objectives of government macroeconomic policy
What are the major objectives of macroeconomic policy?
The four major objectives are (i) full employment, (ii) price stability, (iii) a high, but sustainable, rate of economic growth, and (iv) keeping the Balance of Payments in equilibrium. First, we will look at the way in which these objectives are measured. Secondly, we shall discuss the relative importance of these objectives. Thirdly, we shall see how successful recent governments have been in achieving these goals. Finally, we will look at the difficulties that governments have in trying to achieve all the objectives at once.
How are these objectives measured?
1. Full employment, or low unemployment
The claimant count is the older, more out of date measure of unemployment used in the UK. Those counted must be out of work, physically able to work and looking for it, and actually claiming benefit.
For a more realistic count, and for international comparisons, the ILO (International Labour Organisation) measure is used. This includes the young unemployed who are not always eligible to claim, married women who can't claim if their husband is earning enough, and those who claim sickness and invalidity benefits. Many only slightly inconvenienced unemployed workers are paid these benefits rather than swell the unemployment numbers.
Note the issue of active and inactive members of the population of working age. Only those who are active are included in the working population, which is defined as all those who are employed or registered unemployed. But some of the inactive are in this category by choice, for instance, students and those who retire early.
2. Price stability
Inflation is usually defined as a sustained rise in the general level of prices. Technically, it is measured as the annual rate of change of the Retail Price Index (RPI), often referred to as the headline rate of inflation. For prices to be stable, therefore, the inflation rate should be zero. Generally, governments are happy if they can keep the inflation rate down to a low percentage. For an explanation of how the RPI is formulated, see later. The UK government prefers to target the underlying rate of inflation, or the annual percentage change in the RPIX. This is the same as the RPI except housing costs are removed in the shape of mortgage interest payments. It makes sense for the government to use this measure because the weapon they use to control inflation, interest rates, directly affects the RPI itself.
Other less popular measures include the RPIY, which takes RPIX a stage further by also taking out the effects of indirect taxation (e.g. VAT), and the consumer price index, which is often used when making international comparisons.
3. High (but sustainable) economic growth
Economic growth tends to be measured in terms of the rate of change of real GDP (Gross Domestic Product). When the word real accompanies any statistic, it means that the effects of inflation have been removed. More on this later! GDP is a measure of the annual output (or income, or expenditure) of an economy. Much more on this later! Sometimes GNP (Gross National Product) is used, which is very similar to GDP. Growth figures are published quarterly, both in terms of the change quarter on quarter and as annual percentage changes.
4. Balance of Payments in equilibrium
Briefly, this records all flows of money into, and out of, the UK. It is split into two: the Current Account and the Capital and Financial Accounts (formerly the capital account).
Probably the most important is the Current Account because this records how well the UK is doing in terms of its exports of goods and services relative to its imports. If the UK is to 'pay its way' in the world over the long term, then it needs to keep earning enough foreign currency from its exports to pay for its imports. If this is not the case, the account will be in deficit. Japan has the largest surplus in the world. Although a surplus sounds better then a deficit, both can be bad. Japan's surplus forces other countries in the world to have deficits. In fact, while Japan's surplus is the biggest in the world, the USA's deficit is the biggest in the world. This is not a coincidence! The UK tends to be in deficit, although the Current Account was in surplus a couple of years ago, mainly due our strength in the service sector.
Which objective is the most important?
In the 1960s, the Balance of Payments was considered very important. A deficit was considered highly embarrassing in the days when many still believed, mistakenly, that Britain was a world power. The long term sustainability of a deficit was a big problem in the days before global free movements of capital, and so sterling would be affected which was unacceptable within the 'Bretton Woods' fixed exchange rate system. Nowadays, with a floating pound and huge global capital flows, many economists believe that balance of payments deficits or surpluses simply do not matter. This was reflected in the fact that nobody seemed to bat an eyelid at the continual deficits of the 90s.
Full employment was considered very important after the Second World War. It was probably the number one objective of the socialist government of the late 40s and continued to be at the front of politicians' minds for the next three decades. Unemployment exploded under Thatcher in the 80s, but it was seen as an inevitable consequence of the steps taken to make industry more efficient. It was painful at the time but the lower levels of unemployment today are due, in part, to the structural changes made in the 80s. The fact that de-industrialisation was occurring throughout the western world also made higher unemployment feel inevitable, and so this objective became much less important than it had been.
Growth and low inflation have always been important. Without growth peoples' standard of living will not increase, and if inflation is too high then the value of money falls negating any increase in living standards. Nowadays these are definitely the two most important objectives of UK macroeconomic policy. The Chancellor is always going on about 'sustainable growth', meaning growth without inflation. Probably the biggest piece of economic news each month is the decision taken by the Monetary Policy Committee (MPC) over interest rates, their sole objective being the 2.5% target for the growth in RPIX (plus or minus 1%). It is probably worth noting at this stage: do not confuse objectives of macroeconomic policy with the instruments used to achieve these aims. Low inflation is an objective, the rate of interest is an instrument used to control inflation, not an objective in itself.
If one had to pick the most important objective today, it would have to be inflation. Although it should be growth, all government's efforts are devoted to the control of inflation. If this goal is missed, it is felt, then the goal of higher growth will not be attainable either.
How successful have recent governments been in achieving these goals?
On growth, there tends to be periods of strength (booms) followed by periods of weak or even negative growth (recessions). This is known as the economic cycle. All governments have a goal of eliminating this cycle. In other words, they want continual, reasonable growth that never ignites inflation, perhaps 2½% - 3% per annum. Recent governments have moved closer to this 'Goldilocks' scenario. Notice that the growth rate has been over 2% without getting out of hand for six years. Following the bust/boom/bust of the early 80s/late 80s/early 90s, this is quite an achievement.
Inflation has also been remarkably subdued by historical standards. Following the horribly inflationary 70s (peaked at 25%) and the near 10% figure ten years ago, RPIX has been growing at 3% pa or less for six years.
The goal of full employment has effectively been consigned to the history books. Unemployment reached one million in the 80s for the first time since the 30s, and then proceeded to reach 3 million (or 4 million, depending on the definition) within three years. Having said that, 'full employment' does not mean that everyone has a job. Even in the 'full employment' era of the 50s there were still 300,000 unemployed. Today's figure is falling towards one million which some consider to be fairly close to full employment given the increased flexibility of the UK labour market (much more on that in the upper sixth).
It is a sad fact of economic life that UK consumers prefer imported goods to those made in Britain. The extent of the current account deficit mainly depends, therefore, on how well we export our services. Unfortunately, services are not quite as exportable as goods, so the UK is always fighting a losing battle. Hopefully the changes in technology, and our abilities to exploit them, will allow us to increase our exports of services by enough in the future to allow for the deficit in goods. Some economists believe that there is no problem, because in a world of perfectly mobile capital, the UK no longer relies entirely on their own pool of foreign reserves to pay for its imports. Nowadays, if you want something from abroad but you do not have the foreign currency, then just buy it on the Foreign Exchange Markets!
Are there any conflicts between these objectives?
Unfortunately, it is virtually impossible for a government to score in all these goals at once. We shall begin with the three major conflicts and then look at two more that are linked to microeconomics.
1. Healthy growth and low inflation
If an economy grows too quickly, especially if it is due to excessive consumer spending as it tends to be in the UK, then demand will outstrip supply and prices will rise. Equally, the steps taken to keep inflation low, like relatively high interest rates, can often restrict growth via reduced consumer spending and investment. It is difficult to achieve both aims.
The 'trend' rate of growth is seen as the rate of growth an economy can grow without igniting inflation. Most economists believe that this is around 2½% to 3% at the moment. For the last six years the UK has managed to walk this tightrope without slipping into either higher inflation or recession. Perhaps the economic cycle has been eliminated, but most economists find this difficult to believe.
2. Healthy growth and a Balance of Payments equilibrium
When an economy is growing quickly, consumer spending tends to be high. As we have already noted, British consumers tend to buy goods from abroad in preference to home produced goods. Hence, import growth picks up relative to exports, assuming an average growth rate in the countries that buy British goods, leading to a worsening trade deficit. In the old days when the Balance of Payments was seen as possibly the most important macroeconomic objective, either the exchange rate would give, or import controls were used (not possible these days with the World Trade Organisation), or the government had to deflate the economy, implying a low rate of growth.
3. Low unemployment (or full employment) and low inflation
This is the classic conflict in economic theory. In fact, an economist called Phillips constructed a curve using empirical data to show that this conflict existed (although this did not mean that the relationship would hold forever).
These two variables have, in theory, an inverse relationship. If a government tries to reduce unemployment through reflationary measures, such as lower interest rates or increased public spending, then the resulting reduction in unemployment will push wages, and then prices, higher. On the other hand, when the government tries to control high inflation with higher interest rates and reduced spending, the resulting reduced consumer spending and lower investment will result in job losses. Norman Lamont, Conservative Chancellor of the early 90s, famously said ' unemployment is the price worth paying for lower inflation.'
4. Healthy growth and the environment
Of course, not everyone would consider the environment a 'minor' objective, but unfortunately governments have not quite woken up to the problem yet. Although there have been summits at which controls on various types of pollution were agreed, the US amongst others seem to find it difficult to keep their promises!
Quite simply, the faster the rate of growth, the higher the level of production, and so the level of pollution from factories, cars, etc. rises. Also, vital rain forests tend to disappear, not just because we consume the wood; new factories, towns and housing are built on the resulting land.
5. Healthy growth and equality
Equality was an objective of socialist governments and so is now obsolete in the world of 'new' Labour. Although it is true to say that forcing equality throughout a country can lead to inefficiencies (where are the incentives?), those on the left wing feel that it is an admirable and important aim. Ronald Reagan used to talk about the 'trickle down' effect. As an economy grows the poor may well get a smaller slice of the cake, but the cake gets so large that the poor man still gets more cake. Of course this does overlook the fact that the rich man is getting a larger slice of a bigger cake!
The developed world has grown hugely since the Second World War, but even with the creation of welfare states it is the wealth creators that have benefited hugely whilst those at the bottom of the pile have seen their standard of living just plod along. The communist Soviet Union kept the more equality conscious socialist model going right into the 80s, but its inefficiencies meant that the rate of growth was much slower. Now even they have embraced capitalism, although the transition has not exactly been smooth!
Working with Our Partners
Boston House | 214 High Street | Boston Spa | West Yorkshire | LS23 6AD | Tel +44 0844 800 0085 | Fax +44 01937 529236
Company Registration Number: 04489574 | VAT Reg No 816865400
tutor2u is proud to sponsor TABS Cricket Club and Collingham JFC as part of its programme of investment in local junior sport