Managing the Economy I
The main objectives of macroeconomic policy and
the conflicts between these objectives.
The instruments of policy - fiscal and monetary
polices, prices and incomes policies, exchange
rates and import controls.
Explain why there are likely to be conflicts
between the major objectives of economic policies.
Macroeconomics is the study of aggregates of economic life: total
output, overall unemployment and inflation, the money supply, the
budget deficit, and balance of payments.
The main economic objectives of a macroeconomy are:
1) High level and rapid growth of output and consumption;
2) High employment and low involuntary unemployment;
3) Price-level stability (or low inflation), through prices
and wages set in free markets;
4) Balanced balance of payments, where exports roughly
balance imports and the nation has a stable exchange rate
against foreign currencies.
The major social objectives of a macroeconomy are:
1) Fair distribution of income;
2) Universal access to education, health care and housing;
3) Proper care of people unable to work: old persons,
children and physically and/or mentally disabled
Governments have the following instruments to steer the economy:
A) Fiscal policy (government spending and taxation) determines
the allocation of between private and collective goods/
services. It affects people's incomes and consumption,
investment and savings.
B) Monetary policy (managing interest rates and credit
conditions through regulating the money supply). It affects
sectors in the economy that are interest sensitive (mainly
housing and business investment).
Another area is managing the exchange rate. It affects trade
and flow of capital.
C) Incomes policies (programs that directly/indirectly affect
wages and prices) attempt to control inflation without
incurring the high costs of recessions and unemployment.
Policies, nevertheless, can have contradictory effects. The classical
one being inflation and unemployment when the economy is growing
through demand pull, and not through supply-pull.
Monetary and fiscal policies can affect national income but the opinions
of Keynesians and monetarists differ on the extent of this influence.
By and large, an increase in national income occurs either because
output increase ( the derived demand for labour will increase, so
unemployment will fall) or because price increase, so there is
inflation. With few variations except in the last 15 years or so,
since the Second World War, all governments in the industrialized world
including that of the UK kave used monetary and fiscal policies to
attempt to reduce unemployment or to attempt to reduce the inflation
"Although no firm division can be made, the policies used until the
early or mid 1970s were largely based on the Keynesian view of the
effects of fiscal and monetary policies. More recently, policies have
been based much more on the monetarist view (...it should be noted
that the use of monetary targets, which is broadly monetarist policy,
predates the change from Labour to Conservative government in 1979)"
(J. Craven, "Introduction to Economics. An Integrated approach to
Fundamental Principles", Basil Blackwell, 1984)
And it did continue unchanged (monetarist view, that is), after the
change from Conservative to Labour government in 1997.
Keynesian policies are based on the use of macroeconomic analysis,
like the circular flow of income, which assumes that prices and money
wages do not move towards their equilibrium level.
Monetarist policies are generally based on the use of market analysis,
which assumes that prices change so that markets clear rapidly.
What follows is taken from J. Craven (1984):
After the Second World War, the government used fiscal policies to
FINE TUNE the economy. This fine tuning involved changes in taxation
1.- increase national income when unemployment increased, and
2.- reduce national income when the inflation rate increased
Keynesian analysis predicts that these changes in fiscal policy change
national income through the multiplier process. In the absence of
an 'inflationary' spiral trade-off will occur between unemployment and
inflation, and it will be 'manageable' by the government.
There is a situation when this sequence will breaks down: if workers
and unions can increase money wages in line with increases in prices,
and if firms can increase prices in line with increases in money wages
and other costs, the inflation rate increases more readily than it
Macroeconomic analysis predicts now:
a) increases in government expenditure, or reductions in taxation,
reduce unemployment and increase the inflation rate. THE EXTENT OF
EACH EFFECT DEPENDS ON THE EXISTING LEVEL OF UNEMPLOYMENT. If many
people are unemployed, the increase in national income is mainly
the result of increases in output and employment; if few are
unemployed, the fiscal policy increases the inflation rate.
b) reductions in government expenditure, or increases in taxation,
increase unemployment but have little effect on the inflation rate.
The inflation rate falls only if there is a very large reduction
in national income and an increase in unemployment, which reduce the
bargaining power of workers and the ability of firms to increase
(the outcome of the 'inflationary spiral' is that a 1 per cent increase
in the inflation rate may occur with a small reduction in unemployment
when the government deficit increases, but that a 1 per cent decrease
in the inflation rate can occur only with a large increase in
unemployment. If the government attempts to fine tune, and uses fiscal
policy to reduce unemployment, it is likely to increase the inflation
THE MONETARIST APPROACH
Monetarists see the above fluctuations of national income and its
effects on employment and prices from the point of view that changes
in national income are brought about when, and only when, the supply
of money changes. They argue:
a) attempt to reduce unemployment by increasing the government deficit
do not succeed if the government finances the additional deficit by
borrowing other than from banks. The additional supply of bonds
increases interest rates, and this reduces private investment, with
reduction in employment and output, creating inflationary pressures.
b) national income increases if the additional government deficit is
financed by increases in cash creation or borrowing from banks. This
monetary policy increases the supply of money, and this increases
national income...The main effect of the increase in the supply of
money is an increase in prices.
c) a reduced deficit has no effect unless the supply of money is
reduced. If the government reduces its borrowing, interest rates
fall and private investment increases...If the government reduces
its creation of cash, prices are lower than they would otherwise
have been...the inflation rate is reduced.
The most important monetarist conclusion, therefore, is that Keynesian
fiscal policies CAN DO NOTHING TO AFFECT THE LONG-TERM LEVEL OF
UNEMPLOYMENT...and that government policies affect the inflation rate
only if the supply of money is changed.
The above point of view have been the main "ideological" foundation for
U.K. economic policies since the 1980s. Because of this, dealing with
unemployment, the monetarists think that government policies can have
little effect on the long-term level of unemployment UNLESS THE
GOVERNMENT CAN EITHER:
A) reduce the 'imperfections' of the market that keep real wages above
equilibrium and so keep unemployment at the natural rate, or
B) reduce voluntary unemployment of those who do not want a job at
existing real wages
Both imply policies reducing the inflation rate, and, thus, targets
for changes in the supply of money. In order to do this, the government
must set its target for the increase in the supply of money equal to:
THE EXPECTED RATE OF ECONOMIC GROWTH plus THE DESIRED RATE OF INFLATION
If the policy is successful, unemployment returns rapidly to the
natural rate, state monetarists.
Keynesian disagree with the above saying that:
-persistent unemployment is possible above its natural rate, because
markets do not move towards equilibrium
- persistent unemployment will persist in the presence of an
inflationary spiral even with reductions in the government deficit,
with inflation decreasing very little.
Economic policies are impossible to fine tune, because there is a set
of complex trade-offs between the different economic variables. This
gives room to the existence of contradictory theories recommending
contradictory policies aiming at the same target. If we take Keynesian
and monetarist analysis, we can illustrate this as follows:
--if the government wants to reduce unemployment, Keynesian economists
recommedn an increase in government expenditure or a reduction in
taxation, because this would generate increased outputs and employment
through the multiplier process...There woul be some increase in the
inflation rate, but this would be a minor effect when unemployment is
The monetarist recommendation is that the government can reduce
unemployment only by using policies that reduce transfer payments or
The monetarist view of Keynesian policy is that it would lead only
to increased inflation in the long run.
The Keynesian view of the monetarist policy is that it would increase
unemployment in the long-run.
--if the government wants to reduce inflation, there is less
Keynesians recommend a reduction in government expenditure or an
increase in taxation, and monetarists are likely to emphasize similar
policies, because a reduction in the government deficit implies that
the government can reduce the supply of money without increasing
However, if there is an inflationary spiral (like in the 1970s),
these policies are likely to lead to increases in unmeployment.
Keynesians explain this increase in unemployment as the result of the
reduction in aggregate demand.
Monetarists would explain the increase in unemployment as the result
of increases in real wages above their equilibrium levels, and of the
imperfections that maintain the inflationary spiral and prevent
reductions in real wages toward their equilibrium levels.
Of course, Keynesians will expand demand (including higher wages),
and monetarists will reduce money supply (including lower wages).
In a nutshell, disagreement between Keynesians and monetarists on the
effects of policies designed to affect unemployment and inflation is
based on disagreement on the wasy in which firms respond to changes
in demands, and on whether demands can be ineffective. ( J. Craven, op.
Students should look at the behaviour of unemployment, inflation and
national income (rate of growth of GDP) in the industrialized countries
in the last twenty years or so. The data is available in the
following tables in my databank:
4.- UNITED STATES/Rates of inflation, unemployment and growth/1950-1996
5.- OECD.- Standardised unemployment rates. 1976-1995
6.- OECD.- Consumer Prices (percentage changes). 1970-1996
7.- OECD.- Real GDP (percentage changes). 1970-1998
Students must have in mind that changes in rates of inflation,
rates of unemployment, and rates of growth are closely linked
to social costs. Levels of poverty, patterns of distribution of
income and differentials in access to resources are all closely
related to employment, stable prices and sustained economic growth,etc.