Conflict: Macroeconomic Policy - A-Level Economics
Conflicts between Macroeconomic Policies
The use of one macroeconomic policy can outweigh the effect of another, and therefore conflict arises between different policies:
Fiscal and Supply-‐Side Policies
Expansionary fiscal policy involves increased government spending, and much of this spending is directed to the health and education sectors. Also, there might be reduced taxation, which is also a supply-‐side policy. Therefore, fiscal and supply-‐side policies are effectively working in tandem. Moreover, the supply-‐side effects shifts out the LRAS curve, which partly cancels out any inflationary pressures the rise in economic growth might bring.
However, the effect of fiscal policy on AD tends to be more immediate than the effect on LRAS, so expansionary policy is likely to have inflationary effects in the short run but deflationary effects in the long term due to the impact on LRAS.
In contrast, contractionary fiscal policy involves slowing economic growth in order to lower/ control the inflation rate. However, the impact of reduced spending and increased tax might lead to the LRAS shifting inwards, which can lead to a rise in price-‐ the opposite of what is intended.
Fiscal and Monetary Policies
Fiscal policy has implications for the interest rate and therefore circumstances arise in which fiscal and monetary policy may come into conflict. This means that a way must be found of coordinating fiscal and monetary policy. However, this is often difficult to do because the MPC is intended to act independently of the government in conducting monetary policy in order to meet the inflation target.
Expansionary fiscal policy causes growth but has inflationary pressures. Contractionary fiscal policy slows growth but has deflationary pressures.
Monetary and Supply-‐Side Policies
A tight monetary policy means that interest rates are high to control inflation. However, the high interest rates increase costs for firms if they are borrowing money, which may lead to an inward shift in LRAS and hence potential inflationary effects.
However, these two policies can also work in tandem. Higher interest rates should lead to higher exchange rates (due to the influx of ‘hot money’), which will reduce the cost of imported raw materials, reducing production costs. This effect is especially strong because UK firms import most of their raw materials. The fall in production costs will shift the LRAS out. Therefore, a tight monetary policy can improve the supply side. Although, higher exchange rates are not guaranteed and they harm firms trying to export.
In contrast, loose monetary policy reduces borrowing costs for firms but increases the cost of imported raw materials (assuming that exchange rates fall). However, firms will also gain international competitiveness.
In summary:
Tight Monetary Policy (high interest rates)
- Increase in borrowing costs for firms = LRAS falls
- Higher ER 🡪 Reduction in imported raw material costs = LRAS rises
- Higher ER 🡪 Reduction in international competitiveness = LRAS falls Loose Monetary Policy (low interest rates)
- Decrease in borrowing costs for firms = LRAS rises
- Lower ER 🡪 Increase in imported raw material costs = LRAS falls
- Lower ER 🡪 Increase in international competitiveness = LRAS rises
Monetary Policy and Distribution of Income
A rise in interest rates worsens income distribution because it hurts borrowers (e.g. people paying off a mortgage), and helps savers. Savers are more likely to be the wealthier people in the economy, who have a higher marginal propensity to save (MPS), so they will benefit. Therefore, there is a re-‐distribution of income from borrowers to savers, and from the middle class to the wealthy-‐ income distribution worsens.
Monetary Policy and Current Account
This point is based on the same theory as described in the conflict between Monetary Policy and supply side policies. A higher interest rate leads to a higher exchange rate, which leads to cheaper imports and dearer exports, which leads to a worsening of the current account of the Balance of Payments.
General Evaluation for Conflicts
- Difficulty in measuring the conflicts and effects-‐ unreliable or missing information
- Prioritization of certain policies
- Short Run vs. Long Run
- Many of the conflicts depend on the position of the economy on the LRAS curve (is the LRAS elastic or inelastic?)
- Time Lags
- Magnitude
Macroeconomic policy refers to the actions taken by governments or central banks to influence the performance of the economy as a whole. This includes policies related to inflation, unemployment, and economic growth.
Examples of macroeconomic policies include monetary policy (e.g. setting interest rates), fiscal policy (e.g. government spending and taxation), and exchange rate policy (e.g. manipulating the value of a currency relative to other currencies).
There can be conflicts between different macroeconomic policy objectives. For example, policies that promote economic growth may lead to higher inflation, while policies that aim to control inflation may limit economic growth. There can also be conflicts between short-term and long-term objectives, as well as conflicts between the interests of different groups in society.
The Phillips curve is a graph that shows the relationship between unemployment and inflation. It suggests that when unemployment is low, inflation tends to be high, and vice versa. This relationship can be used to inform macroeconomic policy decisions.
The natural rate of unemployment is the rate of unemployment that exists when the economy is in equilibrium and inflation is stable. It is also known as the non-accelerating inflation rate of unemployment (NAIRU).
Policymakers use macroeconomic models to simulate the effects of different policy options on the economy. These models take into account factors such as interest rates, government spending, and inflation to help policymakers make informed decisions.
The central bank plays a key role in macroeconomic policy, particularly in the area of monetary policy. It is responsible for setting interest rates and controlling the money supply in the economy to achieve specific policy objectives, such as controlling inflation.
International factors, such as exchange rates and trade policies, can have a significant impact on macroeconomic policy decisions. For example, changes in exchange rates can affect the competitiveness of a country’s exports, while trade policies can affect the flow of goods and services across borders.
There are a number of potential limitations of macroeconomic policy, including the fact that policies may not be implemented effectively or may have unintended consequences. Additionally, some factors that affect the economy, such as technological changes, may be outside the control of policymakers.
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