Government Policy

Each component of aggregate demand can be affected by governmental policies. If potential output in the short term is fixed, government policies that affect aggregate demand can affect the unemployment rate and the inflation rate. However, many of the policy tools available to the government act with a time lag, and as a result is it quite difficult to keep aggregate demand constantly at the desired level. The desired level (potential output) is itself constantly changing (usually increasing). Households and firms have minds of their own, and may not behave as predicted—the household savings rate and firms’ investment rates can vary widely. Finally, there are likely to be exogenous shocks to the economy, like natural disasters, sudden changes in import prices, currency crises, etc.

There are two main categories of government economic policy. Fiscal policy involves control of government expenditure and taxation. Monetary policy involves control over the supply of money and hence interest rates.

If the level of demand in an economy equals potential output (Q), then no “gap” exists. However, most of the time the two will not be equal. When aggregate demand is lower than potential output, unemployment over and above the “full employment rate of unemployment” will exist and resources will be wasted.

When aggregate demand is greater than potential output, it is impossible to increase production and therefore prices will rise, resulting in an “inflationary gap.” Eventually, as prices rise, marginal buyers will drop out and demand will decrease to a new full employment equilibrium at a higher price level.

In order to avoid either inflation or unemployment, the government must attempt to equate aggregate demand with potential output, ie force demand towards the value D2. This is the only level of demand at which Q=Y. This simple model shows no inflationary pressure at full employment. Suppose the government is successful in one year in equating Q=Y. However, investment has taken place, so next year potential output will be Q₂ > Q. If aggregate demand remains at Y, an output/employment gap will exist. In order to maintain full employment the government will need to estimate Q₂ and move to a new level of aggregate demand Y₂ such that Y₂=Q₂. The government must continue to estimate potential output and, through fiscal and monetary policy, control aggregate demand in subsequent periods so that Y₃=Q₃, Y₄=Q₄, etc. Needless to say, this is quite a difficult problem.

Under normal economic conditions where Q is increasing from year to year, the government will have to increase Y to match. There are three ways of increasing Y:

·         Government expenditure

·         Reduction in taxation

·         Increase in money supply

If the government increases expenditure, Y is immediately increased by the amount of the expenditure because government demand is part of aggregate demand. However, for the firms producing the goods and services and the households who own resources used by the firms, income will increase. Some of this new income will be spent on additional goods and services. There is therefore a multiplier effect where DY = kDG. In order to increase aggregate demand from Y₁ to Y₂, the government can simply increase its expenditures by (Y₂-Y₁)/k.

Similarly, cutting taxes will increase Y by some multiple of the amount of the tax cut. The fact of the tax cut does not in itself constitute an increase in demand, because the money is not spent on goods as it is in the case of a government expenditure increase. However, the multiplier effect still comes into play as households and firms spend some portion of the increased income provided by the lower tax rate.

Lowering taxes and increasing expenditures are both examples of fiscal policy. The monetary policy solution to low aggregate demand is to increase the money supply faster than the growth in the demand for money. This will cause the price of money—the interest rate, R—to fall. Borrowers (both households and firms) take the cost of borrowing into account when considering taking out a loan. Thus a decrease in R normally results in an increase in borrowing and a resulting increase in Y as the borrowed money is spent on goods and services. Again, the initial round of expenditure will trigger a multiplier effect as the increased income to firms and households results in additional rounds of expenditure and new income.

The process of controlling demand through money supply is complex. The policymaker must first estimate both current Q and Y and the expected change in Q for which Y should be adjusted. This will give the change in Y to be desired. Then, the size of the multiplier must be estimated, which will give the amount of the initial increase in expenditure that will result in the desired overall increase in Y. Then, the sensitivity of consumers and businesses to interest rate changes must be estimated, to determine the change in R that will result in the desired new expenditures. Finally, the current rate of increase of demand for money must be estimated, which will lead to an estimate of the rate of increase of money supply that will result in the desired interest rate. If any significant changes occur while the process is under way, the estimates may be wrong and the process may have to be re-started.

Of course, a combination of fiscal and monetary policy can be used. Tax cuts and increased government expenditure cannot be maintained forever; eventually problems with high government debt will surface. Monetary policy depends on consumers’ and business managers’ expectations and attitudes, which change frequently. And while the goal of closing the inflationary or employment gaps is universally desirable, other social values outside the realm of economics will also contribute to decisions on government policy. Macroeconomic goals generally accepted as desirable are:

·         Low inflation rate

·         Low unemployment rate

·         Balanced government budget

·         Trade balance

·         Stable currency in international exchange markets

There is less agreement about the ideal distribution of Y across C, I and G. Liberals prefer more G than convervatives. Rates of investment vary widely across different nations. There is no widely accepted notion of the ideal tax structure. And our simple model is capable of achieving full employment without inflation, which may not be true of real-world economies which have an inflationary bias. Finally, other social values outside the economic spectrum—like the idea that everyone should be able to get a job—constrain the range of actions available to enact desirable economic policy.