Macroeconomic policy instruments

Macroeconomic policies are usually divided into demands-side (monetary and fiscal policy) and supply side policies. For 30 years or so, until the financial crisis of 2008, monetary policy was geared towards combating inflation, while fiscal policy was aimed at achieving the governments fiscal objectives. Supply-side policies were used to secure economic growth and the government’s other macroeconomic objectives. In this unit it is important to adopt a critical approach to the effectiveness of these policies.

Monetary policy

Monetary policy refers to the use of interest rates, money supply and exchange rate in order to influence the level of economic activity in a country.

There are various aspects of monetary policy:

  • Inflation targets. These are used by many countries in order to maintain a low rate of inflation. In the case of the UK, there is a target of 2%, although the rate may vary up to 1% either side of this, while the European Central Bank has a target maximum inflation rate of 2%. Until 2007, inflation targeting was generally regarded as an effective way of controlling inflation, although countries without inflation targets did not seem to have significantly higher rates of inflation. However, following the financial crisis, many economists have argued that an inflation target based on the CPI is too narrow. Instead there should be targets relating to other variables, such as asset prices. In order to prevent asset price bubbles from occurring.
  • Interest rate changes. These are used to achieve the inflation target. e.g. if the inflation rate is predicted to rise above its target, then the Bank of England increases the base rate. However, the use of interest rates has various disadvantages. i.e. time lag, business costs rise, exchange rate may increase, making a countries goods less competitive.
  • Quantitative easing. This is sometimes mistakenly referred to as printing money. In practice, it relates to the action of the Central Bank in buying up government and corporate bonds from commercial banks and other financial institutions. This has the effect of increasing their deposits, thereby giving them more ability to to lend to private and business customers. However, some argue that this policy is unlikely to be effective if the banks are risk averse and remain unwilling to lend unless the loan is risk-free. There is also a danger that the increase supply of money in the economy could unleash as serious bout of inflation. An increase in the supply of money could also cause a depreciation of the exchange rate which, in turn, would result in net exports and so increase AD.

Fiscal Policy

Fiscal policy refers to the use of government expenditure and taxation in order to influence the level of economic activity in a country. From the 1980s to 2008, its primary role was to stable public finances. However, from 2008 it has once again assumed a role macroeconomic management not only in the UK, but also in China, the USA and various other countries. Some key features of fiscal policy include:

  • Automatic stabilisers: relate to the fact that some forms of government expenditure and revenues from some taxes change automatically in line with GDP and the state of the economy. These stabilisations reduce fluctuations caused by the business cycle. Examples include progressive taxation and welfare payments such as unemployment
  • Discretionary fiscal policy: refers to deliberate changes in taxes and public expenditure designed to achieve the governments macroeconomic targets. For example, the global economic crisis has led to many countries introducing a fiscal stimulus to prevent severe recession. Typically, these have included an increased public expenditure on infrastructure; green technology, targeted subsidies to distressed industries and tax cuts.

Fiscal policy might be effective if the value of the multiplier is high and can have an immediate impact if indirect taxes, such as VAT, are reduced. However, there may be significant time lags. For example, government expenditure on investment projects, such as new hospitals, is unlikely to have an impact for a considerable time because land must be purchased and planning applications approved.

Further, if there is a contractionary fiscal policy in which direct taxes are increased, there could be disincentive effects, while higher tax rates might reduce incentives to work. It is also difficult to determine the magnitude of changes in public expenditure in advance because the value of the multiplier may not be known.

Supply side policies

Supply side policies are a broad range of policies aimed at increasing aggregate supply by increasing competition, increasing incentives and cutting costs. Essentially these are microeconomic policies since they target specific markets, e.g. labour, product or capital markets.

Labour market

Policies aimed at the labour market include:

  • reduction in trade union power: e.g. making strikes without a secret ballot illegal, making sympathy strikes illegal
  • reduction in unemployment benefits: which would increase the incentive for unemployed workers to take jobs
  • improvements in human capital: increased provision and quality of education and training designed to increase the productivity of the workforce
  • reduction in employment protection legislation: making it easier to hire and fire workers, which contributes to a more flexible workforce
  • reduction in income tax rates: the aim of these tax cuts is to increase incentive to work and may be analysed using the Laffer curve

Product market

  • privatisation, deregulation, contracting out:
    privatisation –  involves the sale of state-owned enterprise to the private sector usually through the form of shares. This policy has been adopted across the globe and in the case of developing countries, privatisation has been a condition for loans given by the IMF.
    deregulation – when the government removes official barriers to competition e.g. licences and quality standards
    contracting out – when parts of services operated by the public sector are put out to tender so that the private sector can compete for the business
  • Trade liberalisation: relates to the free movement of goods and services within an economy. Removal or reduction in trade barriers, and the adoption of policies that allow free capital flow between countries, so making it more attractive for transnational companies to invest in the country.
  • promotion of new/small firms: for example, through tax breaks, short-term loans for new businesses and loan guarantees.

Capital market

  • Deregulation of the financial markets: such as the reduction of restrictive practices in the city and stock exchange
  • reduction in corporation tax: or reduction in tax allowances on investment by firms

Criticism of supply side policies

  • Increased inequality: it is argued that they are based on the premise that the rich will work harder if you pay them more, and the poor will work harder if you pay them less
  • Time lags: some of the measures take a long time to have any impact on the supply side of the economy i.e. primary education reform
  • The incentive of tax cuts may be over estimated: in the USA, tax cuts resulted in an increase in labour supply of less than 1%. Similarly, there is little evidence that tax cuts have any significant effect on productivity
  • Ineffectiveness: if aggregate demand is low, these policies may have no effect
  • Adverse effects of deregulation: competition may lead to undesirable consequences. For example, the deregulation of the financial markets resulted in excessive risk-taking, and the near collapse of the banking system

Problems faced by policy makers

Policy makers face a variety of problems when implementing policy:

  • Inaccurate information: for example, information regarding GDP, the balance of payments on current account and retail sales is notoriously inaccurate and subject to subsequent revisions
  • Risks and uncertainties: for example, there is considerable uncertainty over the effect of quantitative easing. Some monetarist economists argue that it could risk unleashing a massive bout of inflation because of the increase in money supply, while others consider the previous experiences in other countries suggests it will have little impact on the economy.
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