Government and the Macro‑economy – Monetary Policy, Fiscal Policy, Supply‑side Policy and the Foreign‑exchange Rate
1. The Basic Economic Problem (Syllabus 1‑2)
- Scarcity – limited resources to satisfy unlimited wants.
- Opportunity cost – the next best alternative foregone when a choice is made.
- Production Possibility Curve (PPC)
- Shows the maximum combinations of two goods that can be produced with existing resources and technology.
- Points on the curve = efficient use of resources; inside the curve = inefficiency; outside the curve = unattainable.
- Outward shift = economic growth (more resources or better technology); inward shift = recession or loss of resources.
- Price mechanism – markets allocate resources through the interaction of supply and demand; changes in prices (including the exchange‑rate) signal where resources should flow.
2. Allocation of Resources (Syllabus 2)
2.1 Demand, supply and price determination
- Demand curve: inverse relationship between price and quantity demanded (law of demand).
- Supply curve: direct relationship between price and quantity supplied (law of supply).
- Equilibrium – where the two curves intersect; market‑clearing price and quantity.
2.2 Elasticities
| Elasticity | Definition | Typical value for a good |
|---|
| Price elasticity of demand (PED) | % change in quantity demanded ÷ % change in price | Usually elastic (>1) for luxuries, inelastic (<1) for necessities. |
| Price elasticity of supply (PES) | % change in quantity supplied ÷ % change in price | More elastic in the long‑run when firms can adjust capacity. |
| Income elasticity of demand (YED) | % change in quantity demanded ÷ % change in income | Positive for normal goods, negative for inferior goods. |
| Cross‑price elasticity (XED) | % change in quantity demanded of Good A ÷ % change in price of Good B | Positive for substitutes, negative for complements. |
2.3 Market failure and government intervention
- Public goods – non‑rival and non‑excludable (e.g., street lighting). Market under‑provides them → government provision.
- Merit goods – socially desirable but under‑consumed (e.g., education, vaccinations). Government may subsidise.
- Externalities – spill‑over effects on third parties.
- Negative externality (pollution) → tax or regulation.
- Positive externality (research) → subsidy or public funding.
- Market power – monopoly or oligopoly can lead to higher prices and lower output; competition policy or regulation may be required.
2.4 Mixed economy
- Combination of market forces and government intervention.
- Government role: provide public goods, correct market failures, redistribute income, maintain macro‑economic stability.
3. Micro‑economic Decision‑makers (Syllabus 3)
3.1 Money and banking
- Functions of money – medium of exchange, store of value, unit of account, standard of deferred payment.
- Forms of money – commodity (gold, silver), fiat (banknotes, coins), electronic (bank deposits, digital currencies).
- Commercial banks
- Accept deposits and provide loans.
- Operate on a fractional‑reserve basis – only a fraction of deposits is kept as reserves (reserve‑requirement ratio).
- Money creation: each round of lending creates new deposits, expanding the money supply.
- Central bank – issues national currency, acts as banker’s bank, regulates the money supply, sets the policy interest rate, maintains financial stability and, where relevant, manages the exchange‑rate regime.
3.2 Households and workers
- Decisions based on income, preferences, interest rates, and expectations.
- Saving vs. consumption – influenced by the real interest rate and confidence about future income.
- Labour supply – affected by wage rates, working conditions, and non‑pecuniary factors (e.g., job satisfaction).
3.3 Firms
- Goal: maximise profit (TR – TC). Decisions on output, pricing, investment and labour demand.
- Cost structure: fixed costs, variable costs, average and marginal cost curves.
- Factors of production – land, labour, capital, entrepreneurship; productivity influences supply.
3.4 Types of markets
- Perfect competition – many buyers/sellers, homogeneous product, free entry/exit.
- Monopoly – single seller, price‑setter, barriers to entry.
- Monopolistic competition – many sellers, differentiated products.
- Oligopoly – few large firms, inter‑dependent pricing.
4. Government & the Macro‑economy (Syllabus 4)
4.1 Fiscal policy
- Government spending (G) – direct injection of demand; multiplier effect depends on marginal propensity to consume (MPC).
- Taxation
- Direct taxes (income, corporation) – affect disposable income and investment.
- Indirect taxes (VAT, excise) – raise prices, reducing consumption.
- Budget balance – surplus (revenues > spending) or deficit (spending > revenues). Deficits financed by borrowing (government bonds).
- Fiscal multiplier – ΔY = k·ΔG (or ΔT) where k = 1/(1‑MPC) in a simple model.
4.2 Monetary policy (covered in detail later)
- Policy interest rate, open‑market operations, reserve‑requirement ratio, direct foreign‑exchange intervention.
4.3 Supply‑side policy
- Improving productivity – investment in education, training, research & development, infrastructure.
- Labour market reforms – flexible wages, reduced trade‑union power, active labour‑market programmes.
- Regulatory reforms – deregulation, simplification of business‑start‑up procedures, competition policy.
- Tax incentives – lower corporate tax, investment allowances, R&D credits.
4.4 Macro‑economic aims
| Aim | Typical indicator | Policy tools used |
|---|
| Price stability (low inflation) | Consumer Price Index (CPI) growth | Monetary policy (interest rates, OMO) |
| Full employment | Unemployment rate | Fiscal expansion, monetary easing, supply‑side reforms |
| Economic growth | Real GDP growth rate | Combination of fiscal, monetary and supply‑side measures |
| External balance | Current‑account balance, exchange‑rate level | Exchange‑rate policy, capital‑account measures |
| Equitable distribution of income | Gini coefficient, poverty rates | Progressive taxation, welfare programmes |
5. Monetary‑policy tools that move the exchange‑rate (Syllabus 4.3, 6.3‑6.4)
- Policy interest‑rate adjustments
- Higher rates → higher return on domestic assets → ↑ demand for domestic currency → appreciation.
- Lower rates → lower return → ↓ demand → depreciation.
- Open market operations (OMO)
- Buy government securities → inject reserves → lower short‑term rates → depreciation.
- Sell securities → withdraw reserves → raise rates → appreciation.
- Reserve‑requirement ratio
- Cutting the ratio frees bank lending capacity, pushes rates down → depreciation.
- Raising the ratio tightens credit, pushes rates up → appreciation.
- Direct foreign‑exchange intervention
- Buy foreign currency (sell domestic) → increase supply of domestic currency → depreciation.
- Sell foreign currency (buy domestic) → reduce supply of domestic currency → appreciation.
6. How changes in the exchange‑rate affect the wider economy (Syllabus 6)
| Variable |
Depreciation of the domestic currency |
Appreciation of the domestic currency |
| Exports |
Cheaper for foreign buyers → increase |
More expensive → decrease |
| Imports |
More expensive → decrease |
Cheaper → increase |
| Current‑account balance |
Improves if export response > import response |
Worsens if import response > export response |
| Inflation (price level) |
Cost‑push pressure from pricier imports |
Downward pressure – cheaper imported goods |
| Domestic output (GDP) |
Potential rise via higher net exports |
Potential fall if net exports contract |
| Unemployment |
May fall if output rises |
May rise if output falls |
Illustrative calculation
Exchange‑rate moves from $1.20 USD/£ to $1.30 USD/£ (an 8.3 % depreciation of the pound). A UK firm sells a product for £100:
\[
\text{Revenue}_{\text{old}} = 100 \times 1.20 = \$120 \\
\text{Revenue}_{\text{new}} = 100 \times 1.30 = \$130
\]
The firm receives $10 more, demonstrating how depreciation can boost export earnings.
7. Interaction between monetary and fiscal policy (Syllabus 4.4)
| Policy mix |
Typical effect on the exchange‑rate |
Key macro‑economic aim(s) affected |
| Expansionary fiscal policy + tight monetary policy |
Fiscal expansion raises domestic demand → higher imports → depreciation pressure; tight monetary policy raises rates → appreciation. Net effect depends on relative magnitude. |
Growth vs. inflation control |
| Contractionary fiscal policy + expansionary monetary policy |
Reduced government spending lowers import demand (tends to appreciate); lower rates push rates down (tends to depreciate). Again, the dominant effect decides the outcome. |
Unemployment vs. price stability |
8. Exchange‑rate regimes and policy autonomy (Syllabus 6)
- Floating (flexible) rate – market determines the rate; central bank retains full control over interest rates and money supply.
- Fixed (pegged) rate – central bank commits to a specific rate; must intervene in the FX market, often sacrificing independent monetary policy.
- Managed float (dirty float) – predominantly market‑driven but the bank intervenes occasionally to smooth excessive volatility.
9. Links to economic development (Syllabus 5)
- Export‑led growth – many developing economies rely on a competitively priced (depreciated) currency to stimulate demand for primary commodities or manufactured goods.
- Terms‑of‑trade – a strong currency lowers the cost of imported technology, health care and education, raising living standards; however, it can erode export competitiveness.
- Balance‑of‑payments sustainability – persistent current‑account deficits may force a devaluation or the need for external borrowing, exposing the economy to exchange‑rate risk.
- Policy choice dilemma – developing countries often face a trade‑off between maintaining a stable exchange‑rate to attract foreign investment and allowing depreciation to boost export earnings.
10. Evaluation – trade‑offs and limits of monetary policy (Syllabus 6)
- Inflation vs. export competitiveness
- Depreciation can raise export volumes but also raises import prices, creating cost‑push inflation.
- If inflation expectations become unanchored, the central bank may be forced to raise rates, undoing the exchange‑rate gain.
- Growth vs. financial stability
- Low rates stimulate borrowing and investment, supporting GDP, but can fuel asset‑price bubbles (housing, equities).
- Policy independence under fixed regimes
- Defending a peg often requires high interest rates, which can suppress domestic demand and increase unemployment.
- Large reserve losses may force a devaluation, damaging credibility and raising borrowing costs.
- External shocks
- Global risk‑aversion (e.g., a financial crisis) can trigger capital outflows regardless of domestic rates, leading to abrupt depreciation.
- Time lags
- Monetary‑policy actions affect the exchange‑rate relatively quickly, but the impact on output and inflation may take several quarters to materialise.
11. Real‑world examples (useful for exam answers)
- United Kingdom, 2016‑2017 (Brexit) – BoE cut rates and expanded asset‑purchase programme; the pound fell ~15 %, giving a short‑term boost to export‑oriented sectors such as aerospace and pharmaceuticals.
- Japan, 2010s (Abenomics) – Bank of Japan kept policy rates near zero and pursued massive quantitative easing; the yen weakened, supporting automobile and electronics exporters while keeping import‑price inflation modest.
- Argentina, 2018 (peg defence) – To defend a pegged peso, the central bank raised rates sharply and used foreign‑exchange reserves. Inflation fell, but the economy entered recession, illustrating the growth‑inflation trade‑off.
- China, 2020‑2022 (managed float) – The People’s Bank of China intervened intermittently to limit excessive yuan appreciation, balancing export competitiveness with capital‑account stability.
12. Suggested diagrams (for exam illustration)
- Foreign‑exchange market: supply‑and‑demand diagram showing the effect of a higher domestic interest rate (right‑ward shift in demand) → appreciation.
- Money‑market (LM) diagram: OMO shifts the LM curve left/right, linking changes in interest rates to the FX movement.
- AD‑AS diagram: a depreciation shifts AD right (through net‑export increase); illustrate the resulting impact on output and price level.
- Balance‑of‑payments diagram: current‑account surplus/deficit before and after a depreciation, with the capital‑account shown.
- PPC diagram: outward shift representing growth from supply‑side policies (e.g., education, infrastructure).
13. Summary checklist (exam revision aid)
- Identify the monetary‑policy tool being used (interest rate, OMO, reserve ratio, direct FX intervention).
- State the expected direction of the exchange‑rate movement (appreciation or depreciation) and explain the underlying mechanism.
- Analyse the likely impact on:
- Exports and imports
- Current‑account balance
- Inflation and price stability
- Domestic output, employment and growth
- Consider the exchange‑rate regime – does it limit the central bank’s freedom to act?
- Evaluate trade‑offs (inflation vs. growth, financial stability, policy independence, external shocks, time lags).
- Link the analysis to the broader macro‑economic aims (price stability, full employment, sustainable balance of payments) and, where relevant, to development outcomes.
- Recall relevant real‑world examples to support your answer.