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Unit 5 Macroeconomic policy: Inflation and unemployment

5.4 The division of labour between fiscal and monetary policymakers

supply-side equilibrium
The economy is in supply-side equilibrium when the markets involved in the production of output are in equilibrium. In the WS–PS model it is the labour market equilibrium; that is, where the price-setting real wage equals the wage-setting real wage.
supply-side policies
Economic policies that are designed to improve the functioning of the economy by increasing productivity and international competitiveness, and reducing costs for producers. They include cutting taxes on profits, tightening conditions for the receipt of unemployment benefits, changing legislation to make it easier to fire workers, and the reform of competition policy to reduce monopoly power.

As illustrated in the previous section, both fiscal and monetary policy can be used to shift aggregate demand. In principle, either or both could be used to boost output, reduce unemployment, or control inflation. But our analysis of two policymakers responding to a demand shock reflects a fairly clear consensus that has emerged in recent decades, in an increasing number of high- and middle-income countries, about how they should be used in practice. Fiscal and monetary policy should be confined to two relatively restricted (but mutually consistent) objectives:

  • Monetary policy, operated by the central bank, should be used to keep the inflation rate as close as possible to an inflation target (most commonly 2%). We shall examine this objective in more detail in Section 5.10.
  • Both fiscal and monetary policies should aim to keep the economy close to supply-side equilibrium.

The limited nature of these objectives can be illustrated by stressing what monetary and fiscal policy do not aim to do within this framework.

In the language of microeconomics, the Phillips curve is the feasible frontier which constrains the ability of the policymaker to implement their preferred outcome. To analyse the policymaker’s problem explicitly using feasible sets and indifference curves, read The Economy 1.0 Section 15.4.

  • Supply-side policies are necessary to shift the equilibrium to one with lower involuntary unemployment: this should be the objective of supply-side policies.
  • In the case of monetary policy, the central bank will not always be able to stabilize inflation at its target without costs to the economy. In the face of an inflationary supply shock, the central bank’s job may be to push output and employment down, in order to bring inflation back towards target, by exploiting the Phillips curve.

In this unit, we take supply-side policies as given. We assume that government policy does not shift the WS and PS curves, but that they may be shifted by shocks (such as to commodity prices set in global markets). The focus here, therefore, is on policies that can help to stabilize the economy relative to this supply-side equilibrium when it encounters demand and supply shocks of the kind analysed in Unit 4.

In Unit 2, we discussed the effect on the supply-side equilibrium of changes in taxation and unemployment benefits. Here, we ignore the supply-side effects of fiscal policy.

Other policy regimes are available

common currency area, currency union, monetary union
A common currency area (sometimes called a currency union or monetary union) is group of countries that use the same currency. This means there is just one monetary policy for the group.
fixed exchange rate regime, target exchange rate regime
In a fixed exchange rate regime (or more accurately, a target exchange rate regime), the objective of monetary policy is to hold the exchange rate constant at a particular value, or within a narrow range of values, against one or more other currencies.

We should stress that while the division of labour between policymakers set out above has become increasingly common (we document this in more detail in Extension 5.9), it is certainly not universal. Alternative approaches to macroeconomic policy fall under the following broad categories and are explained in Unit 7.

  • In common currency areas (most notably the euro area) individual countries give up any independent control of monetary policy, which is set at the level of the common currency area as a whole.
  • In ‘fixed’ exchange rate regimes (the ‘Bretton Woods’ system put in place after the Second World War was a prime example) countries retain their own currencies, but monetary policy is dedicated to holding the exchange rate either fixed, or within a fairly narrow range, against one or more countries. However, in such regimes in contrast to common currency areas, countries do retain some monetary policy autonomy because the possibility remains that the exchange rate may change, either within the system, or by the country leaving the system.
  • In a number of countries today, and many more historically, the division of labour set out above does not apply: monetary and fiscal policy are both directly controlled by the government. China is an important country where this is the case. Annual macroeconomic policy goals are integrated in the five-year plans of the Chinese State Council.

For now we focus on the implications of what can probably best be described as the typical approach to monetary and fiscal policy, as set out in the previous section.

The division of labour in action

Figure 5.6 shows the unemployment rate and estimates of the structural unemployment rate (the ‘NAIRU’) in Canada. It also shows the inflation rate and the inflation target.

The policymaker’s objective is to keep unemployment close to the structural rate (the inflation-stabilizing rate) and inflation close to its inflation target. The Bank of Canada was the second in the world to adopt inflation targeting (1991) with a target of 2%.

The predictions from Unit 4 are that when unemployment is above the structural rate, inflation falls and vice versa. This pattern is reflected in the Canadian data. It also shows a long period, from the mid-1990s to 2020, of successful macroeconomic policy with inflation stable and close to target and unemployment close to the series for structural unemployment, the NAIRU. We will come back to the sharp rise in inflation in 2021–2022.

The line chart depicts the inflaion-stabilizing unemployment (also known as equilibrium unemployment and NAIRU), unemployment rate and inflation rate in Canada from 1985 to 2022. The horizontal axis displays years from 1985 to 2022. The vertical axis that ranges from 0 to 12% displays 3 variables, NAIRU, unemployment rate and inflation rate respectively, all in percentages. The graph displays three lines. The bottom-most line, representing the inflation rate, begins at 4% in 1985, gradually climbing to nearly 6% by 1991. At this point, a 2% inflation target is adopted, and the inflation line fluctuates around this rate until 2020, before sharply rising to 7% in 2022. The NAIRU line shows a steady decline from 8% in 1986 to just over 6% in 2022, indicating a smooth, downward trend. The actual unemployment rate, initially at 11% in 1985, mirrors this trend to some extent but with significant volatility, including a notable peak to nearly 12% and a decrease to 8% in the following years. After stabilising from 1998, it undergoes dramatic changes again between 2019 and 2022.
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https://www.core-econ.org/macroeconomics/05-macroeconomic-policy-04-policymakers-division-of-labour.html#figure-5-6

Figure 5.6 Inflation-stabilizing (equilibrium) unemployment rate, unemployment rate, and inflation rate in Canada (1985–2022).

OECD. 2023.
Note: The indicator of the inflation-stabilizing unemployment rate is the NAIRU; inflation rate uses the CPI.

Question 5.2 Choose the correct answer(s)

Read the following statements and choose the correct option(s).

  • Inflation targeting is a common goal of central banks in most economies.
  • One aim of monetary policy is to keep the government’s debt within sustainable levels.
  • With monetary policy, there may be a trade-off between inflation and employment.
  • When the economy is in supply-side equilibrium, monetary and fiscal policy can be used to reduce involuntary unemployment by raising aggregate demand to change the levels of output and employment.
  • In most economies, central banks aim to maintain a steady rate of inflation (usually around 2%).
  • Keeping the government’s debt within sustainable levels is a goal of fiscal policy.
  • In some situations, like an inflationary supply shock, the central bank may have to push output and employment down to bring inflation back towards its target rate.
  • Monetary and fiscal policy cannot be used when the economy is in supply-side equilibrium.