Macroeconomic Objectives & Policies
Macroeconomic Objectives & Policies
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The 6 macroeconomic objectives: a guide with the conflicts between them
Governments aim for steady growth in real output, at a rate the economy can sustain.
Governments want their people to have more goods and services over time. Economic growth is the first of six macroeconomic objectives, the aims a government sets for the whole economy.
Economic growth: an increase in the real output of an economy over time, measured by the change in real GDP.
Put simply, growth means the economy produces more goods and services this year than it did last year. More output means more income to share, so growth is how living standards can rise.
Why "real"? GDP, gross domestic product, is the value of all the goods and services a country produces in a year. Nominal GDP measures that output at this year's prices. So nominal GDP rises when prices rise, even if no more goods and services are made. Real GDP values output at constant prices, the prices of one fixed year. So a rise in real GDP means more goods and services, not the same ones at higher prices.
A government does not want the fastest growth it can get. An economy's capacity is the most real output it can produce with all its workers, machines and land. If spending grows faster than capacity, firms can meet it for a while only by running their workers and machines beyond their normal limits. They cannot do this for long, so they raise their prices instead, and the general price level, the average level of prices, rises. Growth like that cannot last. The objective is sustainable growth: growth close to the rate at which capacity itself grows.
Hestria is a middle-income country, neither rich nor poor, with an open economy: it trades a lot with other countries. Its real GDP is $800bn a year. Last year its real GDP grew by 1.5%. Hestria's government judges that 3% a year can be sustained, so Hestria grew at half that rate. Its real GDP grew more slowly than the rate at which its capacity can grow.
Real Example: India's real GDP grew by 6.5% in the year to March 2025, its slowest rate in four years. Its nominal GDP grew by 9.8% in the same year. About 3 points of the nominal rise were higher prices, not more goods and services. This is why a government judges growth by the real figure.
Exam Matters: When you define economic growth, include the word "real": it is an increase in real output, measured by the change in real GDP.
Governments want inflation that is low and also stable, because each word protects people from a different harm.
In most economies, prices rise a little every year. The objective is not to stop this. It is to keep the rise low and steady.
Inflation: a sustained increase in the general price level over a period of time.
Put simply, inflation means that a dollar buys less as time passes. At 10% a year, food that costs $100 today costs $110 a year from now.
"Low" and "stable" protect against two different harms. A high rate hurts even when everyone expects it. Cash savings, and incomes fixed in money terms, such as many pensions, buy less every year.
An unstable rate, one that is hard to predict, hurts even when the average is low. Many decisions rest on a guess about future prices. A firm agrees a price for two years, a bank makes a loan, and a worker agrees a wage. A firm that builds a factory pays now and earns from it for many years, so it must forecast its costs and prices for years ahead. If inflation stays near 3%, firms, banks and workers can plan for it. If it is 1% one year and 9% the next, a wrong guess is costly. So many of them delay these decisions or agree only short contracts, and fewer factories are built: investment falls.
Why not aim for zero? At zero, a small fall in spending would push the price level down. This is deflation, a fall in the price level. When buyers expect lower prices, they may wait to buy, so spending and real output may fall.
Hestria has a central bank, which manages the country's money. The central bank has an inflation target, a rate it is told to aim at: 2%, with a band of 1 percentage point either side. Hestria's inflation is 3%: inside the 1% to 3% band, but 1 percentage point above the target.
Exam Matters: When you explain why inflation is harmful, say whether the harm comes from a high rate or from an unpredictable one. The two reasons are different.
Unemployment wastes output that can never be made later, so governments aim to keep it low.
Unemployment: people of working age who are willing and able to work and are actively looking for work, but do not have a job.
Put simply, a person is unemployed only if they want a job, can start one and are looking for one. A full-time student or a retired person who is not looking for a job is not unemployed.
Why does it matter? A worker who cannot find a job produces nothing. A year of labour cannot be stored and used later, so the output that worker could have made this year is lost for ever. The household loses income too. A long spell without work can make the next job harder to find, because skills can become out of date.
Unemployment also costs the government twice. People who lose their jobs stop paying income tax, so tax revenue, the money the government collects in tax, falls. Many of them claim unemployment benefit, a regular payment from the government to people without work, so government spending rises. Both changes come from the same lost jobs. Spending goes up while tax revenue goes down, so the gap between them widens.
Why not aim for zero? At any moment, some people are between jobs: they have left one job and are looking for a better one. This unemployment is usually short, and it helps workers find jobs that suit their skills. So the objective is low unemployment, not none.
In Hestria, unemployment is 6%: 6 in every 100 people in the labour force, the people working or looking for work, have no job.
Real Example: South Africa's unemployment rate was 33.2% in the second quarter of 2025, according to its statistics agency. That was about 8.4 million people who were looking for work and could not find it: about one in three people in its labour force. The goods and services those people could have made are lost.
A current account deficit must be paid for, so governments aim for a current account roughly in balance.
Countries buy goods and services from other countries and sell to them. The balance of payments is the record of all the money flowing between a country and the rest of the world.
Current account: the part of the balance of payments that records a country's trade in goods and services, plus primary and secondary income, with the rest of the world.
Current account deficit: when the value of money flowing out of a country on the current account is greater than the value flowing in.
Put simply, the current account shows what a country earns from the rest of the world and what it pays to it. Primary income is wages, profits and interest. Secondary income is transfers, such as money that workers abroad send home. The current account balance is exports minus imports of goods and services, plus net primary income and net secondary income. "Net" means the income received from abroad minus the income paid abroad. A negative balance is a current account deficit: the country pays more to the rest of the world than it earns from it.
Why does a deficit matter? More money flows out than flows in, so the difference must be paid for. The country usually borrows from abroad, sells assets such as firms or land to foreign owners, or uses its foreign currency reserves, the foreign money its central bank holds. None of these can go on for ever. Lenders may stop lending, a country has only a limited stock of assets to sell, and its reserves can run out.
So the objective is current account equilibrium: a current account roughly in balance over several years, not zero in every year. A deficit in one year can be offset by a surplus in another. A large and lasting current account surplus, where more flows in than out, has costs too: the country usually lends abroad income that it could spend on its own people.
A deficit is measured as a share of GDP, because GDP is the income a country earns in a year. The same deficit is a larger problem for a small economy than for a large one, because it is a bigger share of the income that pays for it.
So for every $100 of income Hestria earns in a year, $3 more flows out on its current account than flows in.
Real Example: In April 2022, Sri Lanka stopped paying its foreign debts for a time. Its foreign currency reserves had fallen to about $1.9bn. It needed this money to pay for imports of essentials such as fuel, and about $4bn of foreign debt was due that year. A country that cannot earn or borrow enough foreign currency cannot pay for the imports it needs. This is the risk that a lasting current account deficit creates.
A government's budget compares its tax revenue with its spending, and the aim is balance over several years.
Each year a government collects tax revenue and spends money on schools, roads, wages and benefits. The two totals are rarely equal.
Budget deficit: when government spending is greater than tax revenue in a year.
Budget surplus: when tax revenue is greater than government spending in a year.
Balanced budget: when government spending equals tax revenue in a year.
Put simply, the key difference between the three is which total is larger: spending in a budget deficit, tax revenue in a budget surplus, and neither in a balanced budget. The budget balance shows which one a government has:
budget balance = tax revenue − government spending
A negative balance is a budget deficit, and a positive one is a budget surplus.
So this year Hestria's government spends $40bn more than it collects in tax. For every $100 of income Hestria earns, its government spends $5 more than it collects. It must find that $40bn from somewhere other than this year's taxes, usually by borrowing.
Why aim for balance? Interest, the price of borrowing, must be paid on what is borrowed, out of future tax revenue. A budget deficit year after year therefore leaves less money for schools and roads later.
But the objective is balance over the economic cycle, the rise and fall of real output over several years. In a downturn, the falling part of the cycle, incomes and spending fall, so tax revenue falls. More people lose their jobs, so benefit spending rises. The budget moves towards a budget deficit, even though the government has changed no tax rate or spending plan. In a boom, the rising part of the cycle, incomes and spending rise, so tax revenue rises. Fewer people claim benefit, so benefit spending falls. The budget moves towards a budget surplus. So a budget deficit in a downturn and a budget surplus in a boom can offset each other over the cycle.
Real Example: Saudi Arabia had a budget surplus of about $28bn in 2022, when its oil revenue rose by about half. In 2023 its oil revenue fell by 12% and its spending rose, and the budget moved to a deficit of about $22bn. So its budget balance moves with the oil market as well as with the government's choices.
Exam Matters: When you define a balanced budget, say what is equal (government spending and tax revenue) and over what period (a year).
Governments aim for a smaller gap between high and low incomes, not for everyone to earn the same.
In most countries, some households earn far more than others. The sixth objective is about the size of that gap.
Distribution of income: how a country's total income is shared between its households.
Put simply, the distribution of income tells you who receives a country's income. A country can have a high total income and still leave many households poor.
One way to measure the gap is by shares. Rank all households by income and split them into five equal groups, or fifths. If income were shared equally, each fifth would receive 20%. In Hestria, the richest fifth receive 45% of all income and the poorest fifth receive 5%. So the richest fifth receive 9 times as much as the poorest fifth.
Greater income equality means making that gap smaller. It is a direction, not equal pay for all. If everyone earned the same, people might gain little from training, working harder or taking a risk, so fewer people might do these things.
Why does the gap matter to the economy, not only to fairness? Poorer households spend a larger share of each extra dollar than richer households do. Richer households save more of each extra dollar. So when income moves towards the richest households, a smaller share of total income is spent than before. Consumption, spending by households, is a component of AD, total planned spending in the economy. Lower consumption therefore lowers AD, if the other components of AD do not change. Firms then produce less real output and need fewer workers, so unemployment may rise.
Ability is also wasted. Where education depends on family income, able children from poor families may leave school early. They become workers with fewer skills than their ability allowed, so the economy produces less than it could.
Equality is about how close incomes are; equity is about whether each household's share is fair.
A government and its central bank can both change total spending, but each uses its own tools.
Aggregate demand (AD) is total planned spending on an economy's output, by households, firms, the government and buyers abroad. If AD grows too slowly, firms sell less, so they need fewer workers and unemployment rises. If it grows faster than the economy can produce, the price level rises. So governments try to manage it.
Demand-side policies: policies that aim to change the level of aggregate demand in the economy.
Put simply, a demand-side policy changes how much is spent in total in the economy. It does not change how much the economy is able to produce.
There are two kinds of demand-side policy, run by two different bodies.
Fiscal policy: the use of government spending and taxation to influence aggregate demand.
Put simply, fiscal policy is the government's budget: what it decides to spend, and how much it collects in tax. Hestria's government spends $270bn a year and collects $230bn in tax.
Monetary policy: the use of interest rates, the money supply and the availability of credit by the central bank to influence aggregate demand.
Put simply, monetary policy changes how much it costs to borrow, and how much banks are able to lend. The money supply is the amount of money in the economy, and credit is money that is borrowed. The best-known tool is the interest rate, which Hestria's central bank, the bank that manages the country's money, has set at 5%.
The key difference is who acts, and with what. Fiscal policy is decided by the government and works through its own spending and taxes. Monetary policy is decided by the central bank and works through the cost and the amount of borrowing. Both aim at the same thing: AD.
Reflationary and deflationary describe which way a policy moves aggregate demand, not which tool it uses.
Fiscal and monetary policy say who acts. A second pair of words says which way the policy moves AD.
Reflationary policy: a policy that increases aggregate demand; also called expansionary policy.
Deflationary policy: a policy that reduces aggregate demand; also called contractionary policy.
Put simply, a reflationary policy adds to total spending and a deflationary policy reduces it. Both fiscal and monetary policy can be run either way.
A tax works through income. A higher tax, on income or on spending, leaves households less to spend on other things, so consumption, a component of AD, falls.
Reflationary policy suits an economy where real output is below what it can produce and unemployment is high: more spending gives firms a reason to produce more and hire. Deflationary policy suits an economy where inflation is above its target. With less spending, firms face less pressure to raise prices. It can also reduce a current account deficit that comes from high spending on imports. Households that spend less also buy fewer imports.
Hestria's inflation is 3%, above the 2% that its central bank is told to aim at, which points to a deflationary policy. But Hestria's real GDP grew by only 1.5% last year, so lower AD would slow its growth further.
Exam Matters: When a question describes a measure, give it both labels: its direction (reflationary or deflationary) and its tool (fiscal or monetary).
Extra government spending adds to aggregate demand in full, but a tax cut adds only the part households spend.
Fiscal policy has two instruments: government spending and taxation. A dollar of each does not change AD by the same amount.
Government spending is itself a component of AD. When Hestria's government pays for a new road, that money is spent on output at once. So $10bn more government spending adds $10bn to AD at first, before the people who receive the money spend part of it again.
A tax cut works in a different way. It raises disposable income: the income households have left after paying tax. Households spend part of each extra dollar and save the rest. Only the part they spend is consumption, which is a component of AD. The part they save is not spent on output.
Both choices cost Hestria's budget $10bn. Yet the spending moves AD further at first, because none of it is saved.
A tax on firms' profits works in a similar way, through investment. A lower tax leaves firms more profit after tax, and they may spend part of it on new machines and buildings.
When AD shifts right, part of the shift becomes extra real output and part becomes a higher price level.
Hestria's economy starts at E₁, the point where AD meets short-run aggregate supply (SRAS): real output of $800bn and a price level of 100.
Hestria's government now raises its spending by $10bn. AD shifts right by more than this, because the extra spending is spent again by the people who receive it. With a multiplier of 2, AD shifts right by $20bn at every price level.
At the old price level of 100, planned spending is now $820bn, but firms are producing only $800bn. This excess demand of $20bn, planned spending above what firms produce, gives firms a reason to produce more.
Why don't firms simply produce $20bn more at the same prices? Because each extra unit costs more to make. Firms must pay overtime and use older machines. They produce more only if they can charge higher prices to cover these costs. This is why SRAS slopes upwards.
So the economy moves up along SRAS to E₂, where the new AD curve meets SRAS: real output of $812bn and a price level of 103. Real output rises by $12bn, not $20bn, and the price level rises by 3%, from 100 to 103. As the price level rises, the real output demanded falls along the new AD curve. So the other $8bn of the shift is never produced.
How much of the shift becomes real output depends on how steep SRAS is. With many idle workers and machines, ones that have no work to do, extra output costs little more to make, so SRAS is flat and most of the shift becomes real output. Near full capacity, SRAS is steep, so most of the shift becomes a higher price level.
A cut in government spending reverses each step:
Exam Matters: On the diagram, mark E₁ and E₂ and read both off to the axes. Show that the rise in real output is smaller than the horizontal shift of AD.
A higher interest rate makes borrowing cost more, so spending falls, but the full effect takes up to two years.
A central bank's main instrument is the interest rate it sets.
Policy interest rate: the rate of interest set by the central bank, which affects the interest rates that commercial banks charge borrowers and pay savers.
Put simply, it is the price of borrowing that the rest of a country's interest rates follow. Commercial banks are the ordinary banks where households and firms borrow and save. When it rises, loans from most banks soon cost more.
Hestria's central bank aims at 2% inflation, but inflation is now 3%. To bring it down, Hestria's central bank raises its policy rate from 5% to 6%. Commercial banks now pay more to borrow, so they charge more on their loans. They also pay savers more, to keep their deposits.
A higher rate also works in two other ways. It lowers the prices of assets such as houses and shares, because buyers can now earn more by saving instead. Owners feel less wealthy and spend less, so consumption falls. And it attracts savings from abroad. Savers abroad must buy Hestria's currency to save in Hestria, so demand for the currency rises, and so does its value. Hestria's exports then cost more for foreign buyers and its imports cost less, so net exports (exports minus imports), another component of AD, fall.
None of this happens at once. Many loans have rates fixed for years, so a higher policy rate does not change what those borrowers pay. Firms also finish projects they have already started. The full effect on inflation takes up to about two years. So Hestria's central bank does not set its rate for today's 3%. It sets it for the inflation it forecasts over the next two years.
A cut in the policy rate reverses each step. Loans become cheaper and saving earns less, so consumption, investment and net exports rise, and AD shifts right. Real output then rises, and the price level rises faster.
Exam Matters: When you analyse a rate change, follow one route all the way from the rate to the price level, naming each link. Then say how long the effect takes.
When the interest rate is close to zero, a central bank can create money to buy bonds instead.
A central bank cuts its policy rate to raise AD. But once the rate is close to zero, it cannot be cut much further. Savers can always hold cash, which pays no interest, rather than accept a rate below zero. So the central bank needs another instrument.
Quantitative easing (QE): the purchase of financial assets, mainly government bonds, by the central bank with newly created money, to increase the money supply.
Put simply, the central bank creates new money and uses it to buy bonds from banks and other investors. Bonds are financial assets: things people and firms buy to earn a return. A government bond is a loan to the government: the government pays its holder a fixed amount each year, and the holder can sell the bond to someone else at its market price.
The $5 payment does not change, so a buyer who pays more for the bond earns a lower return. This matters because a bank that lends for many years will make a loan only if it pays at least as much as a bond would. When bonds earn less, a long loan at a lower rate still pays as much as a bond. So long-term interest rates, such as those on home loans, fall as the bond's return falls.
There is a second route. The banks and investors that sold bonds now hold new money instead, which they can lend. Cheaper and easier borrowing raises consumption and investment, so AD shifts right.
But QE only makes borrowing cheaper and easier. It cannot make anyone borrow, so if households and firms are worried about the future, AD may rise very little.
Lending criteria control how much people can borrow, and they can be aimed at one market.
An interest rate changes the price of borrowing. A central bank can also change the quantity of borrowing, by changing who may borrow and how much.
Lending criteria: the conditions a borrower must meet before a bank will lend, such as a minimum deposit or a minimum income.
Put simply, these are the tests a borrower must pass before a bank will lend. Stricter tests mean fewer people can borrow, whatever the interest rate.
House prices in Hestria are rising fast. Hestria's central bank raises the minimum deposit on a home loan from 10% to 20% of the price. To buy a $50,000 flat, a household must now have saved $10,000, not $5,000. A household with savings of more than $5,000 but less than $10,000 could buy before. Now it cannot, even though the interest rate has not changed. With fewer buyers, builders start fewer new flats, so investment, a component of AD, falls. A lower minimum deposit reverses each of these changes: more households can buy, builders start more new flats, and investment and AD rise.
The advantage is that lending criteria can be aimed at one market. A higher minimum deposit slows borrowing for homes, but loans to firms are not affected. A higher interest rate, by contrast, reaches every borrower in the country.
The weakness is that the rules cover only the lenders the central bank supervises, such as banks. A household turned down by a bank may borrow from another kind of lender instead, so some of the borrowing the rule stopped still happens.
Real Example: In 2015, Hong Kong's monetary authority, which acts as its central bank, lowered the largest loan allowed on many homes from 70% to 60% of the price. Buyers of those homes then needed a deposit of 40% of the price. The rule covered only home loans, so it was aimed at the property market.
A reserve requirement limits how much of its deposits a bank may lend.
Banks lend most of the money their customers deposit. But customers can ask for their money at any time, so a bank must keep part of it ready.
Reserve asset (liquidity) requirement: the proportion of its deposits that a bank must hold as liquid assets rather than lend.
Put simply, a bank must keep part of its customers' money ready to pay out. It keeps it as cash, or as assets it can quickly turn into cash. Only the rest can be lent. When the central bank raises the share that must be held, banks can lend less.
If banks were lending up to the old limit, less lending means fewer loans for homes, cars and machines. Households and firms that cannot borrow spend less, so consumption and investment fall, and AD shifts left. No interest rate has changed: like lending criteria, the requirement works on the quantity of credit. Lowering the requirement reverses this: banks may lend more, and AD rises.
A higher requirement also makes a bank safer. With $20bn ready instead of $10bn, it can pay more customers who ask for their money at once. A lower requirement reverses this too: with less held ready, the bank is less safe. For this reason, some central banks use the requirement mainly to keep banks safe. They use the interest rate to manage AD.
Real Example: In May 2025, China's central bank cut the reserve requirement for most banks by 0.5 percentage points. It expected this to free about 1 trillion yuan for banks to lend. In the same announcement it also cut its policy interest rate, so it used two instruments at once.
The government sets the inflation target, and the central bank decides how to hit it.
Who decides what in monetary policy? In many countries the work is split in two. The government sets the aim. The central bank then chooses and uses its instruments to reach it. This is what implementing monetary policy means.
Inflation target: the rate of inflation the central bank is set to achieve, usually with a band either side.
Put simply, it is the rate of inflation the central bank must aim at, with a little room either side. Hestria's government has set a target of 2%, with a band of 1 percentage point either side, from 1% to 3%.
Central bank independence: when the central bank sets interest rates and its other instruments without being told what to do by the government.
Put simply, the government says what to aim at, but it cannot tell the central bank when or how to move its interest rate.
Why would a government let the central bank decide this? A government that sets interest rates may want to cut them before an election, because cheaper loans make voters feel better off for a while. Cheaper loans also raise spending, which pushes inflation up. If firms and workers expect a government to do this, they also expect higher inflation. So they may raise prices and ask for higher wages in advance, and inflation can rise even before any rate has moved.
An independent central bank has no election to win. So when it says it will keep inflation near 2%, firms and workers are more likely to believe it. They then set prices and wages expecting about 2%. Because prices and wages rise by about 2%, inflation stays near the target.
With inflation at 3%, Hestria is inside the band but 1 percentage point above the target. A rate change takes up to about two years to work fully, so Hestria's central bank acts on its forecast of inflation, not on today's figure.
Real Example: India has had a formal inflation target since 2016. The government, after consulting the central bank, sets the target: 4%, with a band from 2% to 6%. A committee at the central bank then sets the policy interest rate to hit it. This is the split between the target and the instrument.
A central bank is also a bank, for the government and for the country's commercial banks.
A central bank is also a bank, with two kinds of customer.
The first is the government. Hestria's central bank holds the government's account and makes its payments. When the government spends more than it collects in tax, it usually borrows the difference by selling government bonds, and in many countries the central bank arranges the sale. Hestria's budget deficit of $40bn a year is financed in this way.
The second is the commercial banks, the ordinary banks where households and firms keep their money. Each holds an account at the central bank, and they pay one another through these accounts.
Why would a sound bank, one whose loans are good, need help? A bank lends its customers' deposits for many years, as home loans and loans to firms. But customers can ask for their deposits today. If many ask at once, the bank cannot get its loans repaid quickly enough to pay them all. A rush like this is a bank run.
Lender of last resort: the role of the central bank in lending to commercial banks that cannot borrow enough from anyone else, to stop them failing for lack of cash.
Put simply, the central bank lends cash to a bank that has good loans but not enough cash today, so its customers can be paid.
This can stop a run before it starts. Customers rush to withdraw because they fear being too late. If they know the central bank will lend cash to a bank whose loans are sound, that fear is smaller, and so is the reason to rush.
The central bank lends to a bank whose loans are worth more than its deposits. Such a bank is solvent but short of cash, or illiquid. As its loans are repaid over the years, it can pay the central bank back. A bank whose loans are worth less than its deposits is insolvent. A loan cannot fix that. The bank would have more cash, but it would still owe more than it owns.
Exam Matters: When you define lender of last resort, include both parts: it lends to commercial banks, and only when they cannot borrow enough anywhere else.
Fiscal policy can be aimed at the places that need it, but it is slow to start and adds to borrowing.
Fiscal policy has clear strengths and clear weaknesses. Which matters more depends on the state of the economy.
Take the last weakness in Hestria. Its budget deficit is already $40bn, 5% of GDP. Another $10bn of spending, paid for by borrowing, would raise the budget deficit to $50bn. More borrowing means more interest to pay each year, and less left for schools and hospitals later.
The delay matters as much as the borrowing. In many countries the budget is set once a year, and a road may need a year of planning. If the downturn has ended by then, the extra spending raises AD when the economy no longer needs it, and adds to inflation instead.
So fiscal policy is strongest in a deep downturn with a small budget deficit. Then many workers and machines are idle, so extra spending raises real output more than the price level. It is weakest when the economy is near full capacity or the budget deficit is already large.
Exam Matters: When you weigh fiscal policy, say when each weakness matters most, such as a deficit that is already large, instead of only listing the weaknesses.
Monetary policy is quick to decide, but one interest rate reaches every borrower, and its effect is slow to arrive.
Monetary policy's strengths and weaknesses are close to the reverse of fiscal policy's: it is quick to decide and easy to reverse, but it cannot be aimed, and its effect on spending is slow to arrive.
Suppose house prices in Hestria rise fast while its exporters struggle. A higher rate slows borrowing for homes. But it also raises exporters' borrowing costs and the value of the currency, which makes their goods more expensive abroad. So one rate cannot slow the housing market without also hurting exporters.
Why can't a low rate always raise AD? A firm is likely to invest only if it expects to sell what a new machine would make. If it expects falling sales, a cheaper loan does not change that. This is when fiscal policy, which buys output directly, can work better.
So monetary policy is strongest when one problem affects the whole economy and confidence is normal. It is weakest when the problem is in one market, when confidence is low (households and firms expect hard times), or when the rate is already close to zero.
Exam Matters: When you examine a rate change, end with what the result depends on, such as how confident firms are or how close the rate already is to zero.
Supply-side policies raise how much an economy is able to produce, so they shift LRAS to the right.
Demand-side policies change how much is spent in an economy. Supply-side policies work on something different: how much the economy is able to produce. This is its productive capacity: what its workers, machines and land can make.
Supply-side policies: policies that aim to increase the productive capacity of the economy by improving the quantity and quality of the factors of production and the way markets work.
Put simply, a supply-side policy helps the economy make more with what it has, or gives it more to work with. Better-trained workers, more machines and markets that new firms can enter all do this.
Productivity: output per worker, or per hour worked.
Put simply, productivity is how much one worker makes in an hour. If each worker makes more, real output can rise without anyone working longer.
Supply-side policies aim at three targets: higher productivity, more competition between firms, and stronger incentives to work and invest. Each one raises productive capacity, and the long-run aggregate supply curve (LRAS) shows productive capacity. So a successful supply-side policy shifts LRAS to the right.
Hestria starts at E₁, the point where AD meets the first LRAS curve, LRAS₁. There, real output is $800bn and the price level is 100. A supply-side policy now raises Hestria's productive capacity, and LRAS shifts right to $816bn. AD does not move, because nothing has changed total planned spending.
So real output rises by $16bn and the price level falls from 100 to 94. The two move in opposite directions. A demand-side expansion moves them the same way, because a shift of AD to the right raises both real output and the price level. A shift of LRAS to the left reverses each of these steps.
Exam Matters: On an AD and LRAS diagram, label both LRAS curves and mark both equilibria. Read real output and the price level off to the axes at each one.
Competition pushes firms to cut costs, and incentives reward extra work and investment, so both raise productive capacity.
Productivity is one target of supply-side policy. The other two, competition and incentives, change what firms and workers choose to do.
A firm with no rivals can keep its costs high and still sell, because its buyers have nowhere else to go. A firm with several rivals cannot. If its prices stay high, its buyers switch to a cheaper rival. So it must find cheaper methods, better machines or better products, or it loses sales.
A government raises competition mainly by lowering the barriers that keep new firms out of a market, such as official licences that are hard to get. As more firms enter, each faces more rivals. Cheaper methods let a firm make more with the same workers and machines. That is higher productivity, and across many firms it raises productive capacity.
An incentive is a reward for making a choice. One way supply-side policy changes incentives is through the marginal tax rate: the share of the next dollar earned that is paid in tax.
With a larger reward, more hours of work, training for a better-paid job and taking a job at all are each worth more. So more people may choose to do them. More labour, and more skilled labour, raises productive capacity. A lower tax rate on profits works the same way for firms: a firm keeps more of the return on a new machine, the profit it earns, so more investment is worth doing.
Deregulation and privatisation aim to lower firms' costs, and both work best where firms face rivals.
One group of supply-side policies, free-market policies, reduces the government's role in markets, so that competition and incentives can work. The first two are deregulation and privatisation.
Deregulation: the removal of rules and regulations that restrict competition in a market.
Put simply, deregulation lets more firms into a market, or lets firms decide more for themselves. A rule that allows only three bus companies in a city is the kind of rule it removes.
In a product market, where goods and services are sold, deregulation removes rules on who may enter and what firms may charge. New firms may enter, and existing firms then face more rivals, so they must cut costs to keep their buyers.
In a labour market, where firms hire workers, deregulation removes rules on hiring, hours and contracts. A firm that can change hours or end a contract more easily takes less risk when it hires, so it hires more readily. It can also move workers to the jobs where they produce most. More people in work, and workers used where they produce most, both raise productive capacity. The cost can fall on workers, who may have less security in their jobs.
Privatisation: the transfer of ownership of a firm or industry from the public sector to the private sector.
Put simply, the government sells a firm it owns, such as a railway or a power company, to private owners.
Why might a private owner run the firm better? A private owner who makes a loss loses its own money, while a state firm's losses are usually paid from tax revenue. So a private owner has a stronger reason to keep costs down.
But the gain is largest when the firm has rivals to compete with. A state monopoly, the only firm selling in a market, may be sold as a private monopoly. Its buyers still have nowhere else to go. It can keep its prices high and still make a profit. So the sale may change who receives the profit, without making the firm much better run.
Three more free-market policies raise the reward for working, and lower the cost of starting or running a firm.
Three more free-market policies change what people and firms gain from producing.
A lower marginal tax rate raises what a worker keeps from an extra hour and what a firm keeps from extra profit, so more work and investment become worth doing.
Welfare payments, or benefits, are paid by the government to people with low incomes, including the unemployed. When someone takes a job, the benefit usually stops. So the choice to work depends on the gain: the income kept from the job, minus the benefit given up.
A lower benefit level raises the gain from taking a job, so more people may look for work. This raises productive capacity only where there are jobs for them to fill. It also lowers the income of people who cannot find work or cannot work.
Some benefits do not stop all at once. They fall step by step as a person's pay rises. Each extra dollar earned then loses part to tax and part to the benefit that is withdrawn. The share of each extra dollar lost in this way is the effective marginal deduction rate. If tax and withdrawal together take 50 cents of each extra dollar, the rate is 50%, and the worker keeps only 50 cents. The higher the rate, the weaker the reward for earning more.
Bureaucracy here means the forms, licences and permits (official permissions) a firm needs before it can trade. Each costs time and money. The cost is about the same for any size of firm, so it takes a larger share of a new or small firm's sales than of a large firm's. Cutting it lowers firms' costs, so more firms start and compete.
Spending on education and training raises what each worker can produce, but only years after the money is spent.
The second group of supply-side policies has the government act directly.
Interventionist policies: supply-side policies in which the government acts directly, by spending or by giving incentives, to increase productive capacity.
Put simply, the government pays to build up the economy's skills and capital, instead of only removing rules. The first interventionist policy is investment in education, training and skills.
Why does it raise productive capacity? A worker who can repair a machine or read a technical drawing produces more each hour than one who cannot. So better skills raise productivity, and the same number of workers can produce more real output.
Why should the government pay, and not firms? A firm that pays to train a worker may lose that worker to a rival that paid nothing. Every firm faces this risk, so firms may train fewer workers than the economy needs. The government can pay for the training that firms do not.
Suppose Hestria's government spends $5bn a year on technical colleges. The $5bn is government spending, a component of AD. So this year it adds $5bn to AD at first, before any student has finished a course. But productive capacity has not changed yet, so LRAS does not move. It shifts right only years later, when the graduates start work and produce more each hour.
So the policy has a demand-side effect now and a supply-side effect later. For schooling, the delay can be many years, because pupils join the workforce, the people working or looking for work, only when they finish.
The government can add to an economy's capital by helping firms invest, or by building infrastructure itself.
Workers produce more when they have more and better machines to work with. Machines, buildings and other equipment used in production are called capital. Two interventionist policies add to it.
A firm invests in a project only if it expects a high enough return. Suppose a firm in Hestria requires a return of 10% on a new machine, but the machine is expected to earn 9%. The firm does not buy it. A subsidy that pays part of the cost, or a lower tax on the profit from the machine, can lift the return above 10%. Now the firm buys the machine, it has more capital per worker, and productivity rises.
The risk is paying for investment that would have happened anyway. Some projects already earn more than the firm requires. The firm goes ahead with these whether or not it gets help. A subsidy for such a project adds no capital, because the machine would have been bought anyway. It is a windfall, a gain the firm did nothing to earn, and a cost to the budget.
Infrastructure is the roads, ports, power supply and telephone networks that firms share. A faster port cuts the time and cost of shipping for the exporters that use it. Firms spend less of their workers' time and their money on moving goods and waiting, so more is left for producing. So many firms can produce and sell more from the same workers and machines.
Why does the government usually build it? A road is used by many firms and households, and it is hard to charge each user for the benefit. No single firm would earn enough from a road to pay for it alone, so firms build too little of it. Infrastructure also adds to AD while it is built, because the government pays the builders, and it raises capacity only once it is in use.
Start-up finance and regional policy help new firms and poorer regions use resources that would otherwise not be used.
A person with a good business idea usually needs a loan to start a firm. But a new firm has no record of trading, so a bank finds it hard to judge whether it will repay. Many founders also own little that the bank could take if the loan is not repaid. So banks often refuse, and some good firms are never started.
The government can lend to new firms itself, or promise to repay part of a bank's loan if the firm fails, so that banks are willing to lend. More new firms bring more competition and add to productive capacity.
Regional policy: government measures that aim to reduce differences in income and unemployment between regions of a country.
Put simply, regional policy brings firms and jobs to the poorer parts of a country. It may give grants, money that does not have to be repaid, to firms that open there, or build roads and power supply in the region.
Why bring the jobs to the workers, and not the workers to the jobs? Many workers cannot move easily. They may own a home, care for family, or be unable to pay higher rents elsewhere. So one region can have high unemployment while another has jobs it cannot fill.
Does regional policy raise the country's real output? It does when it gives work to idle labour: people who are able to work but have no job. If a grant leads a firm to hire unemployed workers who have the skills it needs, what they produce is added to national real output. But if the firm only moves a factory from another region of the same country, the jobs created in one region are lost in the other. National real output then need not rise: the output has moved from one region to another, not been added.
Supply-side policies can raise real output without raising the price level, but they are slow and uncertain.
The main strength of supply-side policy is the direction of its effect. Because it shifts LRAS to the right, real output rises while the price level falls. A demand-side expansion usually raises real output together with a higher price level. In a real economy AD usually grows at the same time. AD shifting right pushes the price level up, while LRAS shifting right pulls it down. So the price level usually still rises, but by less: inflation is lower than it would otherwise be.
Supply-side policy can help other objectives too. Firms that produce at lower cost can sell abroad at lower prices, which can help the current account. More people in work can also mean lower unemployment over time.
Free-market policies remove rules, sell state firms and cut taxes and benefits. Interventionist policies have the government act directly. Both groups are slow. A new college changes the workforce only when its students finish, and a market opened to new firms changes nothing until a firm enters. Both are also uncertain, because the government cannot make firms invest or make workers respond to an incentive. Because supply-side policies are slow, they cannot quickly correct a sudden fall in AD.
So the two groups fail in different ways. Free-market policies risk a wider income gap, and interventionist policies risk a larger budget deficit and poor choices. Which group works better depends on what holds the economy back. Where rules keep firms out of markets, free-market policies fit. Where skills or infrastructure are short, interventionist policies fit.
In the short run, a policy that lowers unemployment usually raises inflation, so the two objectives can conflict.
A conflict between objectives happens when one policy moves two objectives in opposite directions: one closer to its target, the other further away. The first conflict is between low inflation and low unemployment.
Suppose Hestria's government cuts income tax, a reflationary policy. Households spend part of the extra income, so consumption, a component of AD, rises and AD shifts right. Firms then sell more and raise real output. To produce more, they hire more workers, and unemployment falls. The same shift raises the price level, because each extra unit costs more to make.
Falling unemployment adds a second push. When fewer people are out of work, firms must compete for workers, so they offer higher wages. Wages are a large part of firms' costs, so firms raise their prices to cover them.
Short-run Phillips curve: a curve showing an inverse relationship between the rate of unemployment and the rate of inflation in the short run.
Put simply, an inverse relationship means that when one rate falls, the other rises. So in the short run a demand-side policy cannot lower both rates at once.
On the diagram, the unemployment rate is on the horizontal axis and the inflation rate on the vertical axis. A change in AD moves the economy along the curve. The curve itself stays where it is, because it is drawn for given conditions in the short run, such as the inflation rate that workers expect.
The reverse also holds. A deflationary policy shifts AD left, so inflation falls, but firms cut real output and hire fewer workers, and unemployment rises. Hestria moves back along the curve from Y towards X. This is a trade-off: a choice, not a reason to do nothing. Which point is better depends on which objective is further from its target, and on who is hurt more: people out of work, or people whose fixed incomes buy less.
A supply-side policy can weaken this conflict, though it works slowly. It shifts LRAS, which shows productive capacity, to the right. Firms can then produce more real output and hire more workers while the price level falls instead of rising, so unemployment can fall without the extra inflation.
Exam Matters: When you draw the curve, put the unemployment rate on the horizontal axis and the inflation rate on the vertical axis. Show a reflationary policy as an arrow along the curve, from one point to another, not as a new curve.
Faster growth often harms the environment, but how much depends on how the extra output is produced.
Producing more goods and services usually needs more energy and materials. Factories burn more fuel, more trucks carry goods, and more waste is thrown away. So when real output rises, pollution and the use of resources such as forests and water often rise with it.
This is the conflict. Governments want economic growth, but they also want to protect the environment. The harm from pollution falls on people who are not buying or selling the product, such as a family living beside a new factory, or people born years later. This is an external cost. Real GDP counts the goods and services produced. It takes no account of the dirtier air, so real GDP can rise while people's quality of life does not.
But the conflict is not fixed. The harm depends on two things: how many units are produced, and how much pollution each unit causes. Growth can raise real output without raising the pollution caused by each unit. Growth weakens the conflict when the extra output comes from:
Growth makes the conflict worse when it comes from using more inputs: more coal burned, more forest cleared, more minerals dug from the ground. So faster growth does not have to harm the environment. Whether it does depends on how the growth is produced.
Exam Matters: When you weigh growth against the environment, give both sides: the chain from more real output to more pollution, then a condition that weakens it, such as cleaner energy. End with a judgement on which side is stronger in the case you are given.
When a country's inflation is higher than its trading partners', its exports tend to lose sales and its current account tends to worsen.
Hestria already has a current account deficit of $24bn, 3% of its GDP. Suppose its inflation reaches 5% a year, while prices in its trading partners rise by 2% a year. Hestria's exchange rate, the price of its currency in other currencies, stays the same.
Each year, Hestria's prices rise by 5% and its rivals' prices by 2%. Buyers at home and abroad compare these prices before they choose.
Now suppose Hestria's government and central bank act to bring the current account back towards equilibrium. A deflationary policy shifts AD left, so the price level rises more slowly. If Hestria's inflation falls to its rivals' rate of 2%, its goods stop becoming more expensive compared with its rivals'. With less spending, firms sell less and pay out less, so households' incomes grow more slowly. Households with less income also buy fewer imports. But real output grows more slowly and unemployment rises. One policy helps inflation and the current account, and harms growth and jobs.
The conflict is weaker if Hestria's exchange rate falls. If its currency loses about 3% of its value each year, Hestria's prices, counted in foreign currency, rise by only about 2% a year (5% − 3%), the same as its rivals' prices. So its goods keep their price against rivals' goods, and its exports do not lose sales. But when the currency falls, imports cost more in Hestria's own currency. Households and firms in Hestria buy imports too, so dearer imports raise the price level, and Hestria's inflation rises again.
Exam Matters: When a question gives two inflation rates, compare them. It is the gap between the rates that changes how expensive a country's goods are, not the level of either one.
Growth raises total income, but it can widen the gap between rich and poor households.
Economic growth means more total income. It does not decide who receives that income. Suppose the richest households receive a larger share of the extra income than the share of income they receive today. Then the economy grows and the income gap widens at the same time.
Why would growth favour the rich? Growth is often fastest in a few industries, such as finance or technology. Firms there compete for the few workers with the right skills, so the pay of those workers often rises first and fastest. Many of these workers are already among the highest earners. In Hestria, the richest fifth of households already receive 45% of income, against the 20% each fifth would receive if incomes were equal. Growth led by these industries is likely to raise that 45% share further.
Government policies can also make the conflict stronger. A lower top rate of income tax lets high earners keep more of each extra dollar, so some work and invest more, and growth can rise. But the cut in the top rate raises the income, after tax, of the highest earners only. Their share of total income rises, so the gap widens, unless growth raises other households' incomes by more.
Some policies that narrow the gap, such as education, take years to work. Education and training for workers with few skills raise their productivity and their pay. But the gain arrives only when the trained workers are in jobs, often years later.
So growth does not always widen the income gap. Growth from better education can raise real output and narrow the gap together. Whether growth widens the gap depends on which industries grow and on what the government does with taxes and spending.
Real Example: Brazil's real GDP grew in every year from 2003 to 2010 except 2009. Over 2001 to 2015, income inequality in Brazil also fell. The World Bank links this fall to fast-growing jobs in the formal sector (registered, taxed jobs), higher real wages and government payments that move income to poorer families. So in Brazil, years of growth came with a narrowing gap.
Exam Matters: When you explain this conflict, name one policy or one growing industry and follow it to both objectives: what it does to real output, and what it does to the income gap.
Governments aim for steady growth in real output, at a rate the economy can sustain.
Governments want inflation that is low and also stable, because each word protects people from a different harm.