Government and the Macroeconomy

Macroeconomic aims

A government does not aim to maximise one thing. It balances six separate targets at once, and the weight it gives each one is itself a policy choice.

The six macroeconomic aims

Governments commonly set six macroeconomic aims. Economic growth means raising the economy’s total output over time. Full employment (or low unemployment) means as many people who want work as possible are able to find it. Stable prices (or low inflation) means the general price level rises slowly and predictably rather than erratically. Balance of payments stability means the country’s trade and financial dealings with the rest of the world stay broadly in balance over time, rather than building up an unsustainable deficit. Redistribution of income means narrowing excessive gaps between rich and poor. Environmental sustainability means pursuing these other aims without depleting resources or damaging the environment for future generations.

Why governments choose these aims

Each aim reflects a cost that a government wants to avoid: growth avoids stagnating living standards; low unemployment avoids wasted labour and the social cost of joblessness; low inflation protects the purchasing power of wages and savings; balance of payments stability avoids a currency crisis or unsustainable foreign borrowing; redistribution avoids the social and political strain of extreme inequality; sustainability avoids leaving a smaller productive base to future generations. Governments set criteria for each aim — for example a target inflation rate, or a target rate of growth — so that performance can be judged against a clear benchmark rather than general impressions.

Conflicts between aims

Three conflicts recur often enough in Cambridge questions that each is worth learning as its own short chain of reasoning.

Full employment versus stable prices

As an economy approaches full employment, firms competing for scarce remaining workers bid wages up, and households with more jobs and income spend more. If total demand grows faster than the economy’s ability to produce, the extra spending shows up mostly as higher prices rather than higher output — demand-pull inflation. A government that tries to hold inflation down by cooling demand risks slowing job creation, so the two aims pull in opposite directions near full employment.

Economic growth versus environmental sustainability

Producing more goods and services generally uses more energy and raw materials, and can generate more pollution and waste as a by-product. Pursuing faster growth can therefore erode the resource base and environmental quality that sustainability is meant to protect, particularly where growth relies on fossil fuels or resource extraction.

Full employment versus balance of payments stability

Higher employment means higher household income, and some of that extra income is spent on imported goods and services. If imports rise faster than exports, the current account moves toward deficit. A government pursuing full employment through higher total demand can therefore worsen its balance of payments position at the same time.

Worked example: spotting a conflict

A government cuts income tax to boost total demand and reduce unemployment. Identify one macroeconomic aim this is likely to put at risk, and explain why.

Step 1. The tax cut raises households’ disposable income, so consumption rises. Step 2. Rising consumption raises total demand; if the economy is already near full capacity, prices rise rather than output. Step 3. The aim put at risk is stable prices / low inflation — the same policy that helps employment can fuel demand-pull inflation. Full employment vs stable prices.

The government budget & spending

Before a government can change taxes or spending as policy, it first has to know whether it is already spending more than it raises.

Calculating the budget balance

The budget balance compares total government revenue, raised mainly through taxation, against total government spending in the same period.

Budget balance = Government revenue − Government spending — measured in deficit if negative · surplus if positive.

Worked example: budget deficit

A government’s revenue for the year is $420 billion and its spending is $460 billion. Find the size and type of its budget balance.

Step 1. Budget balance = Revenue − Spending = $420bn − $460bn. Step 2. Budget balance = −$40 billion. Step 3. The balance is negative, so the government is running a budget deficit, not a surplus. $40 billion deficit.

Why governments spend

Government spending is directed at several broad areas, each justified by a different reason: merit goods such as education and healthcare, which the free market tends to under-provide; public goods such as defence and street lighting, which the free market would not provide at all; social security and welfare payments, which support those on low incomes; and infrastructure, such as roads, power and water, which supports production across the whole economy. Each area of spending can serve more than one macroeconomic aim at once — spending on education, for example, supports both long-run growth and redistribution of income.

Taxation

A tax is classified twice over — by how it is collected, and separately by how its burden changes as income rises.

Why governments tax

Taxation raises the revenue a government needs to spend; discourages consumption of demerit goods, such as tobacco; reduces imports, where tariffs are used; redistributes income, where higher earners are taxed more heavily; influences total demand, since higher taxes reduce households’ disposable income; and can encourage environmental sustainability, where a tax is placed on polluting activity.

Classifying taxes by their rate

A progressive tax takes a rising proportion of income as income rises — most income tax systems work this way. A regressive tax takes a falling proportion of income as income rises; a fixed-amount tax on a good falls more heavily, as a share of income, on a low earner than a high earner. A proportional tax takes the same proportion of income at every income level.

Impact of taxation

Higher taxes reduce consumers’ disposable income and firms’ retained profit, which can slow consumption and investment; raise government revenue, which funds spending; and change behaviour — a tax on a demerit good is intended to reduce its consumption. The overall effect on the economy depends on which taxes change and by how much, which is why taxation forms one half of fiscal policy, covered next.

Fiscal policy

Fiscal policy works by changing total demand directly — the government is itself one of the four spenders that make up the economy’s total demand.

The components of total demand

Total (aggregate) demand is the sum of all planned spending in the economy in a period.

Total demand = C + I + G + (X − M) — measured in consumption · investment · govt. spending · net exports.

Fiscal policy measures

An expansionary (loosening) fiscal policy raises government spending (G) and/or cuts taxes, which raises households’ disposable income and firms’ retained profit and so raises consumption (C) and investment (I). A contractionary (tightening) fiscal policy does the reverse — cutting spending and/or raising taxes to reduce total demand.

Effects on macroeconomic aims

Expansionary fiscal policy tends to raise economic growth and lower unemployment, since firms respond to higher demand by producing more and hiring more workers. If the economy is already close to full capacity, the extra demand instead shows up mainly as demand-pull inflation. Expansionary fiscal policy funded by borrowing can also widen the budget deficit and, through higher imports, worsen the balance of payments — the full set of conflicts described on page 04 applies directly to fiscal policy.

Monetary policy

Where fiscal policy spends and taxes, monetary policy works through the cost and availability of money itself.

The three monetary policy measures

A change in the interest rate changes the cost of borrowing and the reward for saving: a lower rate makes loans cheaper, encouraging households to borrow and spend and firms to borrow and invest, raising total demand; a higher rate does the reverse. A change in the money supply works similarly: expanding it (for example through large-scale central bank asset purchases) increases the funds commercial banks have available to lend, encouraging borrowing and spending; shrinking it has the opposite effect. A change in the foreign exchange rate changes the price of exports and imports: a lower (depreciated) exchange rate makes exports cheaper abroad and imports more expensive at home, raising net exports and total demand; a higher (appreciated) rate does the reverse.

Effects on macroeconomic aims

An expansionary monetary policy — lower interest rates, a larger money supply, or a lower exchange rate — tends to raise economic growth and lower unemployment through the same total-demand mechanism as expansionary fiscal policy, and carries the same risk of demand-pull inflation if the economy is near full capacity. A lower exchange rate can improve the balance of payments by making exports more competitive, but a loosening of monetary policy generally pulls in the opposite direction on the price-stability aim.

Supply-side policy

Fiscal and monetary policy both work on total demand. Supply-side policy works on the economy’s capacity to produce in the first place.

Supply-side policy measures

Common measures include: education and training, raising the skill and productivity of the workforce; infrastructure spending on transport, energy and communications, lowering firms’ costs; labour market reforms that make hiring and job-matching more flexible; lower direct taxes, strengthening the incentive to work, save and invest; deregulation, removing rules that raise firms’ costs or block new entrants; improved incentives to work and invest, such as tapering welfare withdrawal as earnings rise; and privatisation, transferring state-owned firms to the private sector in the hope that competition and the profit motive raise efficiency.

Effects on macroeconomic aims

By raising the economy’s productive capacity rather than only its demand, supply-side policy can support economic growth and lower structural unemployment without the same inflationary pressure as demand-side policy, and improved productivity can strengthen export competitiveness and the balance of payments. The cost is time: education, infrastructure and retraining typically take years, not months, to raise output, so supply-side policy is a poor tool for a recession that needs an immediate response.

Economic growth

Growth can come from using existing resources more fully, or from expanding what the economy is capable of producing in the first place — and examiners expect the two to be told apart.

Measuring growth

Economic growth is measured by the percentage change in real Gross Domestic Product (GDP) — the value of all goods and services produced in an economy in a year, adjusted for inflation — from one period to the next.

Worked example: growth rate

Real GDP was $540 billion last year and $560 billion this year. Calculate the rate of economic growth.

Step 1. Change in real GDP = $560bn − $540bn = $20bn. Step 2. Growth rate = (change ÷ original) × 100 = (20 ÷ 540) × 100. Step 3. This economy grew more slowly than one starting from a larger base would for the same dollar increase — the percentage, not the dollar figure, is what is compared between countries. ≈ 3.7% growth.

Two different causes of growth

A rise in total demand — through higher C, I, G or net exports — lets an economy put already-idle resources to work, raising output in the short run without expanding what the economy could produce at full capacity. A rise in the quantity of resources (more workers, more land, more capital) or the quality of resources (better education, better technology, better infrastructure) raises the economy’s underlying productive potential, shown as the rising long-run trend in Fig 4.0 — this is the type of growth that can continue without triggering inflation.

Recession & policies for growth

A recession is a fall in output, and like growth, it can be traced to either side of the economy.

Causes of recession

A demand-side recession follows a fall in C, I, G or net exports — for example, higher interest rates discouraging borrowing, falling consumer confidence, or a slowdown in a major export market. A supply-side recession follows a fall in the quantity or quality of resources available — a natural disaster destroying capital and land, conflict disrupting production, or a skills shortage reducing productivity.

Consequences and policies for growth

A recession raises unemployment and lowers incomes, firms’ revenue and government tax receipts, while raising government spending on unemployment benefits. Policies to promote growth therefore mirror its two possible causes: demand-side policy (expansionary fiscal or monetary policy, §4.2–4.3) is more effective when there is spare capacity to put back to work, while supply-side policy (§4.4) is the more durable tool for raising the economy’s underlying trend rate of growth.

Measuring unemployment

Before unemployment can be treated as a policy problem, it first has to be measured — and the measurement used is the Labour Force Survey.

The unemployment rate

The labour force is everyone in work plus everyone unemployed and seeking work; it excludes those not seeking work at all. The unemployment rate expresses the unemployed as a share of the labour force.

Unemployment rate = (Number unemployed ÷ Labour force) × 100 — measured in %.

Worked example: unemployment rate

An economy’s labour force is 25 million. 23.5 million people are in employment. Calculate the unemployment rate.

Step 1. Number unemployed = Labour force − number employed = 25m − 23.5m = 1.5 million. Step 2. Unemployment rate = (1.5 ÷ 25) × 100. Step 3. A rate this low would normally be read as close to full employment, with the remaining unemployment largely frictional rather than cyclical. 6% unemployment.

The Labour Force Survey

Most countries measure unemployment through a Labour Force Survey, a regular sample survey of households following International Labour Organisation guidelines: a person counts as unemployed if they have not worked in the survey period, are available to start work within two weeks, and have actively looked for work in the last four weeks. Its advantages are that it includes people not claiming unemployment benefits and allows comparison between countries using a common definition; its main disadvantage is sampling error, since it surveys only a sample of households rather than counting everyone.

Types & consequences of unemployment

Not all unemployment has the same cause, so not all of it calls for the same cure.

Four types of unemployment

Frictional unemployment is short-term unemployment among workers between jobs, who have left one job voluntarily and are searching for the next. Structural unemployment arises when the structure of the economy shifts — for example, a declining industry contracts while a growing one needs different skills — leaving workers unemployed unless they retrain. Cyclical unemployment (also called demand-deficient unemployment) is caused directly by a fall in total demand during a recession: as the demand for labour is a derived demand, falling demand for goods and services reduces the demand for the workers who produce them. Seasonal unemployment occurs when demand for labour in a particular occupation ends with the season, such as ski instructors in summer.

Consequences of unemployment

For the individual, unemployment means lost income and can damage confidence, health and relationships. For firms, it means lower sales revenue, since unemployed consumers spend less. For the government, it means higher spending on benefits and lower tax revenue, since income, sales and corporation tax receipts all fall. For the economy as a whole, persistent unemployment risks lost skills among the long-term unemployed, and the social costs of poverty and inequality that follow.

Policies to reduce unemployment

The policy mix a government chooses should follow directly from which type of unemployment it is trying to treat.

Demand-side policies

Expansionary fiscal policy (lower taxes, higher government spending) and expansionary monetary policy (lower interest rates) both raise total demand. Since the demand for labour is derived from the demand for goods and services, higher total demand raises the demand for labour and lowers cyclical unemployment. These policies are most effective when the economy has spare capacity; they do little for frictional, structural or seasonal unemployment, since those are not caused by a shortfall in demand.

Supply-side policies

Education and retraining programmes help structurally unemployed workers move into growing industries; improved information about job vacancies and support with relocation can shorten frictional unemployment; and labour market reforms can make it easier for firms to hire. These policies work more slowly than demand-side policy, but address the underlying mismatch rather than only the shortfall in demand.

Effectiveness

Demand-side policy acts quickly but mainly treats cyclical unemployment, and risks demand-pull inflation if applied once the economy is already near full employment. Supply-side policy is slower and more expensive to implement, but is the more durable solution for frictional and structural unemployment, since it addresses skills and job-matching directly rather than simply adding to total demand.

Inflation & deflation

Inflation is measured against a basket of goods, and like growth and unemployment, it has two distinct causes that call for different remedies.

Measuring inflation

Most countries measure inflation using the Consumer Prices Index (CPI), which tracks the cost of a representative basket of goods and services bought by a typical household over time. The inflation rate is the percentage change in the CPI from one period to the next.

Worked example: inflation rate from the CPI

The CPI was 210 in January last year and 216.3 in January this year. Calculate the rate of inflation over the year.

Step 1. Change in the index = 216.3 − 210 = 6.3. Step 2. Inflation rate = (change ÷ original) × 100 = (6.3 ÷ 210) × 100. Step 3. Most governments target an inflation rate of around 2%, so a rate this high would likely prompt a contractionary policy response. 3% inflation.

Two causes of inflation

Demand-pull inflation occurs when total demand rises faster than the economy’s ability to produce, so the extra spending bids prices up rather than raising output — this is the same mechanism behind the full-employment/stable-prices conflict on page 04. Cost-push inflation occurs when the costs of production rise — for example, higher wages, raw material or energy prices — and firms pass these higher costs on as higher prices, independent of how much is being demanded.

Consequences & policies for inflation

Inflation redistributes real wealth even when nobody’s nominal income changes — which is why it hits different groups so differently.

Consequences of inflation

For savers, inflation erodes the real value of money held in savings, unless the interest rate paid exceeds the inflation rate. For borrowers, unexpected inflation can be an advantage, since loans are repaid in money that is worth less in real terms than when it was borrowed — the mirror image of the cost to lenders, who are repaid in that same devalued money. More broadly, consumers see their purchasing power fall, workers may demand higher wages to compensate, firms face rising costs and uncertainty that can discourage investment, and exporters can lose competitiveness if domestic prices rise faster than those of trading partners.

Policies to control inflation

Demand-pull inflation calls for contractionary demand-side policy: higher interest rates or a smaller money supply (monetary policy), or higher taxes and lower government spending (fiscal policy), each cooling total demand. Cost-push inflation is harder to treat with demand-side policy alone, since the problem originates in costs rather than demand; supply-side policy that lowers firms’ costs — for example, improved infrastructure or productivity-raising training — can ease cost-push pressure over time, though not as quickly as a change in interest rates addresses demand-pull inflation.