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Explain the possible conflicts in the achievement of macroeconomic aims when using demand-management policies. [10]


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!

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