Government macroeconomic objectives and policies

Most of the governments round the world have four main objectives. These are

Keep inflation under control
Maintain a low level of unemployment
Achieve a high level of growth rate
Maintain a healthy balance of payments.

Government Economic Policies

Government influences the economy through its economic policies. These are

Fiscal Policy

It is related with taxes and government spending. This policy is there to control inflation and demand in the economy. Usually government collects money in the form of taxes and spends money through its development expenditure such as building roads, bridge, defense, transports etc. Government constantly monitors the aggregate demand in the economy. Inflation rate gives the correct measure of the aggregate demand in the economy.

When the aggregate demand in the economy is high, prices rise, this shows that the economy is spending too much. In this case, the government will lower is expenditure budget and cut back on investment spending, such as on road construction and hospital equipment. On the other hand the government might also increase the taxes, which would take spending power out of the economy by leaving consumers and businesses with less income to spend.

In the opposite scenario, when the economy is heading for a recession and unemployment is rising, the government might increase its expenditure plans. There might be a reduction in taxes so as to leave consumers and businesses with higher disposable incomes.

Monetary Policy

Monetary Policy is related with a change in interest rates by the government or the Central bank. When the forecast for inflation is that it will rise above the targets set by government, then the Central Bank will raise its base rate and all other banks and lending institutions will follow. It is usually done when the economy is at the boom stage of the business cycle.

A higher interest rate will result in…business will not be able to expand as they have to pay more interest to the bank for their loans and they have less profit left. Businesses that are planning to take loan for expanding may postpone their decisions and wait for a cut in interest rates. Consumers demand will also fall as they will not be getting cheap loans to pay for the buying new houses and luxury items.

If inflation is low and is forecasted to remain below governments targets, then the Central Bank may decide to reduce interest rates.

Supply side policies

It includes all those policies which aim at improving the efficient supply of goods and services. These might include:

Privatization
Imparting training and improving the education level of the workforce resulting in higher skills.
Increase competition in all industries by removing entry barriers, thus leading to more efficiency.

Factors causing a change in components of AD

Change in consumption

A change in consumption is caused by any of the following factors

Changes in income: Income increases consumption increases and vice versa.
Changes in interest rates: Fall in interest rates will make borrowing money cheaper. Consumers will now be tempted to take loans and purchase goods and services. Consumption will rise. On the other hand if the interest rates increase, borrowing becomes expensive. Consumers will be more tempted to save rather than spend. Consumption will fall.
Changes in wealth: A rise in house prices or the value of stock and shares makes a person feel wealthy. Consumers feel more confident and tend to spend more .
Changes in consumer confidence: Higher consumer confidence is likely lead to increased consumption.

Change in Investment

Interest Rates: If interest rates are low firms will find it easy to borrow funds for investment. Investment increase when interest rates fall.
Changes in National Income: If the national income increases, firms will have to invest further to increase output (induced investment).
Technological change: Regular changes in technological front demand firms to invest in order to keep up with the changes and remain competitive.
Business Confidence: The economic environment in an economy is a major factor in determining the investment level. When an economy is showing signs of healthy growth, firms will have positive expectation and will invest in expanding their facilities and to meet higher demands in the future. During troughs firms will be more conservative in their investments and thus AD will be affected.

Change in Government Expenditure

Government Expenditure depends on

Macroeconomics objectives: If the government is considering increasing employment then it might increase its spending on public projects.
Condition of the economy: During phases of slow economic growth, government is more likely to increase its spending in order to stimulate the economy.

Changes in net exports

Exports are domestic goods bought by foreigners. Exports will rise when

Foreigners income rise
Exchange rate of the exporting country is falling.
The economy follows a more liberal trade policy i.e. free trade increase
Inflation rate in the economy is comparatively lower than its trading partners.

Imports are the goods bought from foreign country. Imports will rise when

Domestic income rises. This is because people will increase their consumption and thus imports will increase.
Exchange rate of the importing country increase. Now it becomes cheaper for the country to purchase from outside as their currency is stronger than their trading partners.
If the economy is following a liberal trade policy i.e. free trade increases.
Inflation rate is high

Possible conflict between macroeconomic objectives

It is rare for a country to achieve all of its main objectives at the same time
Frequently conflicts appear between the different aims and as a result, choices might have to be made about which objectives are to be given greatest priority.
This will vary from one country to another since the needs of different nations will differ according to their stage of economic development.

Here are some possible policy conflicts:

Inflation and unemployment: Falling unemployment might create demand-pull and cost-push inflationary pressures leading to a fall in the value of money
Economic growth and environmental sustainability: Rapid economic growth and development frequently puts extra pressure on scarce environmental resources threatening the sustainability of living standards in the future
Economic growth and inflation – an overheating economy may suffer accelerating inflation which then has negative effects on trade performance, business profits and jobs
Economic growth and the balance of payments: Strong GDP growth fuelled by high levels of consumer demand for goods and services might lead to a worsening of the trade balance. This is particularly true when an economy has a high marginal propensity to import.

Unemployment and inflation – the Phillips Curve concept

Falling unemployment might cause rising inflation and a fall in inflation might only be possible by allowing unemployment to rise
If a Government wanted to reduce the unemployment rate, it could increase aggregate demand but, although this might temporarily increase employment, it could also have inflationary implications in labour and the product markets.

The key to understanding this trade-off is to consider the possible inflationary effects in both labour and product markets from an increase in national income, output and employment.

The labour market: As unemployment falls, labour shortages may occur where skilled labour is in short supply. This puts pressure on wages to increase and prices may rise as businesses pass on these costs to their customers.
Other factor markets: Cost-push inflation can also come from rising demand for commodities such as oil, copper and processed manufactured goods such as steel, concrete and glass. When an economy is booming, so does the derived demand for components and raw materials.

Product markets: Rising demand can lead to suppliers raising prices to increase their profit margins. The risk of rising prices is greatest when demand is out-stripping supply-capacity leading to excess demand (i.e. a positive output gap.)