Objectives of macroeconomic policy
Economic growth. An increase in real GDP is often regarded as the fundamental objective of macroeconomic policy by governments, not only in developing countries where it is seen as a means of reducing absolute poverty, but also in developed economies by governments wishing to obtain popularity. Further, many economists regard this objective as being pivotal in achieving the other macroeconomic objectives.
Sustainable growth. This is usually defined as the ability to meet the needs of the present generation without compromising the needs of future generations. There have been growing concerns that rapid economic growth in countries such as China and India is unsustainable in terms of the environment and the rapid depletion of natural resources. The limitation of the external costs associated with economic growth is an objective that can only be met with global cooperation.
A low and stable inflation rate. Apart from other disadvantages, high inflation rates can damage the international competitiveness of a country’s goods, so most countries pursue policies designed to maintain a low and stable rate of inflation. As equally destructive as high inflation is deflation, which is a sustained fall of price level: experience from the 1930s suggests that deflation is often associated with depression.
Full employment. This does not mean that every worker is employed, because there will always be frictional unemployment. However, this is usually regarded as being full employment and is referred to as the natural rate of unemployment. This objective is most likely to be fulfilled if there is economic growth.
Balance of payments equilibrium of current account. One of the major imbalances between countries has been in relation to the balance of payments. While the UK and USA have been running large deficits, China has had persistent surpluses. Although deficits have been financed by inflows into the financial account, many have argued that they are unsustainable in the long term. Huge deficits may result in violent changes in the exchange rate of a country’s currency, contributing to an instability in the whole economy.
Redistribution of income. Most developed countries used progressive tax rates and welfare payments, especially means-tested benefits, to redistribute income from the rich to the poor.
Fiscal balance. In the same way that current account deficits may be unsustainable, the same might also be true of large fiscal deficits. This form of imbalance may prove to be a problem if countries are unable to sell government bonds to finance the deficits.
The aggregate-demand/aggregate-supply model
Aggregate demand is the relationship between the quantity of real GDP demanded and the price level. The main components of AD are consumption, investment, government expenditure and net exports. Shifts in the AD curve may be caused by changes in the folowing:
- Asset prices
- Interest rates
- Foreign direct investment
- Tax rates
- Expectation about the future state of the economy
- Decisions by the government on its expenditure
- The exchange rate
The Keynesian aggregate supply curve
Keynesians consider that the economy could be in long-run equilibrium at less than the full employment level of real output. At low levels of real output it would be horizontal because there would be considerable spare capacity in the economy. As the economy moves towards full employment, bottlenecks in production occur, along with shortages on some resources, which will push up costs, causing the AS curve to rise. At full employment, the AS curve becomes vertical.
The short run AS curve
Short run aggregate supply (SRAS) is the relationship between total quantity of final goods and services supplied (real output) and the price level, holding everything else constant.
Shifts in the SRAS curve may be caused by the following:
- Changes in wage rates: an increase in wage rates will raise costs of production and cause the LRAS to shift to the left
- New legislation: for example, new health and safety regulations or environmental regulations which increase the costs of firms in the economy would cause the SRAS curve to shift tot the left
- Changes in the prices of raw materials and components: a general fall in commodity prices would cause a shift to the right
- Changes in taxation on firms: In the UK, employers (as well as employees) are required to pay national insurance contributions. These are really a tax on employment, so if employers contributions are increases then the SRAS curve will shift to the right
The long-run AS curve
Shifts in the long-run AS curve may be caused by the following factors:
- Technological change: new and more efficient methods of production will affect the LRAS
- The size of the labour force: this can be influenced both by the natural rate of increase or decrease in the population,but also by migration
- Human capital: the skills, knowledge, and expertise of a workforce gained through education and training. This effects productivity
- Capital stock: if the capital stock increase relative to the workforce, then productivity should increase
- Raw materials: the discovery of new raw materials will cause the LRAS to shift to the right