24. Macroeconomic Policies – Macroeconomics: Theory and Policy

24

Macroeconomic Policies

After studying this topic, you should be able to understand

  • Macroeconomic policy is the action taken by the government to achieve the macroeconomic objectives of the economy.

  • Monetary policy is an operation by the monetary authority where as fiscal policy is an operation by the government.

  • The objectives of macroeconomic policy differ from country to country.

  • The objectives of macroeconomic policy are determined by the government keeping in mind the economic and social needs of the country.

  • The targets are the variables, which should be controlled to achieve the macroeconomic objectives.

INTRODUCTION

At many points, in the course of this book, we have observed that the right combination of fiscal and monetary policies can help an economy come out of a recession, an inflationary situation and tackle problems relating to growth and even those on the trade front. Besides these policies, there exist other policies like income policy, growth policy employment policy and others which all fall under the heading of macroeconomic policy. However, our focus will be on the two most important policies, fiscal and monetary polices which we will examine at length in the following chapter.

 

Monetary policy is an operation by the monetary authorities of the country and it operates through changes in the quantity of money. Thus, its immediate impact is felt in the money market.

In spite of the success of the different policies, there appears to be frequent demands indicating that policy makers are highly conservative and restrained in their approach to the implementation of the different policies. Are they really restrained or are they being extra cautious? In the present chapter, we attempt at answering this question and many other questions as well.

 

Fiscal policy is an operation by the government and it operates through changes in the government expenditure and tax collections. Thus, its immediate impact is felt in the goods market.

MEANING AND THE ADVENT OF MACROECONOMIC POLICY

Macroeconomic policy refers to the action taken by the government through the different policies to achieve the macroeconomic objectives of the economy. These macro goals include economic growth, economic development, full employment, equality in the distribution of income, controlling the inflation in the economy through maintaining price stability and others. The most popular macroeconomic policies are the fiscal policy and the monetary policy.

 

Macroeconomic policy refers to the action taken by the government through the different policies to achieve the macroeconomic objectives of the economy.

Monetary policy is an operation by the monetary authorities of the country and it operates through changes in the quantity of money. Thus, its immediate impact is felt in the money market. Fiscal policy is an operation by the government and it operates through changes in the government expenditure and tax collections. Thus, its immediate impact is felt in the goods market.

Before the Second World War, there was a strong conviction that a laissez faire economy was the best. The government’s role should be at a minimum and the economy should function on the basis of the principle of the invisible hand as mentioned by Adam Smith in his famous 1776 book, An Inquiry into the Nature and Causes of the Wealth of Nations where each individual aimed at the maximization of his own welfare and in the process the society’s welfare was maximized. Smith was deeply religious, and saw the invisible hand as the device by which a generous and kind God administered a universe where happiness was at a maximum.

With the advent of Keynes, the role of the government in achieving the macroeconomic objectives was realized. The authorities in the United States and the other countries realized as to how important a role the government played in achieving the objectives of growth, employment and price stability besides the other goals. Thus, laws were passed in many countries underlying the importance of the government in the different aspects of economic activity. Though there were still doubts and differences relating to the extent of responsibility that the government should be assigned in achieving the different goals, but it certainly was the beginning of an era where the role of the government in economic activity gained importance. Slowly, as time passed, the role of the government encompassed the different aspects of life.

To what extent the government has been successful in achieving the macroeconomic objectives over the period is a subject open to debate and differing from one country to another. Nevertheless, the importance of the government cannot be undermined even in today’s world. Hence, we examine it in some depth in the following chapter, which examines the monetary and fiscal policy.

RECAP
  • The role of the government in achieving the macroeconomic objectives was realized only with the advent of Keynes.
OBJECTIVES OF MACROECONOMIC POLICY

The objectives of macroeconomic policy differ from country to country. While an underdeveloped country may aim at growth and development, an industrialized country may aim at providing employment or at achieving a situation near full employment, and also price stability by keeping inflation under control. Hence, the policy makers in the different countries have to consider all these aspects while framing their policies. Hence, policies have to be framed accordingly.

In general, we can categorize the different objectives of macroeconomic policy as below:

  1. A High and sustainable economic growth: In the simplest terms, the economic growth can be defined as the increase in an economy’s output over a period of time. One of the best ways of measuring the economy’s output is the real GNP, the word ‘real’ implying that the effects of inflation have been adjusted for. Sometimes, the GDP is used which is quite similar to the GNP.

     

    Economic growth can be defined as the increase in an economy’s output over a period of time.

    If the real GNP is corrected for the increases in the population another useful concept in economic growth, the real GNP per capita can be obtained. From the real GNP per capita various other related concepts of economic growth can be arrived at, each of which emphasizes some aspect of economic growth. For example, the real consumption per capita indicates the growth in the economic welfare of the consumer.

    One of the main objectives of macroeconomic policy is to achieve a high rate of economic growth, especially in the developing countries. However, achieving a high rate of economic growth is not sufficient. It is important that this rate is sustained for a sufficiently long period of time.

    BOX 24.1

    The attainment of full employment was considered to be very important for the policy makers after the Second World War. For the socialist government of the 40s, the attempt at achieving full employment was one of the primary objectives and continued to remain so for the next three decades. The problem of unemployment became more acute in the 80s. However, it was seen to be an unavoidable consequence of the structural changes which accompanied industrial development but which were necessary to make the industries more efficient. The lower levels of unemployment, which persist in the west today, are a consequence of the industrial development achieved at that time.

  2. Low unemployment or a high rate of employment: Most economies are in a situation where they face some level of unemployment, which may be at a higher level in the less developed countries and at a lower level in the more developed countries. Unemployment is generally accompanied by low living standards, hardships and mental agony.

    As already discussed in Chapter 21, a person is unemployed if he is out of work and (a) has been actively looking for work during the previous four weeks, or (b) is waiting to be called back to a job after having been laid off.

    One of the main objectives of macroeconomic policy has been not only to achieve full employment but also to maintain it at that level. This was especially important after the Second World War. Keynes was one of the first economists who pointed out the need to achieve full employment. However, today the objective of full employment is given much less importance as compared to the other objectives in many countries. Most countries have achieved a situation of near full employment. Not everyone has been able to get a job but the situation is improving every day and the unemployment levels are falling to levels that some consider to be close to the situation of full employment.

  3. Price stability: Inflation is defined as a sustained and appreciable increase in the general level of prices. For price stability, it is necessary for the inflation rate to be zero or near zero. Most economies aim at keeping the inflation rates at low levels. Macroeconomic policy has the control of inflation as one of its primary objectives. In fact if one had to single out the most important objective of macroeconomic policy today, then it would certainly be inflation. A large part of the government’s efforts in every economy are devoted to controlling inflation.

    If one were to analyse the evils of inflation, the foremost among them would be the arbitrary way in which the income and wealth distribution is affected by inflation. It can, in fact, wipe out the purchasing power of individual’s total savings earned in his whole life.

    Economists have put forward the view that a little amount of inflation is good for an economy because a little inflation of about 2–3 per cent will lead to a rise in real wages and thus act as trigger, which will pep up the entire economy.

    Nevertheless, it is a generally accepted fact that high levels of inflation are bad for an economy and thus need to be controlled. A rapid rate of inflation that is unanticipated and thus to which adjustment is not feasible is without doubt harmful for any economy. Inflation at a mild rate may be good for an economy but it is subject to uncertainty. In the light of these arguments, it seems that it is a better option to aim at controlling inflation and maintaining stable prices or a zero inflation rate.

  4. Equilibrium in the balance of payments: As already discussed in depth in Chapter 23, balance of payments of a country is a record of all flows of money into and out of the country. It includes the following two categories of transactions:

Balance of payments of a country is a record of all flows of money into and out of the country.

BOX 24.2

During the 1960s, the balance of payments was regarded as the litmus test. In Britain, a deficit was unpalatable and considered not befitting a world power. Under the ‘Bretton Woods’ fixed exchange rate system when international free movement of capital was not there, a sustained deficit was sure shot indicative of potential erosion in the pound sterling. As years passed with emergence of large global capital flows and with a floating pound, the surpluses or deficits in balance of payments ceased to matter as much. The sustained deficits in balance of payments during the 90s did not result in any discomfort among the economists in Britain.

  1. Current transactions that include exports and imports of goods and services or, in other words, the visible and invisible trade.
  2. Capital transactions that include the inflows and outflows of capital; for example foreign investments and foreign exchange reserves.

Perhaps, the more important of the two is the current account as it records how well a country is performing in terms of its exports of goods and services as compared to its imports-A country has to keep earning sufficient currency through its exports, if it has to not only provide for its imports but all the more important if it has to rise as a nation and take its place in the world.

One of the primary objectives of macroeconomic policy is, thus, to maintain a stable balance of payments position.

Which is the Most Important Objective?

After the Second World War till the 80s, full employment was considered the number one objective of the socialist governments in Britain. This belief, however, crumbled under Thatcher in the 80s when unemployment was accepted as an unavoidable outcome pursuant to the steps undertaken to make industry more efficient. Also, the relative de-industrialization that has since been occurring throughout the developed world has made higher unemployment inevitable. Consequently, this objective has now become less important than it used to be.

Two other objectives, which have always been important in most economies, are a low level of inflation and growth. Peoples’ standard of living will increase only if there is growth. However, a high inflation will wipe out any increase in the standard of living as there will be a decrease in the value of money.

The most important objective today is inflation, and macroeconomic policy in most countries is oriented towards achieving this objective.

The objectives discussed are the primary objectives and the secondary ones, though equally important from the view point of the society, have been emphasized in the conflicts between the different objectives.

The Conflicts Between the Objectives

Unfortunately, it is very difficult for any government to achieve all the objectives simultaneously. This is because, often, there are conflicts between the different objectives such as:

  1. A healthy growth and a low rate of inflation: If an economy grows too quickly and that too due to an excessive increase in the consumer demands, then there will be an increase in the prices. Thus, there will be growth but accompanied by inflation.

    On the other hand if steps are taken to control inflation, for example, high rates of interest, then investment spending will be discouraged thereby hampering growth.

    Hence, it is difficult to achieve both the objectives of low inflation and healthy growth simultaneously.

  2. A healthy growth and equilibrium in the balance of payments: In a growing economy consumer spending is high, especially on foreign goods in comparison to domestic goods. This leads to a worsening of the trade deficit and disequilibrium in the balance of payments. Earlier governments would use import controls to tackle the problem. However, due to the World Trade Organization (WTO) and the move for globalization such controls are no longer feasible.

    It is difficult to achieve both the objectives of healthy growth and equilibrium in the balance of payments simultaneously.

  3. A low rate of inflation and low unemployment: The conflict between inflation and unemployment has been a reason of worry for the economists. As already mentioned in Chapter 21, the short-run modern Phillips’ curves are downward sloping showing a negative relationship between inflation and unemployment in the short run. Thus if the government attempts at controlling a high inflation through high rates of interest and a reduction in government expenditures, then there will occur a decrease in consumption expenditures and also investment spending will be discouraged. This will result in decrease in the demand for labour and, thus, in unemployment.

    A reduction in inflation is possible but only at the cost of a high rate of unemployment. A situation where there is high unemployment and high expected inflation is known as stagflation.

    However, it is important to note that the downward sloping Phillips’ curve implying a trade-off between unemployment and inflation is only a situation which exists in the short run. In the long run the Phillips curve is vertical, implying that the rate of unemployment is independent of the rate of inflation.

  4. A healthy growth and an equal distribution of income and wealth: Often, it has been observed that a country may grow but the effects of the growth may not trickle down to the common man. The rich may just become richer. The socialist countries attempted to improve the lot of the common man. But this meant a slower rate of growth.

    Hence, it is difficult to achieve equality in the distribution of income and wealth side by side with growth because forcing equality can have an adverse effect on the incentives for work and thus lead to inefficiencies.

  5. A healthy growth and a healthy environment: Environment is an objective, which most economies are now realizing as important for macroeconomic policy. However, it is still not being given the importance that it deserves.

    The faster is the growth the higher is the pollution because of the smoke emanating from the factories and cars, disappearance of forests to make way for the new factories and houses, etc. Hence, although growth is taking place but it is at the cost of increasing the levels of pollution.

RECAP
  • The most important objective today is inflation, and macroeconomic policy in most countries is oriented towards achieving this objective.
  • It is very difficult for any government to achieve all the objectives simultaneously because, often, there are conflicts between the different objectives.

Objectives of Macroeconomic Policy in India

‘From a macroeconomic perspective, low levels of budget deficits and public debt are generally considered as key ingredients for economic growth, reducing poverty and improving social outcomes. This owes to the stabilization models attributing resource–expenditure imbalances as the trigger for economic problems of many emerging/developing economies. The fiscal reforms initiated in 1990s as a part of economic liberalization reflected this point of view. Fiscal consolidation began in the early 1990s with fiscal deficit declining from 6.6 per cent of GDP in 1990–91 to 4.1 per cent of GDP in 1996–97; however, it faltered and started deteriorating in 1997–98 and reached a level of 6.2 per cent of GDP in 2001–02. It was against this background, that operationalization of the Fiscal Responsibility and Budget Management Act of 2003 (FRBMA) assumed urgency leading to the notification of the rules under the Act in July, 2004. In the post-FRBMA period, progress in fiscal consolidation was more or less close to the targets envisaged thereunder’. — India Economic Survey 2008–09.

THE FORMULATION OF THE MACROECONOMIC POLICY

The responsibility of formulating the macroeconomic policy in any economy falls on the shoulders of the government. It is the government who has to not only determine the objectives of the macroeconomic policy but has to keep in mind the conflicts between the different objectives also while making the decisions on the instruments and the target variables to be used in the implementation of the policy objectives.

As far as the objectives of macroeconomic policy are concerned, they are determined by the government keeping in mind the economic and social needs of the country. As already mentioned, in an underdeveloped country the policy objectives are oriented towards growth and development where as in an industrialized country it is oriented towards achieving a situation of full employment, and price stability. Thus, the policy makers have to consider all these aspects while framing the policies, deciding on the policy instruments and the target variables.

Targets, Instruments and Indicators of Macroeconomic Policy

We have already discussed at length the objectives of monetary policy. Once the objectives have been decided, the immediate problem before the policy makers is how to achieve the objectives.

The targets are the variables, which are to be controlled to achieve the macroeconomic objectives. In other words, these are the means to achieve the end result. They are the recognized goals of the policies. The targets of monetary policy, for example, include money supply, interest rates and bank credit. The targets of fiscal policy, for example, include consumption expenditure, investment expenditure and savings.

Targets can be further divided into the ultimate targets and the intermediate targets. An ultimate target for an economy could be to attain a zero level of inflation. To be able to serve as a target, a variable should have four qualifications:

  1. The variable should have a relationship with the objectives and this should be clearly understood.
  2. The variable should be directly affected by the policy instruments.
  3. The influence of any non-policy factors should be minimal compared to the policy instruments.
  4. The variable should be measurable and there should be no time lag involved.

The government uses a variety of instruments to achieve the macroeconomic objectives. The instruments are the tools with the policy makers to achieve the target. For example to achieve an exchange rate target, the instrument available with the central bank is the sale or the purchase of foreign exchange.

The instruments of monetary policy include open market operations, cash reserve ratio and statutory liquidity ratio. These instruments of monetary policy influence the target variables of monetary policy to achieve the macroeconomic policy objectives. The instruments of fiscal policy include government expenditure, taxation and deficit financing. Similar to the instruments of monetary policy, the instruments of fiscal policy influence the target variables of fiscal policy to achieve the macroeconomic policy objectives.

Indicators are those economic variables that are signals, which indicate whether we are moving closer to achieving the targets. Thus they are a feedback that provides the necessary information to the policy makers as to whether they are approaching the targets, or adjustments are required to achieve the target.

 

Indicators are those economic variables that are signals, which indicate whether we are moving closer to achieving the targets.

The government faces many problems in trying to attain the objectives it has decided upon; some of them are as follows:

  1. The effects of the policies on the objectives are delayed and distributed over time in the uncertain dynamic world.
  2. There may exist a delay in obtaining the full and complete information about the actual state of the objectives; for example, about the real income and the employment.
  3. The processing and analysis of the information may involve a lot of time.
  4. The objectives may be affected not only by the policy instruments but also by developments, which are not related to the policies.

These innumerable problems act as a hurdle in the task of making the different policies. Hence, often, the policy makers have to rely on what we can think of as proxies for the objectives/goals.

RECAP
  • The instruments of monetary policy influence the target variables of the monetary policy to achieve the macroeconomic policy objectives.
  • The instruments of fiscal policy influence the target variables of the fiscal policy to achieve the macroeconomic policy objectives.
SUMMARY
INTRODUCTION
  1. The right combination of fiscal and monetary policies can help an economy to come out of a recession and an inflationary situation.
  2. In spite of the success of the different policies, there appears to be frequent demands indicating that policy makers are highly conservative and restrained in their approach to the implementation of the different policies.
MEANING OF AND THE ADVENT OF MACROECONOMIC POLICY
  1. Macroeconomic policy is the action taken by the government to achieve the macroeconomic objectives of the economy.
  2. Monetary policy is an operation by the monetary authorities where as fiscal policy is an operation by the government.
  3. With the advent of Keynes, the role of the government in achieving the macroeconomic objectives was realized.
OBJECTIVES OF MACROECONOMIC POLICY
  1. The objectives of macroeconomic policy differ from country to country.
  2. An underdeveloped country may aim at growth and development where as an industrialized country may aim at providing employment or at achieving a situation near full employment, and also price stability by keeping inflation under control.
  3. One of the main objectives of macroeconomic policy is to achieve a high rate of economic growth, especially in the developing countries.
  4. Another main objective of macroeconomic policy has been to not only achieve full employment but to maintain it at that level. Keynes was one of the first economists who pointed out the need to achieve full employment. However, today the objective of full employment is given much less importance.
  5. Inflation is defined as a sustained and appreciable increase in the general level of prices. In fact, if one had to single out the most important objective of macroeconomic policy today, then it would certainly be inflation.
  6. Balance of payments of a country is a record of all flows of money into and out of the country. It includes two categories of transactions: current transactions and capital transactions. One of the primary objectives of macroeconomic policy is, thus, to maintain a stable balance of payments position.
WHICH IS THE MOST IMPORTANT OBJECTIVE?
  1. After the Second World War till the 80s, full employment was considered the number one objective of the socialist governments in Britain.
  2. The most important objective today is inflation, and macroeconomic policy in most countries is oriented towards achieving this objective.
THE CONFLICTS BETWEEN THE OBJECTIVES
  1. A healthy growth and a low rate of inflation: If an economy grows too quickly and that too due to an excessive increase in the consumer demands, then there will be an increase in the prices. Thus, there will be growth but accompanied by inflation.
  2. A healthy growth and equilibrium in the balance of payments: In a growing economy consumer spending is high, especially on foreign goods in comparison to domestic goods. This leads to a worsening of the trade deficit and disequilibrium in the balance of payments.
  3. A low rate of inflation and low unemployment: The short-run modern Phillips’ curves are downward sloping showing a negative relationship between inflation and unemployment in the short run. In the long run the Phillips curve is vertical, implying that the rate of unemployment is independent of the rate of inflation.
  4. A healthy growth and an equal distribution of income and wealth: It is difficult to achieve equality in the distribution of income and wealth side by side with growth because forcing equality can have an adverse effect on the incentives for work and, thus, lead to inefficiencies.
  5. A healthy growth and a healthy environment: The faster is the growth the higher is the pollution because of the smoke emanating from the factories and cars, disappearance of forests to make way for the new factories and houses, etc.
THE FORMULATION OF THE MACROECONOMIC POLICY

The objectives of macroeconomic policy are determined by the government keeping in mind the economic and social needs of the country.

TARGETS AND INSTRUMENTS OF MACROECONOMIC POLICY
  1. The targets are the variables, which are to be controlled to achieve the macro economic objectives. The targets of monetary policy, for example, include money supply, interest rates and bank credit. The targets of fiscal policy, for example, include consumption expenditure, investment expenditure and savings.
  2. The government uses a variety of instruments to achieve the macroeconomic objectives. The instruments of monetary policy, for example, include open market operations, cash reserve ratio and statutory liquidity ratio. The instruments of fiscal policy, for example, include government expenditure, taxation and deficit financing.
  3. The government faces many problems in trying to attain the objectives it has decided upon.
REVIEW QUESTIONS
TRUE OR FALSE QUESTIONS
  1. Macroeconomic policy refers to the action taken by the government through the different policies to achieve some macroeconomic objectives of the economy.
  2. Monetary policy is an operation by the government and it operates through changes in the government expenditure and tax collections.
  3. If the real GNP is corrected for the increases in the population, the real consumption per capita can be obtained.
  4. Balance of payments of a country is a record of all flows of money into and out of the country.
  5. In the short-run the Phillips curve is vertical, implying that the rate of unemployment is independent of the rate of inflation.
VERY SHORT-ANSWER QUESTIONS
  1. Define macroeconomic policy.
  2. What are fiscal policy and monetary policy?
  3. What does the objective of a high and sustainable economic growth imply? Explain.
  4. ‘One of the main objectives of macroeconomic policy has been to not only achieve full employment but to maintain it at that level.’ Explain.
  5. ‘If one had to single out the most important objective of macroeconomic policy today, then it would certainly be inflation.’ Comment.
SHORT-ANSWER QUESTIONS
  1. What do you mean by macroeconomic policy? Which are the two most popular macroeconomic policies?
  2. Discuss any two objectives of macroeconomic policy.
  3. Which is the most important objective of macroeconomic policy?
  4. Does the objective of a healthy growth conflict with any of the other objectives?
  5. ‘The objectives of macroeconomic policy are determined by the government keeping in mind the economic and social needs of the country.’ Comment.
LONG-ANSWER QUESTIONS
  1. Write a short note on the meaning of and the advent of macroeconomic policy.
  2. What are the objectives of macroeconomic policy? Discuss.
  3. Are there any conflicts between the different objectives? Discuss.
  4. Write a short note on the targets and instruments of macroeconomic policy.
  5. What are the objectives of macroeconomic policy in India? Discuss.
ANSWERS
TRUE OR FALSE QUESTIONS
  1. True. Macroeconomic policy refers to the action taken by the authorities to achieve some macroeconomic objectives of the economy. The most popular macroeconomic policies are the fiscal policy and the monetary policy.
  2. False. Fiscal policy is an operation by the government and it operates through changes in the government expenditure and tax collections. Thus, its immediate impact is in the goods market.
  3. False. If the real GNP is corrected for the increases in the population, the real GNP per capita can be obtained.)
  4. True. Balance of payments of a country is a record of all monetary flows into and out of the country. It includes two categories of transactions: current transactions and capital transactions.
  5. False. In the long-run the Phillips curve is vertical, implying that the rate of unemployment is independent of the rate of inflation.