in
GDP and Ps while unemployment level decreased.
Decrease in MS caused the IR to increase to IR2 which resulted in an decrease in investment as
indicated by the MEC curve. A decrease in investment resulted in a decrease in AE causing the
NI to decrease by K (multiplier). Decrease in Y led to an decrease in AD resulting in an decrease
in GDP and Ps while unemployment level increased.
Limitations of Monetary Policy
1. If commercial banks have excess reserves, commercial banks would not need funds from
the central bank and hence central bank’s most important tool, discount rate, would be
ineffective.
2. Economy might be trapped in Liquidity Trap and hence ↑ in MS will keep IR fixed and so
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there will be negligible effect on AD and Ps.
3. Time Lags:- △s in take time to affect macroeconomic variables, normally taking around 6-12
months to for an impact
4. Lack of reliable data:- sometimes macro data may be unreliable and so monetary policy
makers might make wrong decisions which can negatively impact the economy.
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9 → t.IR → s vast + BRT → inflow of money to → F- Rt → → .
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5. △s in IR directly affect ERs which can have a direct impact on the BOPs.
CMP-i.MS I → AIR →
inflow T →
Deep→ ERP →
☒ → on LR Bo Pti
.
6. △s in IRs might have no impact on incentive to enterprise if business expectations have
already been established, eg ↓ in IR may not increase incentive to enterprise if there is
business expectation of low demand.
7. Monetary Policy always creates a conflict in aims i.e XMP may cause a decrease in
unemployment but will lead to an increase in inflation.
Fiscal Policy
It is a government policy which affects AD through taxes and government spending to influence
macro aims.
Governments can either use fiscal policy in a non-discretionary way (automatic stabilizers) or
discretionary way (expansionary and contractionary policies). (see AS chapter 10 notes for
details).
Limitations of Fiscal Policy
1. Time Lags:- Fiscal Policy has even greater time lags than Monetary Policy. This is due to:-
• Recognition Lag:- this is the time between the beginning of a recession or inflation
and the certain awareness on part of the government that it is actually happening. It
can normally take 3-6 months for the government to realise the problem.
• Administrative Lag:- due to the inefficiency of the government, there is some time
lag between which the need for FP change is required and the time when actual
change takes place.
• Operational Lag:- the time lag in which a fiscal action is taken and the time when
that change affects RGDP, employment level, and Ps.
2. Political considerations:- sometimes political objectives such as victory in upcoming
elections may lead to misuse and unfair influence of FP
3. Expectations of Future Policy Reversals:- For example, if tax payers believe that a tax cut is
temporary, they may still save their income so that their net savings are not affected when
tax cuts are reversed.
4. Crowding Out effect:- an expansionary fiscal policy may lead to governments borrowing
from private sector to finance their deficits which can lead to an increase in IRs and
decrease in reserves with private sector to lend out money to non-government businesses.
This can lead to a fall in investment and thus cancelling out the impact of increase in
government spending on AD.
5. Unreliable macro data can lead to incorrect policy actions.
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→ IRK → suis t D.i ERT → Pxtypm I D✗ tf Dm 9 → h L R
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6. Exchange Rate Effect:- in case of a floating exchange rate system, an increase in
→ AD t .
government spending and decrease in taxes will lead to a budget deficit. To finance the
deficit, the government will issue bonds resulting in an increase in the supply of bonds and
decrease in the price of bonds. As a result, the interest rate will increase causing the
demand for local currency to rise. This will cause the exchange to rise resulting in an
increase in export prices and decrease in import prices. This can lead to a current account
deficit if the demand for exports and imports are elastic (Marshal Lerner Condition). The AD
of the economy would fall causing the RGDP to fall (depending upon Multiplier).
XFP may indirectly cause harm to the economy, if a floating exchange rate system is in
place. However, in case of a fixed exchange rate system, this problem is avoided as an
increase in ER will be matched with an increase in MS to keep ER constant allowing for a
further increase in AD.
7. Corruption and inefficiency of government departments.
8. Laffer’s Curve:- it is a curve that shows that initially tax revenue increases with an increase
in tax rate. However, after certain tax rate is introduced, the tax revenue starts to fall. This
occurs due to two reasons. When the tax rate is high, (i) incentive to evade taxes increases
and (ii) willingness to work the decreases which causes the tax revenue to decrease
Tan n
Revenue
This curve here shows the result of
:
empirical studies of the US economy which
i
shows that tax revenue ↑ till the tax rate 1
was increased up to 40%. But, beyond that I
÷
rate the tax revenue decreased due to the
two reasons mentioned above
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Free market vs Interventionist Supply side Policies
Free-market supply-side policies involve policies to increase competitiveness and free-market
efficiency.
Interventionist supply-side policies involve government intervention to overcome market
failure.
Both cause an increase in AS of the economy.
Market based policies Interventionist
Privatisation: sell state owned assets to Public sector investment in infrastructure,
private sector to increase efficiency and improving transport, energy, to reduce costs
improve incentives
Deregulation: allow new firms to enter Education: increase funding to schools and
market and lower stringent laws to make universities, or self provision, to increase
business easy. Open monopolies to productivity
competition
Income tax cuts: greater incentive for Vocational training: govt schemes to provide
workers to work longer hours new skills to those who lose jobs
Labor market reforms: reduce power of Housing supply: increase supply of cheap
trade unions and employers houses to improve geographic mobility
Reduce welfare benefits: increase incentives Health spending: public spending on health
to get a job can improve productivity
-
Subsidies
Advantages of supply side policies
1. No conflicts in aims, as economic growth and low unemployment is accompanied by
low inflation and stable balance of payment.
2. Supply-side policies also leads to structural improvements in the economy over long
run.
Disadvantages of supply side policies
1. These are expensive for government as debt burden and tax increases due to which the
tax burden also increases, this also gives a rise to opportunity cost.
2. Supply side policies have lagged effects which means they are only effective in long run.
AS AS
^
, ,
CPI
÷
ABBAD
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Y, Ya RGDP
