What this lesson teaches
I can explain why governments use policy to raise living standards.
Syllabus 9570, 3.2.3(a). Macroeconomic Policies: Macroeconomic policy decisions undertaken by governments to achieve macroeconomic objectives in relation to living standards
Make a guess
An energy supply shock raises costs and cuts output. Would a big rise in government spending fix it?
- Yes, because higher spending lowers firms' costs.
- Yes. Any fall in output needs more government spending.
- Not well: output rises a little, but prices rise more.
Show the answer
Not well: output rises a little, but prices rise more.
The cause is on the supply side. Adding demand on top of higher costs adds to inflation; policies that ease costs or supply fit better.
Choose a policy by first finding the cause of the problem: demand, supply or structural.
Governments have three main types of macroeconomic policy: fiscal policy (government spending and taxes), monetary policy (the exchange rate or interest rates) and supply-side policies (raising productive capacity).
Demand management, using fiscal and monetary policy, works best when the problem is too much or too little AD.
Supply-side policies work best for problems of capacity, productivity or skills mismatch, but they take longer.
Priorities differ between countries. A developing country may focus on growth and jobs; Singapore, as a small open economy, focuses heavily on price stability, competitiveness and productivity.
- Demand problem
- Fiscal or monetary policy.
- Supply or skills problem
- Supply-side policy.
| Problem | Cause | Suitable tools |
|---|---|---|
| Recession, rising unemployment | Falling AD | Expansionary fiscal policy; slower appreciation |
| Demand-pull inflation | AD too high | Faster appreciation; fiscal restraint |
| Imported cost-push inflation | Rising import prices | Appreciation; targeted transfers |
| Structural unemployment | Skills mismatch | Retraining, career conversion |
| Slow long-run growth | Low productivity | Supply-side policies |
Worked example: Two falls in output, two causes
Economy A has falling export orders and idle factories. Economy B has a disruption to energy supplies, rising costs and lower production.
- A: a fall in AD. Boosting demand can bring idle resources back into use.
- B: a supply shock. Boosting demand would raise output a little but push prices even higher.
- B needs policies that ease costs or supply, plus help for the households hit hardest.
Watch out for this
Any fall in output should be met by raising government spending.
If the fall comes from a supply shock, raising AD adds to inflation. Find the cause first.
Check your understanding
Unemployment is high because workers lack the skills for new jobs. Which policy fits best?
- A cut in interest rates, so firms borrow and hire more.
- A supply-side policy such as retraining.
- A tax increase, to fund more unemployment benefits.
Show the answer
A supply-side policy such as retraining.
Right. The problem is a skills mismatch, not a lack of demand.