This paper explains possible conflicts in the achievement of macroeconomic aims. When
governments utilise demand management policies, there may be conflicts or trade offs amongst those goals. The most common conflict is the conflict
between achieving full employment and price stability. There are also other
conflicts such as those between achieving internal and external stability. This
paper explains various possible conflicts in the achievement of macroeconomic
aims when governments use demand management policies, such as fiscal and
monetary policies.
First,
demand management policies such as expansionary fiscal and monetary policies are
often used to achieve full employment. For example, when there is an increase
in government spending as governments spend on building infrastructure to boost
economic activity, there is an increase in AD and hence an increase in real national
income. As more resources are employed, the economy operates closer to full
employment. However, there is a trade off as the economy will also face demand
pull inflation as demand rises and bids up costs of factors of production.
Demand pull inflation is defined as a persistent, sustained, and inordinate
increase in the general price level due to increases in AD near or at the full
employment level. Many fast developing countries like China with fast-rising AD and
increasingly less spare capacity will likely face this conflict. On the other
hand, contractionary fiscal and monetary policies can be used to reduce demand
pull inflation, but this in turn conflicts with economic growth and employment,
thus posing yet another trade off.
Second,
as expansionary demand management policies are used to achieve economic growth,
the balance of payments may worsen. For example, if interest rates are lowered
to reduce costs of borrowing, households will borrow more to spend on consumer
durables and firms may also invest more as expected net profitability
increases. This leads to an increase in AD and real national income. However,
the demand for imports and hence import expenditure increases too. This is
because many consumer durables may be imported and firms may also import raw
materials and machineries for their investments. Assuming that export revenue
does not rise as quickly, the balance of trade worsens. Ceteris paribus, the
current account and hence balance of payments worsens. Thus countries like Singapore with
high MPM will be more likely to suffer from this conflict. This is because the
increase in import expenditure is larger when national income increases. Vice
versa, contractionary demand management policies to correct or address a
balance of trade deficit can conflict with economic growth and employment.
If a
country wants to achieve economic growth, it may choose to use expansionary monetary
policy to increase AD. When interest rates are lowered, the cost of borrowing
is lowered. This causes households to borrow more to purchase consumer durables
such as televisions and refrigerators. This causes C to increase. Firms will
also find that expected profitability of investment increases as costs of
borrowing falls, given that economic conditions remain the same and returns on
investments do not change. Thus I increases. Since C and I are components of
AD, AD will increase, resulting in an increase in real national output and
hence actual economic growth. However, in an open economy, the lower interest
rates would likely result in capital outflow. If there is massive capital
outflow as funds move to countries which offer higher interest rates, the
capital and financial account will worsen. This leads to a worsening balance of
payments. Hence, the desire to achieve actual growth via expansionary monetary
policy can conflict with the desire to achieve a healthy balance of payments.
Furthermore,
there is also a conflict between achieving a healthy balance of payments and
price stability. If a country is facing a deficit in its current account and balance
of payments, it may make use of demand management policies to improve the
current account. For example, an expenditure switching policy of currency
depreciation would help decrease the price of exports in terms of foreign
currency and increase the price of imports in terms of domestic currency. As
export competitiveness increases, the demand for exports and hence export
revenue increases. At the same time as imports become more expensive, consumers
switch to purchasing domestic goods instead. Assuming that Marshall Lerner
condition holds, when IPEDx + PEDmI >1, balance of trade improves. Since X-M
increases, AD increases and general price levels increase too. However, if the economy is import-reliant,
the depreciation of the currency could lead to imported inflation as the prices
of imported raw materials increase. This causes the SRAS to fall and the
general price level to increase. Thus a healthy balance of payments is achieved
at the expense of price stability. An example of this would be Singapore ,
where imported inflation is likely to happen if the currency depreciates. This
explains why Singapore
is reluctant to depreciate its currency even when BOT is worsening.
In conclusion,
there is a need to consider the use of supply side policies in some cases to
minimise these trade-offs, conflicts in macroeconomic goals. Alternatively, a
suitable mix of government policies may be considered to mitigate possible unintended
consequences which may arise.
JC Economics Essays: Special thanks to W for her contribution of this well-written economics essay. However, this economics essay was not done under timed examination conditions.
This paper explains the possible conflicts amongst macroeconomic goals of governments, and is basically about explaining the various trade offs and conflicts: inflation versus economic growth, internal versus external stability, and other such conflicts.
There are many good points to learn from this paper. First, it directly addresses the question. It also has many definitions and examples, which suggests that the candidate has learnt her economics material well. The essay is also very well written, and is clear cut, accurate, and to the point; however, perhaps some diagrams could have been drawn. What economics diagrams would you have drawn in this case, and why? Economics essays often benefit from a relevant, well labelled, and accurate diagram that illustrates and analyses a point. Thanks for reading and cheers!
