From the previous lessons, we learned that governments can act in the economy to achieve optimum performance of the economy. In doing so, governments usually have four main economic aims:
1. to achieve low and stable inflation (price stability)
2. to maintain a high level of employment and low level of unemployment
3. to encourage economic growth
4. to encourage trade and secure a favourable balance of payments
There are other objectives which are increasingly becoming important for governments:
5. Equitable distribution of income and wealth – a fair share of the national ‘cake’, more equitable than would be in the case of an entirely free market.
6. Increasing Productivity – more output per unit of labour per hour. Also, since labor is but one of many inputs to produce goods and services, it could also be described as output per unit of factor inputs per hour.
7. Thermal Equilibrium – equilibrium in the Balance of payments without the use of artificial constraints. That is, exports roughly equal to imports over the long run.
Which of the above economic objectives are more important?
All of the above are objectives of governments (especially 1 to 4). However, governments at times may give more priority to a particular objective than the others. Let us look at historical preferences.
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. Therefore growth is usually the most important objective of the government.
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. Deficits would reduce the demand for the £ relative to other currencies, and so the value of the £ against other currencies would fall (see the topic called ‘Exchange rates’ for much more detail). This 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 (on current account) 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.
Conflicts between macroeconomic objectives
It is quite often the case that the government will face conflicts between its various economic objectives. This is highlighted by the Phillips’ curve.
In this case, lower unemployment can be achieved at the cost of higher inflation and vice versa. Keynesian Aggregate Demand / Aggregate Supply analysis shares the same conclusion as the Phillips’ curve relationship. In the Keynesian analysis, unemployment is reduced as the economy moves towards the full employment level of national income, but this is achieved at the price of higher inflation – as seen in the Keynesian AD/AS diagram.
In general, the four government macroeconomic objectives can be split into two pairs of two that go together. Low unemployment and a good rate of economic growth tend to go together, but tend to conflict with the economic objectives of low inflation and a Balance of Payments balance. This is because the first two objectives would benefit from a high level of demand in the economy because this will mean more demand for workers to produce these goods that are demanded.
The economy will also tend to grow more rapidly in times of buoyant demand, because domestic producers will expand production to meet the high level of demand. (This is assuming of course that the economy has not reached full capacity). A high level of demand, however, may lead to increasing inflation and a current account deficit on the Balance of Payments. A high level of demand may lead to rising inflation, especially if supply cannot increase to satisfy demand due to supply constraints. Imports may also flood in to satisfy demand if it cannot be satisfied by domestic supply.
Low inflation and balance on the Balance of Payments will tend to be best achieved in times of lower levels of Aggregate Demand. When demand in the economy is low, demand for imports will tend to be low, improving the Balance of Payments situation. A low level of demand will also reduce the possibility of demand-pull inflation. However, in conditions of low Aggregate Demand, the government may find it difficult to achieve its objectives of low unemployment and economic growth. A low level of demand for goods and services will tend to reduce the demand for workers to produce these goods and services, meaning higher unemployment. Similarly, the economy is likely to growl less rapidly if there is a reduced demand for goods and services.
In the classical model of AS/AD, there is no conflict between the government’s economic objectives. Indeed, in this model an increase in AS will tend to achieve a higher rate of economic growth, lower unemployment and put downwards pressure on inflation all at the same time. Many classical economists argue that a low rate of inflation is a pre-requisite for the achievement of the government’s major macroeconomic goals.