The Most Common Macroeconomic Objectives of Governments - Coursework Example

?Macroeconomic objectives are objectives set by the government in order to better the economy and increase growth. This is also the method with whichthey intervene in free markets because free markets usually do not bring about a long-run equilibrium. In an ideal situation where free markets could bring about equilibrium perfectly in the long-run there would be no need for governments to set objectives, but in reality this is not the case. (Mankiw, 2000) The most common macroeconomic objectives of governments are the following: Controlling inflation Keeping the unemployment rate low Equilibrium in the current account and thus keeping the balance of payments positive. Increased growth of the economy through a rise in GDP. Equitable distribution of income Protecting their economy’s environment The order of importance of the objectives varies for different economies due to their different governments and institutions. Most economies would consider inflation as the most important objective where as other economies with a more socialist approach would focus on equitable distribution of income and reducing unemployment. One of the conflicts governments might face is the tradeoff between inflation, employment and GDP growth. When unemployment tends to fall in an economic boost and a strong GDP, the economy may face high inflation rates, both demand-pull and cost-push and the power of money to buy also called the purchasing power parity falls. This may actually have counter effect than what it should have, that is, positive, due to a rise in GDP. Any policies that control inflation may also lower the employment rate, thus achieving one objective, but conflicting the other. The economy may also experience deflation, which is negative inflation and which again lowers the employment rate, and raises the unemployment rate. Then there is the conflict between the objectives of economic growth and environmental protection. In an effort to shift the production frontier outwards, governments may have to forgo the fact that they are putting pressure on the already scarce resources, and actually may lower the living standards which are objectives in almost all economies and may also deplete the scarce resources in their effort to grow. They may also threaten the sustainability of the environment for generations to come. The third conflict is between economic growth and inflation. Rising demand for goods and services may not only increase the price of output but also the price on inputs such as raw materials, energy prices and wages. And so this would lead to increasing inflation, and in some cases hyperinflation. China and India in 2010 faced this kind of accelerating inflation. Higher rates of inflation are also detrimental to economic growth since they affect profits, businesses and jobs. Interest rates curb the high rates of inflation and high interest rates actually appreciate the currency and have a negative impact on exports since they become expensive on the global market and their demand falls thus having a negative impact on the growth rate of the economy. The last conflict is between balance of payments and economic growth. A higher GDP is achieved when consumer demand is usually high. And this usually leads to a worsening of the balance of trade especially if the marginal propensity to trade is high. (Mankiw, 2000) Lastly, the betterment of the balance of payment situation can actually boost growth in the economy, especially by exports, but may cause another objective to fail, that is, it might lead to demand pull inflation in certain cases. (Mankiw, 2000) Governments also have direct control over two of the economy’s macroeconomic policies: fiscal and monetary policies. Fiscal policies deal with the economy’s budget and are managed by the Legislative and Executive branches of the government. Monetary policies are conducted by the central bank of the economy or the Federal Reserve. Fiscal policy is a means by which government controls the economy by adjusting its spending and the tax rate. When the economy is in a recession, the government pumps money into the economy also called ‘pump priming’ by spending more on goods and services such as building schools or railways, roads etc. The government not only fulfils the needs of the people without them having to pay for it but also creates jobs, thus reducing unemployment levels. At the same time, governments can lower the tax rates and this will lead to people having more disposable income and thus an overall increase in consumer demand. However if there is too much money in the economy, this can reduce the worth of money and push up the price level, leading to inflation. An expansionary or loose fiscal policy also leads to a worsening of the government’s budget deficit. An expansionary fiscal policy can be shown diagrammatically as follows: And if the economy needs to be curbed, then the government pulls out money from the circulation in the economy by reducing government spending and by increasing taxes so that consumer’s demand goes down. The government continues to fine tune the economy by these two instruments of spending and taxation in order to keep it at equilibrium and the inflation rate at a moderate of about two percent. However, a fiscal policy only affects a certain group of people and not the masses; a tax rise or cut will only influence one class and the government spending on certain services may create employment for one class of skilled workers rather than decrease unemployment in the whole economy. Also, if the investment rate is very sensitive to the interest rate of the economy, then a fiscal policy will be highly ineffective. Ideally the economy’s position should be such that the government’s expenditure is equal to the tax receipts it receives, or G=T. (Friedman & Heller, 1969) Another instrument is the monetary policy which basically serves to control the economy’s money supply. It is contrasted with fiscal policies and targets the interest rate of the economy. There are two types of monetary policies: contractionary and expansionary. And as their names suggest, contractionary policies aim at shrinking the overall money supply in the economy, or allow it to grow at a very slow rate, and expansionary monetary policies allow the money supply to increase in the economy. Expansionary policies also aim at lowering the interest rate of the economy in order to fight off inflation and unemployment in the economy and increase demand and spending. Contractionary policies aim at controlling inflation and consequentially the price level. An expansionary monetary policy is shown below: T The two policies go hand in hand in an economy. They stabilize the economy by working in different ways and targeting different aspects of the economy, but the most important objective is to increase growth. The Central bank which sets the interest rate and decides the money supply is an independent identity in an economy and thus can influence the economy faster. However, implementation of its policies may take time to occur where as government’s can adjust their spending and tax rates faster. In a recession some economist argue, monetary policy can be effective in increasing demand and output and in this case fiscal policy would be more effective in doing so. However fiscal policy has its own setbacks, such as crowding out. This means that when an expansionary fiscal policy is applied in an economy in recession, it may lead to higher interest rates, and if investment is sensitive to interest rates, then this will lead to investments pulled out of the economy, and this is called crowding out. Thus the expansionary policy would actually have an opposite effect than the one it intended to have. (Friedman & Heller, 1969) A monetary policy also works indirectly on the economy and the Federal Reserve is a better place to stabilize the economy for the short run. However, despite the flaws in the two policies, there are certain scenarios in which fiscal policy works best and those in which monetary policy works better and these two are both employed by the government to stabilize the economy. Bibliography Friedman, M. & Heller, W. W., 1969. Monetary vs. fiscal policy. New York: Norton. Mankiw, N. G., 2000. Macroeconomics. New York: Worth Publishers. Read More