Macroeconomic – Government Policies in Reducing Inflation and Unemployment

MACRO-ECONOMIC| Discuss the role of government policy in reducing unemployment and inflation. In your discussion make use of the diagrammatic representation of the macroeconomy developed in lectures in Term 2| Unemployment and inflation are factors that have negative effects on the performance of the economy as a whole. Therefore, policies to achieve low and stable price in? ation, a high and stable level of employment are big macroeconomics issues of our time.

This essay focuses on discussing the role of government policy on reducing unemployment and inflation in relation to Keynesian and Monetarist approaches, including examples of impacts of expansionary fiscal and monetary policies on New Zealand economy. Fiscal policy is a demand side policy used by the government to help direct the economy by altering the level of expenditure and/or rate of taxes. Expansionary fiscal policy refers to increase government expenditure or a lower tax in order to inject into or withdraw from the circular flow of money respectively, this results a raise in aggregate demand and thus national income.

On the other hand, deflationary (contractionary) fiscal policy is used by the government as a tool to control the pressures of inflation by reducing expenditure or increasing taxes, which thus reduce aggregate demand and preventing excessive inflation. Fiscal policy is used by Keynesians to increase/decrease public expenditure and cut/increase taxes during a recession/boom. When they decrease taxes and increase public expenditure, it encourages people to spend, thus raise consumer expenditure.

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This contributes the reduced unemployment (due to the increased public spending creating more demand and more jobs to increase the supply of goods and services), but an increased inflation (due to the increased spending and wage demands). On the other hand, when Keynesians use fiscal policy to increase taxes and reduce public spending, they cause higher levels of unemployment and lower levels of inflation. This deflationary fiscal policy is usually used during a boom period.

Figure 1 : Keynesians traditionally emphasises the role of fiscal policy as the key tool of economic management and views monetary policy simply as a backup to fiscal policy. They would argue that direct interest rate changes could be used to control aggregate demand. Whereas, Monetarism does not believe that government should intervene by managing the level of aggregate demand, they rather prefer the use of monetary policy to achieve a long-run view of price stability.

Monetary policy involves manipulating the interest rate charged by the central bank for lending money to the banking system in an economy, which influences greatly a vast number of macroeconomic variables. In the UK, the government set the policy targets, but the Bank of England and the Monetary Policy Committee (MPC) are given authority and freedom to set interest rates, which is formally once every month. Contractionary monetary policy may be used to reduce price in? ation by increasing the interest rate.

Because banks have to pay more to borrow from the central bank they will increase the interest rates they charge their own customers for loans to recover the increased cost. Banks will also raise interest rates to encourage people to save more in bank deposit accounts so they can reduce their own borrowing from the central bank. As interest rates rise, consumers may save more and borrow less to spend on goods and services. Firms may also reduce the amount of money they borrow to invest in new equipment.

A reduction in capital investment by ? rms will reduce their ability to increase output in the future. Higher interest rates may therefore reduce economic growth and increase unemployment. Expansionary monetary policy may be used during an economic recession to boost demand and employment by cutting interest rates. However, increasing demand can push up prices and may increase consumer spending on imported goods and services. In some cases, lower interest rates may be ineffective in boosting demand.

Therefore in March 2009 the Bank's Monetary Policy Committee announced that in addition to setting Bank Rate, it would start to inject money directly into the economy by purchasing assets such as government bonds or other securities - often known as quantitative easing. This means that the instrument of monetary policy shifts towards the quantity of money provided rather than the price at which the Bank lends or borrows money (Bank of England website) Fiscal and Monetary policies come with their own set of advantages and disadvantages.

The most likely argument against its implementation is the substantial lag that accompanies both these policies, for example the time from when the policy has been implemented till the time its impact is felt in the economy. The following section will indicate how the expansionary Fiscal and Monetary Policies impact price stability (inflation rate: 1-3%) and full employment objectives of New Zealand. Both monetary and fiscal policies have a significant impact on inflation.

An Expansionary Monetary policy results in lowering the interest rate (OCR) as previously mentioned that in turn increases the quantity of goods and services demanded at any given price level, hence contributing to shifting aggregate demand to the right. In a climate of recession, where money supply is limited, Inflation is not a significant factor in the decision making of the NZ government or the RBNZ Governor; on the contrary increase in inflation is rather seen as positive sign of growth during recession as it indicates an increase in demand.

This is further evident by the recessionary climate resulting in a drop in inflation as quoted "Inflation is set to plunge over the next year, starting with a 0. 5% fall expected for Q4 2008. Retail spending is expected to be down significantly for November, as weak core sales were amplified by lower spending on fuel (petrol prices fell by 16% in the month). Car sales could see a technical bounce after plunging by 14. 5% in October, but they will remain at very depressed levels. " The above quote underlies the fact that in the current environment an increase in inflation will be seen as a positive sign.

The expansionary fiscal and monetary policy pursued presently fare well in a recessionary climate, however if they are pursued over a long period of time, then they could lead to creating an inflationary gap. An inflationary gap occurs when aggregate demand exceeds supply. This can thus result in "Overheating the economy" i. e. Actual GDP exceeds Potential GDP and leads to a significant Trade deficit and unemployment as well. Figure 2: Inflationary Gap The aim of full employment objective is to keep the level of unemployment in check. The increase of unemployment is accompanied with a recession, due to primarily a drop in aggregate demand.

The impact of the expansionary fiscal and monetary policy as mentioned above results in increasing aggregate demand thus essentially resulting in people demanding and consuming more, which results in people buying more goods and services that consequently results in reducing unemployment as demand exceeds supply as opposed to the current scenario, and thus resulting in more people being employed to meet demand. The impact of this expansionary policy may lead to an increase in inflation; however in the short run there exists a trade-off relationship between unemployment and inflation as can be seen in the figure below.

Figure 3: Philips Curve describing Inverse Relation of Inflation and Unemployment In conclusion, fiscal and monetary policies are tools used by most national governments to control the economy, including the term of reducing inflation and unemployment. Inflation and unemployment are factors that could give negative impact on the economy if either of them is high. Government needs to predict precisely the situation of the economy to issue the right fiscal or monetary policies. It usually takes at least several months for policies to take fully effect. References: Lipsey ; Chrystal, 2011. Economics. 12th ed.

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