44 Macroeconomic conflicts and trade-offs

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Key points:

There are potential conflicts and trade-offs between macroeconomic objectives

There are potential conflicts and trade-offs between different economic policies

Using several policies at once can sometimes reduce or solve policy conflicts

Macroeconomic objectives:

The govt. has a number of macroeconomic objectives

These include:

High and sustainable E. growth

Low unemployment

Low steady inflation

Sustainable current account equilibrium on the balance of payments

Sustainable fiscal position

Environmental objectives

Wealth equality

A successful sustainable economy:

At point H, the economy is in both SR and LR equilibrium, AD = SR and LR AS

At 0Y, there may be structural unemployment but we will assume there is full employment

The UK economy is growing at 2.5% per year, the average for developed countries

Over time AD is increasing, shown by the shift in demand curve to the right

It is matched by SR and LR AS

At J is a new equilibrium, output is higher.

Mild inflation shown by price increase from 0P1 to 0P2 = caused by AD rising faster than SR and LR AS

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Conflicts between macroeconomic objectives

Macroeconomic objectives can conflict, especially when the economy is in disequilibrium

Equilibrium = the point at which supply equals demand for a product

Disequilibrium = where internal and/or external forces prevent market equilibrium from being reached or cause the market to fall out of balance, supply and demand are not equal

Inflation is too high:

Assume the rate of inflation is too high

1 way to reduce rate of inflation is to reduce AD e.g. cutting consumer or govt spending

Reducing AS is likely to lead to a recession and cyclical unemployment

A recession means rate of E. growth will be negative

Growth is too low:

Assume rate of e. growth is too low

1 way to increase it in the SR is raise AD = lower unemployment BUT increase in inflation, rise in imports due to higher incomes BUT this leads to deterioration in current account position

Another way is to raise growth of LR AS = BUT many methods will lead to a fall in wage rates

E.g. Reducing trade union power, making wages more flexible and easier for firms to sack workers = downward pressure on wages = inequalities on income

Supply side reforms mean looser environmental controls = conflicts with environmental objectives

Unemployment is too high:

If unemployment is too high a way of reducing is to raise AS = BUT might conflict with inflation and current account objectives

Another way is by supply-side reforms = BUT more jobs may lead to greater inequality if jobs are low paid

Also more jobs might jeopardise environmental objectives

The current account on the balance of payments is deeply in red:

If imports are greater than exports there would be difficulty for a country to finance the deficit

Cutting imports by reducing domestic consumption and investment = higher unemployment as a fall in AD will hit demand for domestically produced goods

The fiscal deficit is too high:

If govt is borrowing too much it may correct it by cutting its spending and raising taxes

BUT these will lead to higher unemployment and lower e. growth in the SR

If fiscal austerity is great enough, the economy will fall into deep recession

Fiscal austerity = decisions by a government to reduce the amount of government borrowing

Inequalities in income and wealth are too great:

Correcting inequalities could involve direct govt. intervention by redistributing income through taxes and govt. spending

Direct supply of better education = LR workers earning higher wages

Correcting inequalities may involve intervening in markets

E.g. Setting min. wages or giving trade unions more power

Reducing inequality = likely to have an effect and raise LR unemployment and increases LR growth

Failure to correct inequalities in education is likely to reduce LR growth

A failure to correct inequalities in education is likely to also reduce LR e. growth

The environmental situation is deteriorating:

If environmental indicators start to deteriorate, the govt. can introduce policies to reverse this

Investing in cleaner tech == low e.growth as investment resources are diverted into resources not contributing to e. growth

Tightening environmental regulation discourages investment == lower e. growth and higher unemployment

Investing in pollution reducing equipment = increase in investment and AD == raise growth and lowers unemployment

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Conflicts and trade-offs between economic policies:

Different economic policies have a n. of different effects

These effects can inflict with other places or lead to conflicts within macroeconomic objectives

Expansionary and contractionary fiscal and monetary policy:

Expansionary fiscal and monetary policy = increase in AD = SR e. growth and reduce unemployment

BUT it's likely to lead to higher inflation and deterioration on the current account on the balance of payments because an increase in D will be met by an increase in imports too

Contractionary monetary and fiscal policy = decrease in AD = low e. growth and higher unemployment

BUT leads to lower inflation and improvement on the current account on the balance of payments as a decrease in D means exports will rise as exchange rate is lowered

Changes in interest rates:

The govt. may use interest rates as part of monetary policy to increase AD, inflation and unemployment in the SR

BUT persistent high interest rates damage LR investment = reduces LR growth

Persistent high interest rates also raise value of currency against foreign countries so it is more difficult to export

Low interest rates benefit borrowers

High interest rates benefit savers and lenders

Quantitative easing (reduces interest rates to v. low levels) encourages those well off to bottom money and buy assts

Quantitative easing also leads to rise in price of assets due to higher D == quantitative easing increases wealth inequality

Supply side policies:

Supply side policies should increase productive potential of the economy = pushing LR AS curve to the right

In the LR supply side policies should reduce inflationary pressures

BUT those policies encouraging investment in physical capital leads to higher AD in short term = increases inflationary pressures in short term

Those policies designed to reduce trade union power make wages more flexible or reduce min wages = increase in income inequality as wages on the bottom of income distribution fall

Cutting unemployment benefits to encourage work = increase in income inequalities in the SR

Fiscal deficits:

Countries with deficits too high can attempt to reduce it by cutting govt. spending and raising taxes == higher unemployment and low growth in SR

The higher the fall in output and the higher the fall in tax revenue == the more ineffective the policy

Budgets to cut govt. spending and raise taxes likely widen inequalities un income and wealth

Environmental policies:

Environmental policies could lead to lower LR AS = lower E. growth

Because economic policies could increase the cost of production and reduce investment

BUT sometimes environmental policies can force inefficient firms to become more efficient e.g. recycling

Environmental policies can increase LR AS as there is less cost airing from the environmental market failure

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Resolving conflicts and trade-offs:

Trade-offs and conflicts can be resolved by using many economic policies at the same time

Cyclical unemployment:

Assume their is cyclical unemployment due to a recession

Expansionary fiscal and monetary policy will increase output and reduce unemployment BUT at the cost of higher inflation

IF supply side policies are also used, they could limit the increase in inflation by pushing SR and LR S curves to the right

IF supply side policies result in lower wages, the govt. could increase benefits or tax credits to prevent an increase in inequality of income

Demand pull inflation:

Assume inflation is too high and caused by excess demand in the economy, the economy is at full employment

The govt. could use contractionary fiscal and monetary policies to reduce AD

If the fall in D is not as high as needed, the economy won't fall back to a LR equilibrium level of output

BUT a fall in AD could lead to a ruse in structural unemployment, this is where supply-side policies can be used e.g. train workers

Excessive fiscal deficit:

Assume the govt. has an excessive fiscal deficit of 10% of GDP and needs to reduce this to 3% of GDP

Ideally, monetary value of deficit needs to fall but at the same time the level of GDP needs to rise = these 2 will reduce deficit as a % of GDP = the govt. could cut spending and raise taxes

BUT this is deflationary = lowering e. growth and raising unemployment

A way is to increase public spending on infrastructure whilst cutting other areas of govt. spending

Infrastructure will have a high multiplier effect and uses resources of the construction industry

Unemployed builders are put back to work almost immediately

AD will rise = Increase in LR AS as spending on infrastructure results in an increase in capital stock of the economy

Another way is to target tax rises on individuals and firms least likely to cut their spending as a result of tax rises

E.g. an increase in VAT, would affect the poor and leads to a fall in their spending, this is not a good policy

HOWEVER, introducing a higher rate of tax for top earners has less affect on AD as top earners have lower marginal propensity to consume

Targeting profit tax rises on companies with large cash reserves is unlikely to have much impact on AD

SOME multinational companies avoid paying taxes whatsoever as they use tax avoidance measures BUT they also hold large amts. of Chas due to distributing it to shareholders incurring in large amts. of tax

Increasing the amt. of profit tax they pay in UK would reduce fiscal deficit and is unlikely to have a negative effect on AD in the UK.