How the priority given to macroeconomic objectives has changed

Overview

Main objectives of macroeconomic policy and institutional design entrench a particular ranking of objectives.

What you need to know

Answer each one before you reveal it.

Questions from this subtopic

Each one with the model answer underneath.

1. 1

   What are the main objectives of macroeconomic policy?

   Model answer

   The traditional four are steady economic growth, a low and stable rate of inflation, a high level of employment and low unemployment, and a sustainable position on the balance of payments. Governments now generally add several more: a fair distribution of income and wealth, sound and sustainable public finances, the stability of the financial system, and environmental sustainability, meaning growth that does not depend on depleting natural resources or on emissions that impose costs later. Some also identify regional balance as an objective in its own right, since national averages can conceal large and persistent differences between parts of a country.

2. 2

   Explain why a government cannot pursue all its macroeconomic objectives at once.

   Model answer

   Because the objectives conflict and there are fewer instruments than targets. Expanding demand to raise growth and employment adds to inflation once capacity is limited and raises imports, worsening the external position; restraining demand to control inflation costs output and jobs. Consolidating the public finances withdraws demand and often falls hardest on lower incomes, setting sustainability against growth and against distribution. Raising taxes to improve distribution may weaken incentives, setting equity against efficiency. Pursuing growth by the cheapest available means may conflict with environmental objectives. Each instrument affects several objectives simultaneously, so improving one generally means accepting a worse outcome on another, and the ranking is a political choice rather than something economics can settle.

3. 3

   In broad terms, how has the priority attached to macroeconomic objectives shifted over recent decades?

   Model answer

   The emphasis has moved several times. In the decades after the Second World War, full employment was treated as the overriding objective and demand management was the principal tool. As inflation accelerated and proved persistent, the control of inflation displaced employment at the top of the list, and institutions were redesigned to entrench that priority. Once inflation was low and stable, attention moved towards the supply side, productivity and long-run growth. A severe financial crisis then added the stability of the financial system as an objective in its own right and brought the sustainability of the public finances to the front. More recently, environmental sustainability and the distribution of income, both between individuals and between regions, have been given far greater weight than they once carried. The pattern is that priorities move in response to whichever objective has most conspicuously failed.

4. 4

   Analyse why the control of inflation came to be treated as the dominant macroeconomic objective.

   Model answer

   Experience of a sustained period of high and variable inflation demonstrated costs that had previously been underestimated: savings and fixed incomes were eroded, relative price signals were obscured so resources were misallocated, long-term contracts and investment became difficult, and effort was diverted into protecting against price movements. It also became clear that attempting to hold unemployment below the rate the economy could sustain did not deliver permanently higher employment but instead produced accelerating inflation, so the apparent trade-off that had justified giving employment first place did not hold in the long run. Once inflation is embedded in expectations it is extremely costly to remove, requiring a deep recession, so preventing it came to be seen as protecting employment rather than sacrificing it. That reasoning led to explicit inflation targets and to independent central banks charged with meeting them.

5. 5

   Why did the stability of the financial system become an explicit objective?

   Model answer

   A severe banking crisis demonstrated that price stability and stable growth are not sufficient: an economy can have low inflation and steady output while credit and asset prices build up imbalances that eventually collapse, and the resulting contraction in lending can produce a deeper and longer recession than any ordinary downturn. It also became clear that supervising each institution separately does not make the system safe, because risks accumulate collectively and identical prudent responses across all firms can be destabilising in aggregate. The cost of the crisis, in lost output, unemployment and public money committed to rescues, was large enough to justify treating stability as an objective in its own right rather than as a by-product of good monetary policy, which is why macroprudential instruments and bodies charged with using them were created.

6. 6

   Why has the sustainability of the public finances become an objective rather than merely a constraint?

   Model answer

   Successive shocks required very large increases in borrowing, leaving debt ratios far above their earlier levels, and at the same time ageing populations committed governments to rising spending on pensions, health and care that will continue regardless of the cycle. The combination means that a government that does not manage its debt deliberately will find the ratio rising indefinitely, and a large debt makes the budget sensitive to interest rates and removes the room to respond to the next shock. Treating sustainability as an explicit objective, with published rules and independent assessment of whether they are being met, is an attempt to counteract the natural bias towards spending now and taxing later, and to make the cost of borrowing decisions visible at the time they are taken rather than years afterwards.

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