The Instruments of macroeconomic

policy..

Macroeconomic policy is concerned with the operation of the economy as a whole. In broad
terms, the goal of macroeconomic policy is to provide a stable economic environment that is
conducive to fostering strong and sustainable economic growth, on which the creation of
jobs, wealth and improved living standards depend. The key pillars of macroeconomic
policy are: fiscal policy, monetary policy, exchange rate policy, Trade Policy, Price
and income Policies. This brief outlines the nature of each of these policy instruments and
the different ways they can help promote stable and sustainable growth.

1: Fiscal policy
Fiscal policy operates through changes in the level and composition of government
spending, the level and types of taxes levied and the level and form of government
borrowing. Governments can directly influence economic activity through recurrent and
capital expenditure, and indirectly, through the effects of spending, taxes and transfers on
private consumption, investment and net exports.

Under current institutional arrangements, fiscal policy is the only arm of macroeconomic
policy directly controlled by government.

As an instrument for stabilising fluctuations in economic activity, fiscal policy can reflect
discretionary actions by government or the influence of the ‘automatic stabilisers’. A fiscal
stimulus package is an example of discretionary action by government intended to support
aggregate demand by increasing public spending and/or cutting taxes.

The ‘automatic stabilisers’ refers to certain types of government spending and revenue that
are sensitive to changes in economic activity, and to the size and inertia of government
more generally. They have a stabilising effect on fluctuations in aggregate demand and
operate without requiring any specific actions by government. For example, if the economy
slows, on the revenue side of the budget the amount of tax collected declines because
corporate profits and taxpayers’ incomes fall; on the expenditure side, unemployment
benefits and other social spending increases. The effects of these changes tend to offset
part of the decline in aggregate demand that would otherwise occur. This cyclical sensitivity
makes fiscal policy automatically expansionary during downturns and contractionary during
upturns in economic activity.

At least conceptually, the operation of the automatic stabilisers over the economic cycle
should have no effect on the underlying structural position of the budget. A short-term
cyclical deterioration in the budget bottom line should be reversed as economic conditions
improve.

As well as having a short-term stabilisation role, fiscal policy can also be framed against
longer-term objectives. This can include ensuring the long-term sustainability of the budget
and its capacity to meet future challenges, such as population ageing, and seeking to
increase the long-term growth potential of the economy, through investments in areas such
as infrastructure and education.

2: Monetary Policy

Monetary policy is a central bank's actions and communications that manage the

money supply. The money supply includes forms of credit, cash, checks, and
money market mutual funds. The most important of these forms of money is
credit. Credit includes loans, bonds, and mortgages. 

Monetary policy increases liquidity to create economic growth. It reduces liquidity

to prevent inflation. Central banks use interest rates, bank reserve requirements,
and the number of government bonds that banks must hold. All these tools affect
how much banks can lend. The volume of loans affects the money supply.
Key Takeaways

 The Federal Reserve uses monetary policy to manage economic growth,

unemployment, and inflation. 
 It does this to influence production, prices, demand, and employment.
 Expansionary monetary policy increases the growth of the economy, while
contractionary policy slows economic growth. 
 The three objectives of monetary policy are controlling inflation, managing
employment levels, and maintaining long term interest rates. 
 The Fed implements monetary policy through open market operations,
reserve requirements, discount rates, the federal funds rate, and inflation
targeting.

Three Objectives of Monetary Policy

Central banks have three monetary policy objectives.1 The most important is to
manage inflation. The secondary objective is to reduce unemployment, but only
after controlling inflation. The third objective is to promote moderate long-
term interest rates.

The U.S. Federal Reserve, like many other central banks, has specific targets

for these objectives. It wants the core inflation rate to be around 2%.2

Beyond that, it prefers a natural rate of unemployment of between 3.5% and

4.5%.3

The Fed's overall goal is healthy economic growth. That's a 2% to 3% annual

increase in the nation's gross domestic product.4

Types of Monetary Policy

Central banks use contractionary monetary policy to reduce inflation. They
reduce the money supply by restricting the volume of money banks can lend. The
banks charge a higher interest rate, making loans more expensive. Fewer
businesses and individuals borrow, slowing growth.

Central banks use expansionary monetary policy to lower unemployment and

avoid recession. They increase liquidity by giving banks more money to lend.
Banks lower interest rates, making loans cheaper. Businesses borrow more to
buy equipment, hire employees, and expand their operations. Individuals borrow
more to buy more homes, cars, and appliances. That increases demand and
spurs economic growth.5

Monetary Policy vs. Fiscal Policy

Ideally, monetary policy should work hand-in-glove with the national

government's fiscal policy. It rarely works this way. Government leaders get re-
elected for reducing taxes or increasing spending. As a result, they adopt an
expansionary fiscal policy. To avoid inflation in this situation, the Fed is forced to
use a restrictive monetary policy.

3: Exchange-Rate Policies

Because changes in exchange rates have macroeconomic effects on a nation’s

economy, nations need to think about what exchange rate policy they should
adopt. Exchange rate policies come in a range of different forms listed in Figure
1: let the foreign exchange market determine the exchange rate; let the market
set the value of the exchange rate most of the time, but have the central bank
sometimes intervene to prevent fluctuations that seem too large; have the central
bank guarantee a specific exchange rate; or share a currency with other
countries. Let’s discuss each type of exchange rate policy and its tradeoffs.

Floating Exchange Rates

A policy which allows the foreign exchange market to set exchange rates is referred to
as a floating exchange rate. The U.S. dollar is a floating exchange rate, as are the
currencies of about 40% of the countries in the world economy. The major concern with
this policy is that exchange rates can move a great deal in a short time.
Consider the U.S. exchange rate expressed in terms of another fairly stable currency,
the Japanese yen, as Figure 2 shows. On January 1, 2002, the exchange rate was 133
yen/dollar. On January 1, 2005, it was 103 yen/dollar. On June 1, 2007, it was 122
yen/dollar, on January 1, 2012, it was 77 yen per dollar, and on March 1, 2015, it was
120 yen per dollar. As investor sentiment swings back and forth, driving exchange rates
up and down, exporters, importers, and banks involved in international lending are all
affected. At worst, large movements in exchange rates can drive companies into
bankruptcy or trigger a nationwide banking collapse. However, even in the moderate
case of the yen/dollar exchange rate, these movements of roughly 30 percent back and
forth impose stress on both economies as firms must alter their export and import plans
to take the new exchange rates into account. Especially in smaller countries where
international trade is a relatively large share of GDP, exchange rate movements can
rattle their economies.
However, movements of floating exchange rates have advantages, too. After all,
prices of goods and services rise and fall throughout a market economy, as
demand and supply shift. If an economy experiences strong inflows or outflows of
international financial capital, or has relatively high inflation, or if it experiences
strong productivity growth so that purchasing power changes relative to other
economies, then it makes economic sense for the exchange rate to shift as well.

Using Soft Pegs and Hard Pegs

When a government intervenes in the foreign exchange market so that the
exchange rate of its currency is different from what the market would have
produced, it is said to have established a “peg” for its currency. A soft peg is the
name for an exchange rate policy where the government usually allows the
exchange rate to be set by the market, but in some cases, especially if the
exchange rate seems to be moving rapidly in one direction, the central bank will
intervene in the market. With a hard peg exchange rate policy, the central bank
sets a fixed and unchanging value for the exchange rate. A central bank can
implement soft peg and hard peg policies.

Suppose the market exchange rate for the Brazilian currency, the real, would be
35 cents/real with a daily quantity of 15 billion real traded in the market, as shown
at the equilibrium E0 in Figure 1(a) and Figure 1(b). However, the government of
Brazil decides that the exchange rate should be 30 cents/real, as shown in
Figure 1(a). Perhaps Brazil sets this lower exchange rate to benefit its export
industries. Perhaps it is an attempt to stimulate aggregate demand by stimulating
exports. Perhaps Brazil believes that the current market exchange rate is higher
than the long-term purchasing power parity value of the real, so it is minimizing
fluctuations in the real by keeping it at this lower rate. Perhaps the target
exchange rate was set sometime in the past, and is now being maintained for the
sake of stability. Whatever the reason, if Brazil’s central bank wishes to keep the
exchange rate below the market level, it must face the reality that at this weaker
exchange rate of 30 cents/real, the quantity demanded of its currency at 17
billion reals is greater than the quantity supplied of 13 billion reals in the foreign
exchange market.
The Brazilian central bank could weaken its exchange rate in two ways. One approach
is to use an expansionary monetary policy that leads to lower interest rates. In foreign
exchange markets, the lower interest rates will reduce demand and increase supply of
the real and lead to depreciation. This technique is not often used because lowering
interest rates to weaken the currency may be in conflict with the country’s monetary
policy goals. Alternatively, Brazil’s central bank could trade directly in the foreign
exchange market. The central bank can expand the money supply by creating reals,
use the reals to purchase foreign currencies, and avoid selling any of its own currency.
In this way, it can fill the gap between quantity demanded and quantity supplied of its
currency.

Figure 3(b) shows the opposite situation. Here, the Brazilian government desires a
stronger exchange rate of 40 cents/real than the market rate of 35 cents/real. Perhaps
Brazil desires the stronger currency to reduce aggregate demand and to fight inflation,
or perhaps Brazil believes that that current market exchange rate is temporarily lower
than the long-term rate. Whatever the reason, at the higher desired exchange rate, the
quantity supplied of 16 billion reals exceeds the quantity demanded of 14 billion reals.

Brazil’s central bank can use a contractionary monetary policy to raise interest rates,
which will increase demand and reduce supply of the currency on foreign exchange
markets, and lead to an appreciation. Alternatively, Brazil’s central bank can trade
directly in the foreign exchange market. In this case, with an excess supply of its own
currency in foreign exchange markets, the central bank must use reserves of foreign
currency, like U.S. dollars, to demand its own currency and thus cause an appreciation
of its exchange rate.

Both a soft peg and a hard peg policy require that the central bank intervene in the
foreign exchange market. However, a hard peg policy attempts to preserve a fixed
exchange rate at all times. A soft peg policy typically allows the exchange rate to move
up and down by relatively small amounts in the short run of several months or a year,
and to move by larger amounts over time, but seeks to avoid extreme short-term
fluctuations.

3:Trade Policy
 reforms—and other sorts of reform—are often hampered by the expectation that they
may be reversed. Adjusting to reform typically involves investments, but these
investments will not be made unless investors are confident that the reform will persist.
These problems are mitigated if a country has a ‘commitment mechanism’ guaranteeing
that the reform will be durable, and membership of a RIA can, in some circumstances,
provide such a mechanism (Fernandez and Portes 1998).
The commitment mechanism operates most obviously for trade policy—membership
requires that tariffs with member countries be cut, and reneging on agreed internal
liberalization is likely to bring swift retaliation by partner countries. However, it has been
argued that RIAs are valuable as commitment mechanisms for a much wider range of
measures. Although NAFTA was ostensibly about trade policy, an important part of its
motivation was the desire on the part of both the Mexican and US governments to lock
in the broad range of economic reforms that the Mexican government had undertaken in
the preceding years. The EU Articles of Agreement with eastern European accession
candidates are explicit in promoting ‘full integration into the community of democratic
nations.’ And the intervention of other Mercosur countries is credited with having
averted a military coup in Paraguay in 1996 (Survey on Mercosur, The Economist,
October 12, 1996). Paradoxically, it is even suggested that the value of a RIA as a
commitment mechanism is greatest in areas other than trade policy, because there is
already a way committing to tariff reductions—the tariff bindings of the GATT/WTO.

The Effects of Trade Policy

One possibility is that trade policy changes lead to the trade of new products and
varieties. Following the convention in the trade literature, we will use the term “product”
to describe genuinely new products, and the term “variety” to refer to a product/source
country pair. For example, if a policy change leads to the import of bananas, and
bananas were previously not imported, bananas will be considered a new product. If
bananas were already imported, but a trade policy change leads to imports from a new
country, such as Ecuador, Ecuadorian bananas will be referred to as a new variety. In
addition to the introduction of new imported products and varieties, trade policy may
also indirectly lead to the introduction of new domestic products. This could occur if the
technology and imported inputs for producing certain products domestically were
unavailable or too expensive prior to trade liberalization and the reduction of trade
barriers made their production economically viable. And vice versa, trade policy could
lead to the discontinuation of production of certain domestic products or varieties, if
these could no longer compete with imports following a reduction in import barriers. n
The empirical trade literature has extensively investigated the effects of trade on the
extensive margin (see Broda and Weinstein, 2006; Feenstra, 1994). However, the
majority of the work has focused on the impact of trade, not trade policy. Both Feenstra
and Broda and Weinstein rely on an identification strategy that does not use any
information on trade policy. They find very large effects of trade on the extensive
margin, but given that trade policy is completely absent from their work, it is not clear
that these effects can be interpreted as the outcome of trade policy.

5: Price and Income Policy

ncomes policies — wage and price controls, tax incentives, indexing, or other measures to fix
income shares — are generally used to control inflation. Governments very often resort to wage
and price controls during wartime to minimize war-induced inflations. The U.S. government
imposed such controls during World Wars I and II. However, economies are increasingly
experiencing high peacetime inflation rates and, while wage and price controls are one solution,
adherence by participants is difficult to obtain, unless the country is in a state of national
emergency. As a result, economists have proffered some alternative inflation-fighting incomes
policies that persuade — rather than coerce — participants into compliance. <

The theory behind incomes policies is that inflation is cost-induced. Workers seek higher wages.
Investors seek higher interest rates. Landlords desire higher rents. Owners want more profits.
As each group seeks to raise its position in the income distribution, costs rise and prices rise. As
prices rise, real income falls, and the cycle starts over with each group attempting to increase its
own income. What is needed is a mechanism for stopping the upward cost-price spiral in its
tracks.

    II. Wage and Price Controls

Absolute Controls The government can set or "freeze" the absolute level of wages and prices
to fix income shares. In an inflationary period, the frozen wages and prices are the maximum
prices to be paid. In a deflationary period, the frozen wages and prices are the minimum prices
to be paid. The most ubiquitous minimum price, however, is the minimum wage. Although the
government has imposed minimum prices in some individual markets, wage and price controls
are generally maximums, above which participants may not trade.

Rate of Growth Controls The government can set or "freeze" the annual percentage changes
for wages and prices to ensure that income shares remain fixed over time. In an inflationary
period, the annual percentage increase in wages and prices is limited to some maximum rate of
increase. In a deflationary period, the annual percentage decrease in wages and prices is
limited to some maximum rate

Legal Implications of the Controls

Voluntary Controls Very often, especially in a peacetime inflation, the government will set
benchmarks for pricing behavior. Since these benchmarks are not legally binding, firms may
adhere to or violate the controls as they see fit. Voluntary controls are "guidelines" or
"guideposts" rather than hard and fast rules legislated by the government. Generally, voluntary
controls are supported by "jawboning" or excessive verbal pressure on firms by the government
to adhere to the "guidelines".

Mandatory Controls If "guidelines" or "guideposts" prove unworkable, the government may

legally force firms to adhere to the controls. Mandatory controls are legislated rules for wage
and price behavior and may or may not come with penalties. If there are no penalties, then
violation becomes the rule and adherence is the exception. If there are penalties, adherence or
violation of the controls depends upon the excess of benefits from violation over the costs of the
penalties, if caught.

the end