Policy makers usually use Fiscal policy to alter the level, timing or composition of government expenditure and/or the level, timing or structure of tax payments. And they use
Monetary policy to alter the supply of money and/or credit and also to alter interest rates.
But some policies are not always successful; a good example was the decision to use monetary policy to solve the liquidity trap. This policy aimed to reduce interest rates and stimulate investment spending. But interest rates had already fallen to almost zero and nominal interest rates couldn’t fall below zero (so people would hold on to cash rather than make a loan.) In that environment, expansionary monetary policy raised the supply of money, but because interest rates couldn’t fall any further, the extra liquidity did not have any effect.
Unemployment is one of the economic problems that policy makers try to improve. Each type of unemployment requires different remedial policies. There are three main types of unemployment: frictional, structural and demand deficient unemployment. Both frictional and structural unemployment require microeconomic policies to improve the structure of the labour market. However, macroeconomic policy must be applied to improve Keynesian unemployment.
Frictional unemployment could be reduced by policies which improve the provision of information concerning job vacancies.
Structural unemployment could be reduced by policies designed to improve the occupational mobility of labour.
To help resolve Keynesian unemployment, macroeconomic policies must be applied to increase the level of aggregate demand in the economy.
There is difficultly in trying to specify what the desirable level of unemployment is. And therefore it is not easy to specify the precise level of unemployment consistent with the theoretical concept of full employment especially with changes in the size of the working population.
Trying to maintain a relatively stable price level is another of the main policy goals pursued by Western governments. However, like unemployment, inflation is not perfectly anticipated, it is very difficult to define what constitutes an acceptable rate of inflation as it is influenced by changing economic, political and historical circumstances. And so trying to formulate an accurate policy will be extremely tough.
A considerable degree of uncertainty remains over the precise values of the parameters of models used. This uncertainty influences the way in which policy instruments are used in order to achieve certain declared objectives. It is not sufficient that the policy maker knows the general direction of the effect of any of a change in a policy instrument on the target variables. They must also know how much the target variables respond to a change in an instrument. Such precise econometric evidence is hard to gather in the real world and in practice there are a variety of estimates of the size and timing of policy multipliers.
Every government is concerned with the distribution of income and wealth both between individuals and regions within an economy. Their general aim is to ensure a more equitable distribution. Most policies have distributional effects that must be taken into consideration. For example, the introduction of more complicated tax systems are likely to bear more heavily on small than large firms who already possess sophisticated financial accounting systems.
Distribution aims are the subject of a considerable degree of controversy but at the very least; policy makers must take into consideration the distributional effects of macroeconomic policies adopted.
There may be potential conflicts between aims of macroeconomic policy. It is very difficult for a policy maker to achieve all aims simultaneously by using one policy instrument. For example, a policy decision might be made to maintain a fixed exchange rate and attempt to correct a balance of payments deficit by reducing imports by domestic deflation. If this is the case, there is a potential conflict between full employment and balance of payments equilibrium for a country with a fixed exchange rate.
Because of these potential conflicts the policy maker must allocate priorities to the various objectives before making a decision.
All policy changes operates with a lag i.e. a period of time before it is effective. There is the inside lag, which is the time taken for an authority to initiate a policy change. Also, there is the outside lag, which is the time taken for that policy change to influence the target variables.
The inside lag will normally be a discrete lag in that nothing at all will happen until the policy change is initiated. However, there will be a definite time lapse between the recognition of the need for a policy change and when the policy change is implemented. If, on the other hand, a package of policy changes is introduced the inside lag may be spread out over a period of time.
The outside lag can also be divided into:
- The time taken to influence the intermediate policy variables (e.g. the time between a tax rate change and its influence on aggregate demand).
- The time lag between the change in the intermediate policy variables and the target policy variables (e.g. the time gap between a change in aggregate demand and the level of employment).
The outside lag is a distributed lag, as the effects of a policy change will spread over a period of time. For example, if policy makers decide to decrease taxes, it will take some time for consumers to adjust their pattern of consumption and their response to a rise in disposable income is likely to continue over several periods.
The length of time associated with the outside lag is unlikely to be constant. The time lag involved would be likely to vary depending on: whether fiscal or monetary policy changes are initiated; the economy at the time of the policy changes; and the way expectations are formed.
Decisions within an economy are normally taken with regard to expected rather than actual values of variables. Because of this, there are two problems. Firstly, policy changes are likely to influence expectations. For example, an announcement that the rate of monetary expansion is about to be increased may cause an increase in the expected rate of inflation. These expectations are likely to influence the behaviour of economic units so that the effect of monetary expansion may be felt mainly in price rather than quantity changes.
The second problem exists because of disagreement on how expectations are formed. This creates a problem for the policy maker, as there will be great difficulty in trying to model these expectations.
How successful a policy turns out to be will partly depend on forecasts of the future course of the economy. Forecasts are essential to the policy maker as they provide a frame of reference so that the authorities can allow for lags in the response of the economy to planned policy changes.
Policy makers will have to examine a range of available information before formulating a successful policy.
Recent history and the latest statistical data on certain key economic variables (i.e. data on unemployment, prices, investment, exports, imports etc.) will give an indication of the current state of the economy and its likely future course. However, this data takes time to collect, process and analyse. Gaps also exist in the information gathered i.e. (the black economy) in which income and employment is generated but the tax authorities do not know the exact amount of income and employment that exists within this part of the economy, and so the actual current state of the variables is not known for certain.
Because of these imperfections the policy maker needs to begin by assessing the present state of the economy before being able to forecast its most likely future course taking in account that the information gathered is not totally accurate.
In addition, a natural disaster (i.e. earthquake) or exogenous shocks (i.e. oil shock 1973-1974) could seriously damage the economy and so the implemented policy may no longer be useful. But policy makers and economists have no way of predicting sudden shocks to the economy.
In conclusion, policy makers are faced with many constraints when they attempt to formulate macroeconomic policy.
One of the most significant constraints is the fact that policy makers do not have perfect information of the current economy. There are gaps in the information and there is no way of gathering present information of the economy as the data takes time to collect.
When formulating macroeconomic policy, different policy makers will base their new policy on theoretical models. The problem here is that there are numerous models with different views and assumptions as there is no ‘true’ model. Also, it is difficult to predict accurately what the desirable rate of inflation and employment is. Subsequently, not all policies will succeed.
When a policy is established, time lags exist, which means that it may take some time before a problem is noticed and for a policy to be developed (inside lag) and then there is the outside lag, which is the time it will take before the results of the policy can be seen. Time lags are not constant and as a result it is possible for stabilisation policy to be destabilising. During these time lags, exogenous shocks may occur which may mean that the policy is not effective anymore.
Lastly, policy makers have to be very careful when formulating new policies, as they will want to maintain their credibility and Governments their electoral appeal. This will mean that their policies must be successful and the results must be visible to the general public in order for them to support the introduction of this policy and the Government.
References:
Frugman, Paul R - Brookings Panel on Economic Activity (1998).
Argy, Victor - International Macroeconomics: Theory and Policy (1994)
Sloman, John - Economics (2002)
Walsh, Carl – Monetary Theory and Policy (2003)
Mankiw, N Gregory - Macroeconomics (fifth edition) (2002)