Macro-economic policy

Policy objectives

Governments and other policy makers have at their disposal a wide array of individual policies to help them achieve their objectives. There are several macro-economic objectives, including:

Stable prices

Maintaining a stable price level – which means keeping the rate of inflation within certain limits – typically, around 2% per year in most countries.

Full employment

Achieving full employment – typically assumed to be around 4% unemployment. This means that some level of unemployment is accepted as inevitable, given that people will be changing jobs, and some will be unemployed as a result of business failures.

Stable and sustainable growth

Maintaining stable and sustainable growth levels, which typically means growing at a level which does not exhaust scarce resources or drive up the prices of resources. A common benchmark for stable growth is for GDP to increase at, or just above, the long-term trend-rate for an economy.

A balance of payments

Achieving a balance of payments with the rest of the world.

In addition to these core objectives, policy makers can set targets to control pollution and other negative externalities, and to achieve greater equity through reduction in inequality and poverty.

In recent years the control and management of public finances is seen as an increasingly important objective, especially following the financial crash of 2008 to 2010.

Policy instruments

To achieve these objectives, policy makers can select the policy tools they expect will help them best achieve the chosen objective.

Policies can be put into one of two main categories – those that influence demand and those that influence supply – commonly called demand-side and supply-side policy.

Demand side policies

On the demand side we have fiscal and monetary policy. While fiscal policy uses taxation, public spending or borrowing to achieve changes in aggregate demand, monetary policy attempts to influence aggregate demand by expanding or contracting economy activity through the regulation of the supply of money, or the demand for money.

Monetary transmission mechanism

In a modern economy, fiscal policy is the responsibility of government, while monetary policy is the responsibility of the central bank. Fiscal and monetary policy can be used to target any policy objective, although typically, monetary policy is given over to the pursuit of a stable price level.

It should be noted that tax policy can be used as a supply-side tool, especially to encourage work and enterprize.

Supply-side policies

Supply-side policies are often categorised in terms of whether they try to enhance the workings of the free market economy, such as by deregulation and removing the constraints imposed by government, or whether they involve more intervention by government, such as increased spending on education and healthcare, and on infrastructure.

In terms of specific supply-side policies, reducing marginal tax rates can achieve an incentive effect as it can encourage people to work. The Laffer curve can help illustrate this effect. Improving labour productivity is also seen as a key supply-side objective.

Productivity improvements

Productivity is measured either as output per worker, or output per hour worked. Three factors stand out as key areas for an economy to improve:

  1. Firstly, improving the level of education and skill of the work-force. Given that education is a merit good, it is unlikely that the free market will supply a sufficient quantity of education, hence the significance of state involvement.
  2. Secondly, improving the flexibility of labour to be able to adapt to changes in the demand for labour. Again, education can help this, as can incentives to retrain, and subsidies and grants to firms to engage in training. Labour mobility is a key component of flexibility. When labour is geographically immobile, government may subsidise public transport or provide re-location assistance. In the case of occupational immobility, improving education and skills, and providing better information to job-seekers can help. Reducing barriers to entry into the labour market can also help improve mobility and flexibility, such as encouraging more part-time work.
  3. Thirdly, industrial and technology policy can help encourage an economy to improve the efficiency and competitiveness of its industries. Finally, improvements in a country’s infrastructure, including its transport and communications networks, can help improve factor productivity.

It should be noted that objectives may be in conflict with each other, such as the inflation-unemployment conflict as identified in the Phillips curve.

Video on macro-economic policy

Aggregate demand

Aggregate demand and the AD curve.

Aggregate demand
Fiscal policy

How can fiscal policy influence aggregate demand?

Fiscal policy
Monetary policy

How effective is supply-side policy?

Supply-side policy

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