Government macroeconomic policy objectives and indicators of national economic performance
Government policy objectives
The main government macroeconomic policy objectives are:
- low unemployment
- low and stable inflation
- a satisfactory balance of payments position
- avoidance of excessive exchange rate fluctuations
- steady economic growth
To asses how successful a government is in achieving these objectives, economists examine a number of key indicators, which include:
- level of output
- economic growth
- inflation rate
- rate of unemployment
- balance of payments position
1. The level of output and economic growth
One of the main indicators of a nation’s economic performance it its level of output. Output can be measured in terms of Gross Domestic Product and Gross National Product. Therefore, GDP is a measure of the total output produced by factors of production based in the country. Three ways of calculating GDP are through the output, income and expenditure methods, which should all be equal according to the circular flow of income.
The output method: It measures the value of output produced by the industries. Important not to repeat, therefore the value added by each firm is counted.
The income method, etc
The expenditure method: Total expenditure plus addition to stocks are measured.
Nominal and real GDP
Nominal GDP is GDP measured in terms of the prices operating in the year in which the output is produced, not affected by inflation variations. Economists find this measure to be misleading in evaluating a country’s progress and therefore use the Real GDP: they do this by measuring GDP at constant prices, at the price operating in the selected base year. By doing this they remove the distorting effect of inflation on GDP.
The most common definition of economic growth is an increase in real GDP, which should allow citizens to enjoy a higher living standard.
Actual and potential growth
Increases in output can be referred to as the actual growth whereas increases in the productive capacity of a country can be called potential growth. A shift outwards in the PPC means that a country is capable of producing more goods (potential growth), while a movement outwards of the production point means that the economy is actually producing more output.
The measurement problems are all used in an attempt to gain an accurate measure of national output and its changes. However, a number of difficulties arise in achieving a completely accurate figure. The key difficulties are:
- The existence of a hidden economy, as some goods and services are deliberately not declared for two reasons –to avoid taxes, and because the activity itself is not legal. However, some idea of the hidden or informal economy can be gained by measuring any gap between expenditure and income methods.
- Non-marketed goods and services: Services which are produced and which are either not traded or which are exchanged without money changing hands go unrecorded.
- Government spending: In the Expenditure method, government spending on final goods is included, and therefore, as some of it goes onto public goods such as defence or fire services, which are not sold, a rather distorted view of what was happening is given to output.
A low and steady inflation provides a number of benefits for a country, in particular that of enabling businesses to forward with confidence in business. Country with a rapidly rising inflation rate in excess of that of its main trading partners will be likely to experience a number of problems, including difficulty in selling its goods at home and abroad.
One of the measures of inflation is the Retail Price Index, which is a measure of changes in the prices of consumer goods bought in the
There are various problems which should be noted when considering the accuracy of methods of measuring inflation. These problems include:
- Changes in quality: The price changes that are measured do not take quality into account
- Special offers, prices of second-hand goods, retail sales and car boot sales.
- Changes in the pattern of expenditure: Measure of RPI may lag behind the new and more modern products that consumers are now purchasing.
Causes of inflation
Demand-pull inflation: This type of inflation tends to be associated with a situation of boom in an economy, with a positive output gap. Demand for goods and services is rising faster than can be supplied from within, as a consequence, firms raise prices, with the security that they will sell everything they produce.
Cost-push inflation: This type of inflation tends to occur when the costs of production are increasing. When the cost of a raw good increases, this leads firms to raise their prices due to increased costs. This in turn triggers off wage demands as real income have fallen. Consequently, a wage-price spiral can come about, fuelling further increases in the RPI unless theses wage increases are matched by gains in productivity.
Monetary economists would disagree with the above theory. They argue that inflation is simply a monetary problem, caused by a change in the money supply in an economy, particularly where governments act irresponsibly in the way they print money.
Employment and unemployment
Countries measure both the numbers in employment and the numbers of those unemployed. If there is unemployment, output will be below its potential level, tax revenue will be lower and more state benefits will have to be paid out. Unemployment also leads to increases in the crime levels. The level of unemployment is different from the rate of unemployment. The level refers to the number of people who are unemployed whereas the rate of unemployment is the number of people in the labour force.
The exchange rate is the price of one currency in terms of another. It is the external value of a currency (the internal is the purchasing power of that currency within the country).
- In a floating exchange rate system, this price is determined by market forces of supply and demand.
- In a fixed system, the government intervenes to maintain the external value of the currency.
Changes in the exchange rate
In a floating system, an increase in the exchange rate is an appreciation, while a fall is a depreciation.
In a fixed system, if the rate at which the currency is fixed is increased this is a revaluation, if a lower rate is fixed, this is a devaluation.
At any moment in time there are many exchange rates. The value of one currency might go up against some and down against others.
Trade weighted index: measures the value of a currency against a basket of currencies which are weighted according to their importance in
Effective exchange rate: takes into account how much trade the country does with other countries (and weights movements accordingly). It also considers the extent to which the country competes with these other countries internationally.
Real exchange rate: takes inflation into account
The demand for a currency (pounds, for e.g.)
This refers to the desire to change foreign currencies into a country’s currency (pounds) in order to:
- spend on
goods and services UK
- save in
banks and other financial institutions Uk
- speculate on the currency in the hope that pound will become more valuable in the future
The demand for pounds will increase if:
goods and services are demanded more (quality improves, more tourism, foreign income increases, etc) UK UKinterest rates increases, because there will be a greater desire to save in the to ear higher rates of return UK
- People think its value will increase in the future so they buy it now
The elasticity of demand for pounds.
If the pound falls, the price of
The supply of pounds
This refers to the desire to change pounds into other currencies in order to:
- buy overseas goods and services and travel abroad
- save in overseas financial institutions
- speculate on a foreign currency in the hope that it will increase in value
The slope of the supply of pounds
If the demand for imports is elastic, then when their price rises in pounds, the total amount spent on them falls. This means the supply of pounds is upward sloping.
The supply of pounds will increase if:
- overseas interest rates increase so saving abroad becomes more attractive
- overseas goods are demanded more
- people think the pound will fall in the future so they sell now
Floating exchange rate system
The exchange rate is determined by demand and supply of the currency in the foreign exchange market. There is no government intervention.
Advantages of a floating exchange rate system
· The exchange rate automatically adjusts so that supply equals demand- this automatically eliminates balance of payments deficits or surpluses. If imports rise, for e.g. the supply of pounds increases, leading to a fall in their price. As the pound falls, exports become more competitive and imports become less competitive which should eliminate the deficit.
· There is no need for the central bank to keep foreign reserves.
· The government can pursue its own domestic policies, such as adjusting interest rates more easily.
· It prevents imported inflation- if one country has higher inflation, then under a fixed exchange rate system, another country will import those via higher import prices
· It may reduce speculation as it represents a risk
Disadvantages of a floating exchange system
· It causes instability which deters investment and trade (although business can avoid exchange rate movements by buying or selling currency at some date in the future in the forward currency markets to reduce the risk)
· It can lead to inflation- if a country has inflation which makes its goods uncompetitive, this will lead to a fall in demand for its currency and a fall in the exchange rate. This makes its goods competitive again but makes imports more expensive, which in the long run will lead to more inflation (cost-push)
· Speculation on future movements can lead to major changes in the rate.
· Governments are not forced to control their economies, e.g. they do not have to ensure that domestic inflation is in line with other countries to ensure their firms are competitive (because the country’s currency can float downwards)
The Government and the exchange rate
The government can influence the exchange rate by:
- buying and selling currency
- changing interest rates to influence capital inflows and outflows from the economy
To increase demand for the currency the Government can:
- buy the currency
- raise interest rates to attract investors
Fixed exchange rate
The government intervenes to maintain the exchange rate. If the price is about to fall, the Gov. increases demand by buying its own currency (using foreign currency reserves) or increasing interest rates. If the price is about to increase the Government sells its own currency (compra dolares
Advantages of fixed exchange rates
· Provides stability for firms and households- this encourages investment and trade.
· They act as a constraint on domestic inflation- if a country has a higher inflation than its trading partners, it will become uncompetitive (the currency will not depreciate to offset the inflation). Firms have to control costs to compete.
· In theory they prevent speculation, as there is no point because the value is fixed.
Disadvantages of fixed exchange rates
· A government must have sufficient reserves to intervene to maintain the price of it currency
· A country’s firms may be uncompetitive if the exchange rate is at too high a rate
· The Government must make intervention a priority. This may mean it undertakes policies which damage the domestic economy(e.g. to keep demand for pounds up, the Gov. might increase interest rates, which causes less demand within the country)
Exchange Rate Mechanism (ERM): Each country agrees to stabilize its currency against a central rate. The central bank must intervene to keep currency within this band.
Fiscal and monetary policy and exchange rate systems
Under a fixed exchange system, monetary policy becomes more difficult- any change in the interest rate will lead to inflows or outflows of currency and put pressure on the currency e.g. the Government tries to control the money supply, leading to higher interest rates which encourage inflows on the capital account. These inflows increase the money supply again.
Fiscal policy is effective, e.g. the Government tries to deflate the economy through higher taxes and less spending. This reduced aggregate demand and spending on imports. Lower demand will also reduce demand for money and interest rates. Lower interests rates lead to capital outflow which reinforces the contradictory fiscal policy.
In a floating system monetary policy is more powerful
For example, an expansion of the money supply will reduce interest rates, which will boost spending within the economy. It will also lead o outflows of currency of the capital account. This will lead to a fall in the value of the currency which will boost exports leading to a further increase in aggregate demand.
Alternatively, a tight (contractionary) monetary policy increases interest rates and reduces aggregate demand. Higher interest rates lead to capital inflows and an appreciation of the currency. This further reduces aggregate demand
Fiscal policy is less effective, e.g. contractionary fiscal policy reduces income and demand for money. This reduces interest rate and leads to an outflow on the capital account. This in turn leads to a depreciation of the exchange rate which raises aggregate demand.
The balance of payments
The balance of payments is a record of a country’s economic activities with other countries. It provides information of the country’s current and future international competiveness and net movements of income and assets. The first part of the balance of payments is divided into 2 main sections: the current account, the capital account. These are a record of all money entering and leaving the country over the period of a year.
The current account
This in turn has four main headings:
- Balance of payments (trade in goods and services): this covers the exports and imports of goods and services. It is the visible trade account.
- net factor income (such as interest, profits and dividends flowing in and out of the country)
- transfer payments (such as foreign aid and contribution to E.Union).
The capital account
The capital account records investments and financial flows. Movements in money capital by firms, households, and the Government, e.g. to invest in factories or in shares.
If, at a given exchange rate, there is excess demand for currency i.e. there is a greater demand for pounds than supply, the Government will have to sell pounds to keep the value constant. (“This is entered as a negative number under official financing in the balance of payments.”)
Outward investment will later generate income an will be shown as such in the current account, whilst inward investment is likely to result in certain income streams leaving the UK as debit items in the current account.
Balance of payments and floating exchange rates
In a free floating exchange rate system the balance of payments will automatically balance. The exchange rate automatically changes automatically until the supply of pounds equals the demand for pounds i.e. the number of pounds leaving the country equals the number entering. This does not mean each element of the BoP balances, current account can have deficit and capital account surplus, or viceversa.
Balance of payments and fixed exchange rates
If the exchange rate is fixed above the equilibrium rate (price) there will be excess supply of currency i.e. more money wants to leave the country than come into it. There is a balance of payments deficit.
If the price is fixed below the equilibrium rate (price) there will be excess demand for the currency à more money wants to come into the country than leave it. This means there is a balance of payments surplus.
Policies to reduce the balance of payments surplus
- reflate to boost demand and so increase imports
- remove import controls
- revalue the currency
Problems of a balance of payments surplus
- as one country’s surplus is another’s deficit, the country with the deficit may introduce protectionist measure
- a large and sudden surplus in the balance of payments of a country may lead to an increase in the exchange rate, which can make the country firms uncompetitive
- if the exchange rate is fixed, a balance of payments surplus will increase the domestic money supply (a surplus means there is excess demand for the currency so the Gov. must sell it). This increase in the money supply may lead o inflation
Current account deficit
Occurs when a country spends more on foreign goods and services than is being spent on that country’s goods and services. Money is leaving the country.
In the long run this could indicate problems with the competitiveness of a country’s industries. Usually more of a problem in a fixed exchange rate system, compared to a floating rate. In a floating system the external value of currency falls, making exports competitive again. In a fixed system the deficit may be offset by inflows on the capital account or the Government will have to intervene to buy up excess currency (this cannot continue indefinitely as the country will run out of foreign currency reserves).
Policies to reduce a balance of payments deficit
- Expenditure switching policies: These are attempts to make imports relatively expensive compared to exports by introducing:
- import controls such as tariffs
- bringing about a reduction in the exchange rate such as a devaluation
- Expenditure Reducing policies: The Government attempts to reduce spending throughout the economy (deflate the economy) This is likely to reduce the amount spent on imports. To reduce spending, the Government could increase taxation rates, cut its own spending or increase interest rates.