Government and Economy
2.1.3 Relationships between objectives and policies
Government and the economy
Trade-offs between macroeconomic objectives
Trade-off: The choice between two objectives, where for one objective to increase the other must decrease.
Ideally, a government wants strong economic growth, low inflation, low unemployment, no large current account deficit and a protected environment, all at the same time. But fiscal, monetary and supply-side policies all have good and bad effects, so a policy that helps one objective can harm another. This means a government often has to accept a trade-off, e.g. putting up with higher inflation in return for lower unemployment. Which policies it uses depends on the state of the economy at the time.
Unemployment and inflation
How policies to cut inflation can raise unemployment:
- Monetary policy: higher interest rates put people off borrowing and raise mortgage payments, so households spend less. Firms face higher interest costs and invest less. As demand falls, firms cut output and lay off staff. If the exchange rate rises too, exports become harder to sell, and exporters may also cut jobs.
- Fiscal policy: higher taxes leave consumers less to spend, so firms produce less and need fewer workers. Cuts in government spending mean teachers, nurses and other public sector staff may lose their jobs, and public services get worse.
The trade-off works the other way too: boosting demand to create jobs can push prices up. Many economists believe a government must accept higher unemployment if it wants lower inflation, and that unemployment will rise even more if it tries to cut inflation very quickly.
Supply-side policies may avoid this trade-off, because they bring inflation down by raising output, not by cutting demand. However, they are slow to work, so governments usually use them alongside other policies.
Example: Inflation in a country reaches 8%. The central bank raises interest rates from 4% to 7%. Over the next two years, inflation falls to 3%, but car sales slump, a furniture maker closes a factory and unemployment rises from 5% to 7%.
Economic growth and inflation
To boost growth, a government can use expansionary fiscal policy (lower taxes or more government spending) or expansionary monetary policy (lower interest rates or asset purchasing). Both raise aggregate demand, so firms produce more and the economy grows.
Why faster growth can lead to inflation:
- Overheating: if policy is too expansionary, demand rises faster than firms can increase output. Firms respond by raising prices instead of producing more, which causes demand-pull inflation.
- Limited capacity: inflation is more likely when firms are already working close to full capacity, or when resources such as skilled labour are hard to find.
- Lower living standards: if prices rise quickly, people’s money buys less, so some of the gain from growth is lost.
Supply-side policies can help growth without adding to inflation, because they allow firms to produce more. Extra government training schemes, for instance, can increase the supply of skilled workers, so firms can meet rising demand without putting up prices.
Example: A government cuts income tax and the central bank cuts interest rates, and growth jumps to 8%. Building firms are already at full capacity and cannot find enough skilled electricians, so wages and building costs rise quickly, and inflation climbs from 2% to 6%.
Economic growth and environmental protection
Why growth can damage the environment:
- More production: power stations, chemical plants and factories produce more output and more emissions.
- More vehicles: as incomes rise, more people buy cars, which adds to emissions and traffic congestion.
- Loss of habitats: forests, swamps and other natural areas are cleared for farming, housing, roads and industry, leaving less space for wildlife.
- Using up resources: growth uses more scarce resources, including ones that cannot be replaced.
How policy creates the trade-off:
- Protecting the environment can slow growth: taxes, regulation, fines and pollution permits add to firms’ costs and can restrict business development. Some firms may close, causing job losses.
- Growth may be seen as worth the damage: in developing countries, many people would not want to stop growth that reduces poverty, raises life expectancy and improves living standards, even if the environment suffers.
- The trade-off may be limited: growth creates wealth that can pay for cleaner technology, e.g. people can afford electric cars instead of cheaper petrol cars. Not every industry pollutes, and many countries now recycle and reuse more.
Example: A government plans a new coal-fired power station that would create 2 000 jobs and supply cheap energy to factories. Opening it would help growth but raise air pollution. If the government refuses permission, the air stays cleaner, but the 2 000 jobs and the cheap energy are lost.
Inflation and the current account
How high inflation harms the current account:
- Exports: as prices rise, exports become more expensive, so foreign buyers want fewer of them.
- Imports: consumers switch from expensive home-produced goods to relatively cheaper imports.
How the choice of policy affects the trade-off:
- Monetary policy: higher interest rates can increase demand for the country’s currency and push up the exchange rate. Exports then cost more abroad and imports cost less at home, so the current account may get worse for a time, even as inflation falls. How much worse depends on the price elasticity of demand for exports and imports.
- Fiscal policy: cutting government spending or raising taxes reduces demand without directly affecting the exchange rate. Export and import prices stay fairly stable, so the current account is not made worse.
- Supply-side policies: these hardly affect the exchange rate. They can help firms produce more at lower prices, which boosts exports and helps the current account.
Example: To bring inflation down from 7%, a central bank raises interest rates from 3% to 6%. Demand for the currency rises, and its value goes up by 10%. Exporters lose orders, shoppers buy more imported goods, and the current account deficit widens from $4bn to $6bn.
