Governments can use a combination of fiscal policy, monetary policy, exchange rate policy, supply side policies and direct controls to achieve a wide range of economic objectives.
Use of fiscal policy is important in helping to:
- provide public services (especially where there is market failure)
- redistribute income and wealth
- achieve environmental objectives
- promote growth and development
- regulate the business cycle (reduce severity of booms and recessions)
Fiscal policy is one of the main demand management tools. The automatic stabilisers, together with active or discretionary fiscal policy can stabilise the economy and help achieve the main macroeconomic objectives of growth, full employment, balance of payments equilibrium, stable prices and equitable distribution of income.
Since the global financial crisis of 2007/8 many countries have had to deal with the legacy of spiralling budget deficits and big increases in the national debt. This has created a conflict of objectives. Reducing government borrowing and the national debt has prolonged and deepened a severe recession and delayed recovery in many countries. But many economists (and governments) believe this has been necessary to protect the long run health of the economy. Unsustainable levels of borrowing and debt create a major burden for future generations and a lower long run growth rate. But the austerity policies of higher taxes, and cuts in spending on public services and welfare benefits particularly hurt poorer and vulnerable people, increasing inequality.
Some economists believe that austerity policies are wrong and that it is better to wait for economic recovery to automatically improve public finances. Higher GDP will increase tax revenues and reduce welfare benefits spending. This may be an option for a country that had tron public finances _before _the financial crisis started. For instance in the UK, the national debt was only 40% of GDP in 2007. But countries like Greece already had national debts above the 60% limit considered acceptable by the EU. Such countries would not have persuaded international bodies such as the IMF to provide credit unless they adopted austerity measures.
Exchange Rate Policies
Influencing the exchange rate can be an important tool for governments trying to improve their balance of payments, or make the economy more competitive. For much of the 19th and 20th centuries the major economies of the world operated a fixed exchange rate system. This collapsed in the 1970s. Some countries (mainly small ones) may seek to fix their exchange rate against a major currency such as the dollar or euro. Others adopt some variation of a floating or managed exchange rate.
Countries that have had major international indebtedness problems have usually been obliged to let their currencies depreciate as a condition of financial assistance from the IMF or other lender. This is controversial as it may worsen poverty by raising import prices. It also makes it cheaper for foreign multinationals to buy up assets in the countries concerned.
Exchange rate policy is also at the heart of the ‘trade war’ between the USA and China. The US government believes China deliberately keeps its exchange rate below its market equilibrium in order to make its exports super competitive. The Americans have resorted to raising tariffs to reduce imports from China (and other countries too). The trade war threatens to cause a global recession.
In the contemporary global economy, governments have limited control over the money supply. Financial markets are globalised, with banks able to lend and borrow from each other across national frontiers. It is therefore difficult for central banks to regulate the amount of credit (borrowing) in the domestic economy. We have also seen the growth of a ‘shadow banking system’, comprising other financial institutions. These include providers of ‘peer to peer lending’, and crowdfunding. These are alternative ways in which savings can be channeled to borrowers and are not regulated by central banks.
Central banks in many countries focus on controlling inflation through interest rate policy. The central bank may have an inflation target (often 2%), and has to raise or lower interest rates to try to keep inflation close to the target.
In recent years the risk in many countries has been deflation ___rather than inflation. This has resulted in the use of quantitative easing (QE) to prevent the so-called ‘__death spiral_’, where falling prices cause people to postpone spending in anticipation of further price cuts. This causes a fall in AD, resulting in further price cuts and falls in AD. The problem is that once interest rates are zero, the central bank cannot stimulate spending further by more cuts in interest rates
An unwanted side effect of QE is that it has caused a big rise in asset prices, especially houses, as much of the money ‘printed’ by the central bank has found its way into the housing market. This has worsened the housing crisis in some countries.
Supply Side Policies
Supply side policies can promote growth, development and international competitiveness. Improving access to education and healthcare raises productivity and can reduce inequality. In rich countries there may be an emphasis on expanding access to higher education. In poorer countries the major concern may be improving literacy.
These interventionist policies include minimum wage laws, price controls, and exchange controls or environmental regulations. Such controls may be targeted at specific objectives such as reducing poverty, correcting a current account deficit or preventing environmental degradation. These market interventions may produce benefits if set at an appropriate level and are properly enforced. A minimum wage that is too far above the free market level might just cause higher unemployment, for instance. Maximum prices for food or fuel might lead to a black market being established that defeats the object of the price control.
Macroeconomic Policies to Deal with External Shocks
In a globalised economy, countries are vulnerable to the impact of economic events in other parts of the world. These are called external shocks. Demand-side shocks will cause a decrease or increase in aggregate demand. A supply side shock will move the short-run aggregate supply curve up or down.
The global financial crisis was a demand side shock. In the immediate aftermath governments responded with a mixture of fiscal and monetary policy actions. There was a huge increase in discretionary fiscal spending. This included bank bailouts and subsidies to industries in particular peril, such as the car industry. There was a massive increase in the money supply through quantitative easing in an attempt to increase AD.
Big increases in commodity prices, especially oil can cause a supply side shock, especially for countries that are heavily dependent on imports of commodities. This shifts the short run AS curve upwards, leading to a fall in output and employment, together with a rise in the price level. A government can respond by boosting AD through fiscal and/or monetary policy, but this will result in an inflationary wage/price spiral. It may also lead to a worsening balance of payments. The alternative is to deflate the economy through tightening fiscal and/or monetary policy. This will squeeze inflation out of the economy, but may push it towards a recession.
Measures to Control Multinational Companies
In a globalised economy, multinational companies have increasing power, some of them have annual revenues that exceed the GDP of a small or middle sized country. Although multi-nationals can bring many economic benefits to a country through inward investment, technology transfer and the creation of jobs, they can also cause harm to the host country through environmental degradation, tax avoidance and repatriating profits. Many also make corrupt payments to host governments to win contracts or for the right to exploit mineral deposits.
Larger, more powerful developing countries are in a much stronger bargaining position to extract benefits from multinationals that want to do business there. China, for instance, with its vast domestic market is very attractive to multinationals. The Chinese government usually insists on joint ventures with local companies and technology transfer. Smaller, weaker countries, especially those with corrupt governments find it much harder to control the activities of multinationals.
Even large, rich countries find it hard to control some of the actions of these companies, who can switch production easily to other places. There is widespread concern about their ability to shift profits from high tax countries to low tax countries through transfer pricing. This occurs when a multinational has operations in a number of countries. A multinational chain of coffee shops may register its intellectual property (such as its logo) in a country with very low company taxes. It then charges a very high price for the use of this logo to its coffee shops in other countries where taxes are higher. The effect of this is that the company makes most of its profits in the low tax country. The problem of transfer pricing can only really be solved by countries moving towards common systems and rates of taxation, which greatly reduces the freedom of individual governments. The companies can play one country off against another, leading to a ‘race to the bottom’ with regard to taxes.
Problems for Policy Makers
Governments face a number of difficulties when trying to work out the best policies to achieve macroeconomic objectives:
Risks and uncertainties – The future course of events is always uncertain. For instance the UK does not yet know what the impact of Brexit will be on the economy. Political events can be very important in terms of their economic consequences.
_Inaccurate or incomplete information _– Governments have to make policy decisions on the basis of information which is not 100% accurate. For instance, GDP and balance of payments data are based on estimates and are subject to revision. This could lead to an inappropriate policy choice, if for instance the data suggested the economy was growing more slowly than was in fact the case. Also, economic data is already out of date by the time it has been collected.
External shocks – As discussed above, the domestic economy is to some extent influenced by events outside of a government’s control. These shocks are difficult to predict.
- Identify the main ways in which a government can protect the economy from an external shock.
- Your answer should include: demand side shock / supply side shock / fiscal policy / monetary policy / demand management / active fiscal policy