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Macroeconomic Policy

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Macroeconomic Policy

Have you ever thought about the differences between micro and macroeconomic policies? Well, these policies reflect what the subjects study, of course. Macroeconomics and microeconomics both study the behaviour of elements in an economy, but while microeconomics focuses on the choices that individual consumers and firms make, macroeconomics considers economic decision-making on a larger scale such as as a region, a country, or the entire world. This article will look at the definition of macroeconomic policy, so keep on reading to not miss out!

What are macroeconomics and macroeconomic policies?

The starting point of macroeconomics is the market behaviour and government policies theory developed by John Maynard Keynes in the 1930s. It basically examines the behaviour, performance, and decision-making of an economy as a whole.

Macroeconomics is the study of how a market behaves on a large scale such as a region, a country, or the entire globe.

The phenomena examined under the scope of macroeconomics include inflation, GDP, unemployment, and economic growth rate.

For example, macroeconomics might consider questions such as:

  • What drives inflation so high?
  • How to lower the unemployment rate?
  • Which tools can be used to boost economic activities?

Define macroeconomic policy

How can we define macroeconomic policy? Well, macroeconomic policies are used by the governments across the globe to try and achieve a balanced economic performance.

Macroeconomic policies are instruments that help policymakers regulate an economy. It consists of two main subsets: monetary policy and fiscal policy.

Monetary policy is the change of short-term interest rate and reserve requirement to influence economic activities. Fiscal policy, on the other hand, is the use of government spending and taxes to boost economic performance.

A government’s macroeconomic objectives

Governments have many objectives that they wish to achieve, which can be political, social, or economic. To accomplish these objectives, a government tends to set policies. This brings us to the term ‘policy objective’.

A policy objective is a goal that the policymakers of a government wish to achieve.

Some examples of policy objectives include:

Let's take a closer look at each of these objectives.

Economic growth

Economic growth is important as it contributes to a better living standard, a lower rate of unemployment, and higher tax revenues for the government.

To stimulate economic growth, a government can enact policy to increase aggregate demand (national expenditure) or aggregate supply (national output).

Economic growth is the increase in the value of national output/national expenditure. It is measured by the annual percentage change in the real GDP.

Aggregate demand is the sum of consumption, investment, government spending, and exports minus imports in an economy. A rise in any of these elements will lead to an increase in aggregate demand and thus national expenditure.

Aggregate supply is the total supply of goods and services within a country. An increase of aggregate supply due to increased capital, labour or technology progress can lead to higher national output.

Macroeconomic Policy Economic growth StudySmarterFig. 1 - Long-Run Economic Growth

As you can see in Figure 1, there is an increase in aggregate demand (AD) and long-run aggregate supply (LRAS), which causes the GDP to rise (Y1 to Y2) without increasing the price levels (P1).

Short-run vs long-run economic growth

A production possibility frontier (PPF) gives information on an economy's capacity to produce goods and services given existing resources. It also illustrates the choice of an economy to produce more capital goods or consumer goods. At any given point on the PPF curve, the production of more capital goods will result in fewer consumer goods produced and vice versa.

Suppose more resources are used to produce capital goods. Then, in the short run, the consumption will go down and the economy will suffer a temporary recession. If the investment is successful, then, in the long run, the productive capacity will increase, causing the economy to grow again.

The shift of the PPF curve to the right (or outward) shows this. In both the short and long run, the investment in capital goods comes at the expense of consumer goods. (See Figure 2).

Macroeconomic Policy production possibility frontier StudySmarterFig. 2 - Production Possibility Frontier

Full employment

In a perfect world, the unemployment rate would be zero since if you're not looking for work at the going wage rate, you will not be counted as 'unemployed'. Unemployment only takes into account people who are actively seeking jobs but aren't able to find one.

Full employment occurs when anyone looking for work at the going wage rate can get a job.

However, in practice, the economy never experiences zero unemployment. This is due to frictional unemployment - the situation where people delay getting a job in search of the best possible employment. The typical rate of frictional unemployment in an economy is around 2-3%.

Another way to define full employment is based on the full capacity of the economy.

Full employment and full capacity

Full employment will happen at output Y2, which is the maximum output of the economy. At this point, the economy cannot produce more goods and services since it has utilised all the resources available. Any increase in aggregate demand (AD) will only cause the price levels to rise without increasing real output. (See Figure 3).

Macroeconomic policy Full employment StudySmarterFig. 3 - Full Employment

Full employment and PPF curve

Any point on the PPF curve represents the maximum output an economy can produce. These are points A and B, as you can see in Figure 4. At point C, the economy is not operating at its full capacity, thus there is unemployment due to resources not utilised. Point D is only feasible if there is an increase in the productive potential of the economy enacted by the supply-side policies.

Macroeconomic policy Full employment PPF curve StudySmarterFig. 4 - Full Employment PPF Curve

To curb short-run unemployment, the government can increase aggregate demand by enacting fiscal policy (lowering tax and increasing public spending) or providing subsidies in certain industries to encourage firms to hire more people. To increase employment to D, a government can pursue long-term supply-side policies to increase the productive potential of the economy.

Price stability

Price levels are regulated by the supply and demand of goods and services within the economy. A significant surge or fall in the supply/demand can cause the price levels to fluctuate wildly and put the economy at risk. Thus, one of the government's main objectives is to maintain price stability.

Price stability occurs when the price levels in an economy don’t change drastically.

Since price levels determine inflation (the general increase in price levels), a government’s price stability methods often involve keeping inflation at a lower rate.

A high inflation rate can result in lower real wages and reduced purchasing power. This means that people are less willing to spend and as a result, production will fall and the economy might undergo a recession.

To fight inflation, the government often adopts a contractionary monetary policy by raising the interest rates. This causes the cost of borrowing money to increase and discourages people from borrowing money to spend on goods and services. As a result, consumption will drop and so will the price levels and inflation.

Balance of payments

A key aspect of the balance of payments is the current account. It consists of the value of exports and the value of imports. If the value of exports exceeds the value of imports there is a balance of payments surplus. Conversely, if the value of imports exceeds the value of exports, there is a balance of payments deficit.

The Balance of Payments (BOP) is a statement recording all the financial transactions made between the residents of a country and the rest of the world over a certain period, such as over a quarter of a year or a year.

A balance of payments deficit means that the government must borrow money from another source to pay for its imports. The money can come from another component of the balance of payments (like a BOP Financial account) or they can come from public spending. In the short run, a balance of payments deficit can stimulate economic growth.

However, in the long run, the country will struggle to pay off debts if it borrows. So the government needs to balance their policies in order to re-distribute their spending effectively.

Government macroeconomic policies

What tools can the government use to achieve its macroeconomic objectives? There are two main tools to help the government maintain a stable macroeconomic environment: fiscal policy and monetary policy.

Fiscal Policy

The main goals of fiscal policy include:

  • Providing public services.

  • Redistributing wealth and income.

  • Achieving environmental objectives.

  • Promoting economic growth.

  • Regulating the economic business cycle.

Fiscal policy is the government's use of taxes and public spending to achieve economic objectives.

There are two main types of fiscal policy: expansionary and contractionary.

  • Expansionary fiscal policy aims to increase aggregate demand and shift the AD curve outwards by reducing taxes and raising government spending. With lower taxes, individuals and households have more income at their disposal to spend on goods and services. This increases production and creates new job opportunities. The increased government spending will also boost economic activities which require workers to be hired, contributing to lower employment levels.

  • Contractionary fiscal policy tries to reduce aggregate demand and shift the AD curve inwards by increasing taxes and decreasing public spending. By increasing taxes the government can reduce the budget deficit, fight inflation, and resolve other balance of payment issues.

To learn more about expansionary and contractionary fiscal policy, check out our article on Types of fiscal policy.

Monetary Policy

Similar to fiscal policy, there are two types of monetary policy: expansionary and contractionary.

  • Expansionary monetary policy aims to boost economic activities by lowering interest rates or increasing the money supply. When the interest rates decrease, the cost of borrowing money is lower. More individuals and firms will be inclined to borrow more money and spend it. This improves the overall production and economic growth.

  • Contractionary monetary policy tries to reduce inflation and reduce the size of the budget deficit by increasing interest rates. With higher interest rates, the cost of borrowing money will increase. This discourages individuals and firms from borrowing from the central bank and spending it on goods and services.

Monetary policy is the central bank’s use of interest rates to influence macroeconomic factors such as inflation, consumption levels, economic growth, and liquidity.

To learn more about expansionary and contractionary monetary policy, check out our article on Monetary Policy.

Demand-side vs supply-side policies

Overall, the government can regulate the economy through demand-side and supply-side policies. The main difference is that demand-side policies are designed to affect the aggregate demand, whilst supply-side policies are designed to affect the aggregate supply and productivity.

Demand-side policies include:

  • Fiscal policies such as tax cuts and increased government spending.

  • Monetary policies such as reduced interest rates.

Supply-side policies include:

  • Interventionist supply-side policies such as government provision for private sector firms, training, education, and infrastructure. This policy emphasises the role of the government more than the role of the market.

  • Non-interventionist supply-side policies such as tax cuts, welfare benefit cuts, privatisation, marketisation, and deregulation. In this policy, the market plays a more important role than the government.

To learn more about supply-side policies, check out our article on Supply-side Policies.

The UK government's macroeconomic policy

Let’s see how the UK government applies what we've just learned to its macroeconomic policies.

Here are the four main macroeconomic objectives in the UK and the tools used to achieve them:

  1. Maintain low inflation: since 2009, the UK government has been working on keeping inflation at a low level. The current aim of the UK government is to maintain inflation levels at 2%.1 This is mainly done through monetary policies set by the bank of England, more specifically through monetary policy.

  2. Reduce budget deficit: the UK government aims to reduce the size of the budget deficit with both monetary and fiscal policy, especially the expansionary fiscal and monetary policy.

  3. Lower unemployment levels: the UK government utilises the instruments of fiscal and monetary policy to keep unemployment levels at a minimum. The current unemployment rate aim of the country is around 3%.

  4. Limit the balance of trade deficit: to accomplish this, the British government has developed a ‘12-point plan’ to help firms based in the UK increase their exports to 1 Trillion pounds.2 Some of the 12-point-plan strategies include an internationalisation fund that allows UK businesses, especially small and medium-sized businesses, to grow international sales. Along with this is the Export Support Service that helps UK firms to conduct more productive business in the European Union and North America.

International macroeconomic policy

When looking at macroeconomic policy in an international context, we may consider how the governments utilise macroeconomic instruments such as a fiscal policy to influence the exchange rate of international trade. Fiscal policy may affect the exchange rate through income changes, price changes, and interest rates.

In the UK, the government can influence the exchange rate by enacting an expansionary fiscal policy through tax cuts. With lower tax rates, imports increase and with it the demand for foreign currencies. This causes the value of the British pound to depreciate relative to those currencies, which makes prices of the imported goods more expensive, whilst exports get cheaper. This can improve the Balance of Payments.

The implementation of fiscal policy also has a general impact on the price levels.

When the UK government decides to spend more on promoting further economic activities such as consumption, the overall demand for goods and services will increase, resulting in higher price levels in the economy, or inflation. As the general price levels increase, imports will become more attractive. This will lead to a higher demand for foreign currency as foreign imported goods are cheaper. With more people purchasing foreign currencies, the value of the British pound will fall.

If the government increases its spending, it will have to get that money from somewhere, usually, from borrowing through selling bonds. Selling bonds to its citizens can increase interest rates, which boosts foreign currency inflows as more foreign investors are attracted to high-interest rates. This capital inflow from foreign investors will lead to an appreciation of the exchange rate.

Macroeconomic Policy - Key takeaways

  • Macroeconomic policies are instruments that help policymakers regulate an economy. It consists of two main subsets: monetary policy and fiscal policy.
  • A policy objective is a goal that the policymakers of a government wish to achieve.
  • The main macroeconomic policy goals are to achieve high levels of economic growth, have a sustainable balance of payments, low and stable inflation levels, and low unemployment.
  • The main macroeconomic tools a government uses include fiscal policy and monetary policy.
  • The UK has set the policy goals to keep inflation levels at 2% and unemployment levels at 3% as well as introduce a ‘12-point plan’ to promote exports from UK-based businesses to reduce the size of the budget deficit.
  • The government can influence the exchange rate of international trade through fiscal policies.

References

  1. Bank of England, Inflation and the 2% target, 2022, https://www.bankofengland.co.uk/monetary-policy/inflation
  2. Gov.uk, Made in the UK, Sold to the World: New strategy to boost exports to £1 trillion, https://www.gov.uk/government/news/made-in-the-uk-sold-to-the-world-new-strategy-to-boost-exports-to-1-trillion

Frequently Asked Questions about Macroeconomic Policy

  • Attain high levels of economic growth.
  • Maintain low levels of unemployment.
  • Achieve price stability.
  • Maintain a satisfactory balance of payments.

An example of macroeconomic policy would be expansionary fiscal policy, where the government attempts to boost aggregate demand through a reduction of taxes and increased government spending. 

Macroeconomics deals with concepts such as economic growth, inflation, the balance of payments, and unemployment. 

The tools of macroeconomic policy are fiscal policy, monetary policy, and supply-side policies. 

Macroeconomic policy is the instrument that helps policymakers regulate an economy.

Final Macroeconomic Policy Quiz

Question

Define supply-side policies.

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Supply-side policies are policies that aim to increase productivity and efficiency in the economy.

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What is the objective of supply-side policies?

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The objective of supply-side policies is to boost aggregate supply (AS) to result in increased output.

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How do supply-side policies impact the LRAS curve?


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They aim to shift the LRAS curve to the right.

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How do supply-side policies aim to reduce inflationary pressure?

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By removing market imperfections.

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What are the two types of supply-side policies?


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Free market and interventionist policies.

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What do free market supply-side policies aim to encourage?


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Competition, market reform, and incentives.

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What is privatisation?


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When the government sells its previously state-owned assets to private individuals or companies.

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Deregulation can:


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All the answers are correct.

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Name an example of trade liberalisation.

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Eliminating trade barriers like tariffs.

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How could decreasing corporate taxes impact aggregate supply?


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Decreasing corporate taxes can allow firms to retain more of their profit and invest it back into the economy, increasing the output of the economy and shifting LRAS to the right.

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What are interventionist supply-side policies?


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Interventionist supply-side policies are policies that require government intervention to boost the economy.

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Name two examples of interventionist policies.


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Investment in human capital and investment in new technology.

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Which of the following is NOT an interventionist policy?


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Reducing unemployment benefits.

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Name two advantages of supply-side policies.

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Sustainable growth and the ability to increase employment.

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Name two limitations of supply-side policies.


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Time lag and costs.

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What is aggregate supply?

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Aggregate supply (AS) is a measure of the total volume of goods and services produced in the economy over a given time period.

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Name two types of aggregate supply.

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Short-run and Long-run

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What remains constant in the movement along the aggregate supply curve?

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Other factors

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What changes in the shift of the aggregate supply curve?

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Other factors

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Which is the vertical aggregate supply curve?

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The long-run aggregate supply curve

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What is the Phillips curve relationship?

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The Phillips curve relationship is an inverse statistical relationship between the rate of inflation and the rate of unemployment.

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How is the Phillips curve drawn?

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The Phillips curve is drawn as a downward sloping smooth curve in the unemployment-inflation plane.

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How are the rate of inflation and the rate of unemployment related according to the Phillips curve relationship?


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The rate of inflation and the rate of unemployment are inversely related. As the rate of unemployment decreases, the rate of inflation increases and vice versa.

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How many inflation theories does the Phillips curve relationship explain?


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Two inflation theories.

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Which inflation theories does the Phillips curve relationship explain?


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The Phillips curve relationship explains demand-pull inflation and cost-push inflation theories.

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What is the cause of demand-push inflation?


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Excess demand in the economy.

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What is the cause of cost-pull inflation?


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Rising costs of production due to trade unions bargaining for higher wages on behalf of the employees.

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What is the long-run Phillips curve?


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The long-run Phillips curve is a vertical line crossing the short-run Phillips curve at a point where the short-run Phillips curve crosses the horizontal axis.

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At which point does the long-run Phillips curve cross the short-run Phillips curve?


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A point where the inflation rate is zero and unemployment rate is called the natural rate of unemployment.

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What is the natural rate of unemployment?

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The natural rate of unemployment is the long-run level of unemployment below which employment can’t increase without accelerating the rate of inflation.

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Why is the long-run Phillips curve vertical?


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The long-run Phillips curve is vertical at the natural rate of unemployment because the trade-off relationship between the rate of unemployment and the rate of inflation disappears in the long-run.

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What does the Phillips curve predict?


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The Phillips curve predicts a trade-off between the rate of unemployment and the rate of inflation.

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Why is the Phillips curve important?


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The Phillips curve is an important tool for the government policy of reducing the rate of unemployment in the economy whilst taking into account the rate of inflation.

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What are adaptive expectations?


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Adaptive expectations are a type of agents’ expectation formation about the future solely based on the values observed in the current and recent past periods.

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What are rational expectations?


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Rational expectations  are a type of agents’ expectation formation about the future based on all the observed data (current and past), whilst acting in their full self-interest.

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Can unemployment be reduced in the long run?


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Unemployment can be reduced in the long run if the government implements appropriate supply-side policies to reduce the natural rate of unemployment.

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What will be a result of a supply-side policy targeted at reducing the natural rate of unemployment in the long-run?


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Shift in the LRPC

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What will be a result of a demand-side policy targeted at reducing the natural rate of unemployment in the short-run?

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Movement along the SRPC

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What does the trade-off region on the Phillips curve represent?

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The trade-off region on the Phillips curve represents the government's options. There are several policy choices that a government can pursue when targetting a particular level of employment and inflation.

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Which expectation theory underpins the short-run Phillips curve?


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Theory of adaptive expectations

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Who suggested the other concept of LRAS?

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Keynesians.

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When does macroeconomic equilibrium occur?

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Macroeconomic equilibrium occurs when aggregate demand meets aggregate supply.

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How can we determine the output gap?

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The output gap is the difference between the actual output and the potential or trend output.

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What are the types of the output gap?

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  1. Positive output gap
  2. Negative output gap

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What is a positive output gap?

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A positive output gap occurs when the actual output is above the potential or trend output.

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What is a negative output gap?


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A negative output gap occurs when the actual output is below the potential or trend output.

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What is Gross Domestic Product?

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Gross domestic product (GDP) is the total economic activity (total output or total income) in a country's economy.

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There are ____ ways of measuring GDP.

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3

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What are the three ways of measuring GDP?

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Expenditure, income and output.

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Explain the output approach of measuring GDP.

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This approach includes adding up the total value of final goods and services produced in a country's economy over a period of time.


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