GOVERNMENT MACRO INTERVENTION Broad topic objectives: To explain; The aims of macro policies The Phillips curve & Laffer curve The possible conflicts in policy framework

Introduction and aims Reading & discussion tasks from page 265. Highlight the major macroeconomic objectives. Compare your answers.

Aims of macroeconomic policy 1. Sustainable economic growth 2. Low & stable price inflation 3. Equilibrium or stable BOP position 4.Full employment/low unemployment . 5.Minimal exchange rate fluctuations

Relationship between inflation & unemployment. It is depicted by the ‘Phillips curve’ Its was developed by prof A.W. Phillips of New Zealand but it was Milton Friedman who put it into mainstream econ thinking in the 1970’s.

In 1958 ,Phillips plotted 95 years of data of UK wage inflation against unemployment. He found an inverse relationship btn inflation and unemployment at least in the SR

i.e. A fall in unemployment may cause higher inflation due to the extra AD generated leading to eventual rise in prices. Task: draw fig 10.20 page 267. [short run Phillips curve] NB: NAIRU is defined where the curve cuts the x axis

The long run Phillips curve Its also called the expectations – augmented Phillips curve. Milton Friedman argued that the SR curve is drawn at a given level of inflation expectations. As expectations rises, the curve will shift upwards at the level of NAIRU. .

There will be no trade off btn inflation & unemployment in the LR leading to a vertical LR Phillips curve. Prep- page 268

Task : page 266 Read & make short notes on the relationship between internal & external value of money. Discuss on the uniqueness of this relationship. It’s the relationship btn inflation & exchange rate

Relationship between BOP & inflation It’s shown by the J-curve effect. High inflation reduces price competitiveness & export revenue. Imports expenditures rise worsening the current account balance. Again, a current account surplus may raise net exports & AD due to high incomes.

High AD may raise domestic prices and reduce the internal value of money. However, the rising net X may cause the exchange rate to rise which makes M cheaper. This may encourage local firms to reduce their prices too.

Problems arising from policy conflicts (page 269) E.g. pursuit of a low rate of inflation may increase unemployment according to Phillips curve. To avoid conflicts btn policy objectives a govt must employ separate policies for each objectives.

E.g. to reduce unemployment, a government may cut taxes instead of raising money supply. Task: copy the definition of Tinberg’s rule from page 269 Read the hand out from economicscafé.com

Economics Lecture Notes – Chapter 12 http://www.economicscafe.com.sg/economics-lecture-notes-chapter-12/ Prep: page 270

Government failure Occurs when govt intervention reduces rather than increasing economic performance. i.e. intervention worsening market failure E.g. To correct a negative output gap, a govt may underestimate the national income multiplier.

Too much spending will thus cause a positive output gap! In other cases, policy effectiveness is affected by time lags e.g. changes in tax structures takes time to construct & administer.

Some policies may also be counter-cyclical i. e Some policies may also be counter-cyclical i.e. going against fluctuations in economic activity. E.g. during a boom the Fed may raise interest rates to encouraging savings & reduce borrowings.

Economic agents may however continue to borrow & spend if they are optimistic about the future. The failure also manifest in the implementation of political manifestos by new govts.

LAFFER CURVE: It shows the relationship between tax rates and tax revenue collected by governments. As tax rates increases, tax revenue collected increases up to a certain point. There’s an optimum tax rate that must be set so as to maximize tax revenues.

Raising tax rate beyond the optimum rate would be govt failure & would encourage tax evasion. A rate of 0% and 100% will yield no tax revenue Explain why this is so

Plenary Read the summary from page 272 Do the revision questions from page 272.