Why governments target inflation, unemployment, the external balance and growth

Overview

Full employment not the same thing as zero unemployment, link between the growth objective and the unemployment objective and government publish its macroeconomic objectives instead of pursuing them privately.

What you need to know

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Questions from this subtopic

Each one with the model answer underneath.

1. 1

   Why does a government commit to a published numerical inflation target rather than simply promising to keep inflation 'low'?

   Model answer

   A published number anchors expectations, because firms setting prices and workers bargaining over wages can plan around a figure they believe will hold. A vague promise gives them nothing to anchor to, so they fall back on recent experience, which makes inflation self-perpetuating. A number is also testable, so the body responsible can be held to account when it misses.

2. 2

   Which four objectives dominate UK macroeconomic policy, and what is each one measured by?

   Model answer

   Price stability, measured by the annual percentage change in a consumer price index. Low unemployment, measured by the share of the labour force without work but seeking it. A sustainable balance of payments, measured principally by the current account balance as a share of GDP. Economic growth, measured by the annual percentage change in real GDP.

3. 3

   Why is price stability treated as an objective in its own right rather than only as a means to faster growth?

   Model answer

   Inflation imposes costs even when output is unaffected: it erodes the real value of savings and fixed incomes, redistributes arbitrarily from lenders to borrowers, and forces firms to spend resources repricing. Because these costs fall on identifiable people regardless of what happens to output, controlling inflation is a goal in itself and not merely an input into growth.

4. 4

   If inflation is costly, why does the government aim for a small positive rate rather than zero?

   Model answer

   A small positive rate gives room to cut real wages without cutting anyone's cash pay, which helps labour markets adjust when demand falls. It also keeps the economy away from deflation, which is harder to escape because interest rates cannot fall far below zero. Finally, measured inflation slightly overstates true inflation because indices struggle to capture quality improvement, so a measured target above zero is closer to genuine price stability.

5. 5

   Why does the government treat unemployment as a problem when the unemployed continue to receive benefit payments?

   Model answer

   Benefits transfer income but do not replace the output the unemployed would have produced, so the economy is permanently poorer by that lost output. Benefits are also financed by taxation, so employment brings a double gain to the public finances through higher tax receipts and lower spending. Beyond the arithmetic, long spells out of work erode skills and damage health, which reduces a person's future earning power.

6. 6

   Why is full employment not the same thing as zero unemployment?

   Model answer

   In any functioning economy some people are between jobs at any moment, because matching workers to vacancies takes time and because people quit to search for something better. This frictional unemployment is a sign that the labour market is reallocating labour, not that it has failed. Full employment therefore means that everyone willing to work at the going wage can find work reasonably quickly, which is consistent with a positive measured rate.

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