Unit 5 Macroeconomic policy: Inflation and unemployment

5.2 The role of government: Introducing fiscal and monetary policy

How do the decisions and choices made by government policymakers affect the macroeconomy? We know from Unit 3 that governments are responsible for a large fraction—up to 20% in some countries—of aggregate expenditure on goods and services. Changes in government spending directly affect aggregate demand. Taxes and government transfers affect household incomes, so they affect aggregate demand too, through their effect on household consumption.

fiscal policy, discretionary fiscal policy

Fiscal policy refers to policies setting the levels of taxes, transfers, and goverment spending. Since fiscal policy affects the level of aggregate demand, it may be used by the government to stabilize the economy by changing aggregate demand; in this case, it may be described as discretionary fiscal policy. See also: aggregate demand.

monetary policy

Central bank or government actions aimed at influencing economic activity through changes in interest rates or the prices of financial assets. See also: quantitative easing.

demand shock

An unexpected or exogenous change in demand. In macroconomics a demand shock means a change in aggregate demand, such as a rise or fall in autonomous consumption, investment, or exports. In microeconomics it refers to an exogenous shift in the demand curve for a particular good. See also: supply shock, exogenous shock.

Of course, government spending, transfers, and the taxes that finance them depend on the extent to which goods like health, education, and pensions are provided by the public rather than private sector. As Figure 5.2 illustrates for the US, the extent of these activities—the size of government—increased over the twentieth century in many countries. But what is important for macroeconomic policy is that changes in government spending, transfers, and taxes change the current level of aggregate demand and thereby allow the government to influence GDP. This is what we mean by fiscal policy.

Our model of aggregate demand suggests another channel through which policymakers can affect macroeconomic outcomes. Aggregate investment depends on the interest rate, because a higher interest rate raises the cost for firms of borrowing to finance investments in machinery and buildings. Governments or central banks to which they delegate the power are able to control interest rates. So changing interest rates is another policy tool that can be used to affect aggregate demand. This is what we mean by monetary policy.

Voters hold governments responsible for inflation and unemployment. If the government can control, or at least influence, aggregate demand then we know from the combined supply-side, multiplier, and Phillips curve model used in Unit 4 that it can influence the levels of employment and unemployment, and that inflation will rise or fall depending on whether employment is above or below the supply-side equilibrium level. Therefore, if the economy is affected by a shock that raises unemployment or inflation, policymakers can respond. In the next section, we will analyse an example: we will use the model to explore how monetary and fiscal policy could be used to reduce unemployment and stabilize inflation after the economy experiences a negative demand shock.

The government budget

Government expenditure and transfers have to be paid for—in the longer term, if not immediately. If the tax revenue collected by the government in one year is exactly sufficient to finance its spending on goods and services (G), on fixed investment, and on transfers (benefits and pensions), then the government budget is balanced.

But if, for example, policymakers want to stimulate the economy by raising aggregate demand in a recession, they may want to raise expenditure without increasing taxation (since that would have a negative effect on demand). If it spends more in total than it receives in tax revenue, the government budget is in deficit. The government’s budget deficit is:

\[\begin{align*} &\text{(spending on goods and services + government fixed investment + transfers} \\ &\text{+ interest payments)} − \text{taxation} \end{align*}\]

The tools of fiscal and monetary policy

In this unit, we shall consider two different policymakers and how they intervene to influence aggregate demand and inflation. The two policymakers are the government, which sets fiscal policy, and the central bank, which sets monetary policy.

The tools of fiscal policy by which the government influences the economy are changes in spending and government revenues (mostly via taxation). Fiscal policy affects aggregate demand in three distinct ways:

• government spending on goods and services (such as education), G
• government investment (such as public infrastructure investment) which is a component of aggregate investment, I
• taxes and transfer payments (for example, benefits and pensions), which affect aggregate demand indirectly, to the extent that they affect household disposable income and hence aggregate consumption, C.

government budget deficit

If government spending exceeds its tax revenue in the same year, the government budget is in deficit and the size of the deficit is the difference between spending and tax revenue.

inflation target, inflation targeting

Inflation targeting is a form of monetary policy, where the central bank changes interest rates in order to influence aggregate demand and keep the economy close to an inflation target rate, which is normally specified by the government.

policy (interest) rate

The nominal interest rate set by the central bank, which applies to banks that borrow base money from each other, and from the central bank. Also known as: base rate, official rate. See also: real interest rate, nominal interest rate.

nominal interest rate

An interest rate is nominal if it is not corrected for inflation. The rates quoted by high-street banks on loans and savings accounts are nominal interest rates. See also: interest rate, rate of interest, real interest rate.

We assume that, as in the case in most high income and some middle income economies today, monetary policy is delegated to the central bank, which is given the task of controlling inflation. Typically, the government requires it to keep inflation as close as possible to a particular inflation target rate.

In normal times, central banks have a single tool that they directly control: the policy interest rate, also referred to as the policy rate. Changes in this interest rate feed through to changes in market interest rates (such as mortgage interest rates and rates on car loans), affecting the cost of borrowing for business investment, housing, and consumer durables, as well as the rewards from saving. The way that the central bank controls the policy rate, as well as how banks respond to changes in the policy rate is explained in Unit 6 (page 000), when we introduce money and banks.

Real versus nominal interest rates: The Fisher equation

Since inflation plays an important part in modelling the economy, it is necessary to draw attention to the distinction between the nominal and the real interest rate. We have previously emphasized the distinction between the nominal and real wage.

The policy rate set by the central bank is a nominal interest rate, as are most market interest rates. In any given currency if you are a borrower, the nominal interest rate on your debt tells you how many units of currency (dollars, euros, pounds, or whatever currency you use) you will have to pay in a year’s time in exchange for borrowing one unit of currency today. If you are a lender, it tells you how much you will receive in a year’s time by giving up one unit of currency today.

real interest rate

An interest rate corrected for expected inflation (that is, the nominal interest rate minus the expected rate of inflation). It represents how many goods in the future one gets for the goods not consumed now. See also: nominal interest rate, interest rate, rate of interest.

Fisher equation

The relation that gives the real interest rate as the difference between the nominal interest rate and expected inflation: real interest rate = nominal interest rate – expected inflation.

However, economic theory tells us that the interest rate that is relevant for spending and saving decisions in the economy as set out in Unit 3 is the real interest rate—the nominal interest rate adjusted for expected inflation.

Suppose you are offered an interest rate of 4% on a savings account. That might sound good, but if inflation is expected to be 4%, at the end of a year you would only be able to buy the same basket of goods as when you lent the money. So in real terms, you would not have received any compensation for lending the money: the real interest rate is zero. Note that it is expected inflation, not actual inflation, that matters when you decide whether to take up the offer—that is what affects your evaluation of the interest rate on the account.

Conversely, if you are a borrower, paying a 4% interest rate in a situation where prices rise by 4% over the year of the loan, you will be able to purchase the same consumption basket at the end of the year as at the beginning, without having to sacrifice any of your consumption to pay back the loan. Therefore, again, the real interest rate is zero. When evaluating an investment project, therefore, the expected inflation rate needs to be taken into account. For a given nominal interest rate, higher inflation reduces the real interest rate, reducing the real cost of borrowing.

More generally, the equation for the real interest rate is known as the Fisher equation, named after Irving Fisher, whose physical model of the economy we discuss in Unit 2 of The Economy 2.0 Microeconomics. The Fisher equation states that the real interest rate (per cent per annum) equals the nominal interest rate (per cent per annum) minus the inflation expected over the year ahead:

\[\begin{align*} r = i - \pi^E \space \text{(Fisher equation)} \end{align*}\]

The Fisher equation highlights the fact that for a given nominal interest rate, i, higher expected inflation, \(\pi^E\), reduces the real interest rate, r. Conversely, when prices are expected to fall over the year ahead—that is, expected inflation is negative, this raises the real interest rate above the nominal interest rate. Question 5.1 provides an example.

Monetary policy and real interest rates

There are several channels through which monetary policy affects aggregate demand. We shall discuss these in more detail in Sections 5.10 to 5.12. At this stage we simply rely on the assumption that by controlling nominal interest rates, the central bank can also effectively control real interest rates. The Fisher equation tells us that, as long as inflation is sufficiently predictable (that is, \(\pi^E\) is known), this will indeed be the case.