Government Macro‑economic Intervention – Conflicts Between Full Employment and Balance‑of‑Payments Stability
1. The Basic Economic Problem (Syllabus Unit 1)
- Scarcity – resources are limited but wants are unlimited.
- Choice & Opportunity Cost – deciding how to use resources means giving up the next best alternative.
- Production Possibility Curve (PPC)
- Shows maximum output of two goods when all resources are efficiently employed.
- Points inside the curve = under‑utilisation (unemployment); points outside are unattainable.
- Movement along the curve illustrates opportunity cost (e.g., to produce more cars we must give up some computers).
2. Allocation of Resources (Syllabus Unit 2)
2.1 Market Mechanism – Demand and Supply
- Demand curve – downward sloping; quantity demanded falls as price rises.
- Supply curve – upward sloping; quantity supplied rises as price rises.
- Market equilibrium – where D = S; determines the market price and quantity.
- Disequilibrium:
- Surplus (excess supply) → downward pressure on price.
- Shortage (excess demand) → upward pressure on price.
2.2 Elasticities
| Elasticity | Definition / Formula | Determinants (Cambridge) | Typical Shape on a Graph |
|---|
| Price‑elasticity of demand (PED) | \(Ed = \frac{\% \Delta Qd}{\% \Delta P}\) | Availability of substitutes, proportion of income spent, time horizon, necessity vs luxury. | Flatter demand curve = more elastic. |
| Price‑elasticity of supply (PES) | \(Es = \frac{\% \Delta Qs}{\% \Delta P}\) | Spare capacity, time to adjust production, nature of the good. | Flatter supply curve = more elastic. |
| Income elasticity of demand (YED) | \(Ey = \frac{\% \Delta Qd}{\% \Delta Y}\) | Normal vs inferior goods, luxury vs necessity. | Positive for normal goods, negative for inferior goods. |
| Cross‑price elasticity of demand (XED) | \(E{xy} = \frac{\% \Delta Q{dx}}{\% \Delta P_y}\) | Substitutes (positive) or complements (negative). | Shows how a price change in good y affects demand for good x. |
2.3 Market Failure & Government Intervention
- Externalities – costs or benefits that affect third parties (e.g., pollution, education).
- Public goods – non‑rival and non‑excludable (e.g., national defence, street lighting).
- Information asymmetry – one party has more or better information (e.g., used‑car market).
- Government can correct failures through:
- Taxes / subsidies (internalise externalities).
- Regulation (e.g., pollution standards).
- Provision of public goods.
- Mixed economy – most modern economies combine market mechanisms with government intervention to achieve macro‑economic aims.
3. The Six Macro‑economic Aims (Cambridge IGCSE 0455)
- Full employment – keep unemployment low (especially cyclical unemployment).
- Balance of payments (BOP) stability – avoid large, persistent current‑account deficits or surpluses.
- Economic growth – increase real GDP over the medium term.
- Price stability – keep inflation low and predictable.
- Equitable distribution of income – reduce poverty and inequality.
- Environmental sustainability – protect natural resources while pursuing growth.
4. Why the Aims Can Conflict
Most macro‑policy tools affect aggregate demand (AD) and the external sector at the same time. An action that raises AD to reduce cyclical unemployment usually raises import demand, widening the current‑account deficit. Conversely, policies that improve the BOP by restraining AD can increase unemployment. The conflict is most evident between full employment and BOP stability.
5. Fiscal Policy
5.1 What Is Fiscal Policy?
- Government decisions about taxation and public spending that influence AD.
- Budget balance = Tax revenue – Government spending.
- Surplus → revenue > spending.
- Deficit → spending > revenue.
5.2 Main Fiscal Tools & Their Expected Effects
| Tool | Effect on AD | Effect on BOP (Current‑account) |
|---|
| Increase government spending (G) | ↑ AD → higher output & employment | ↑ national income → ↑ imports → deficit widens |
| Decrease government spending | ↓ AD → lower output, higher unemployment | ↓ income → ↓ imports → surplus or smaller deficit |
| Cut taxes (e.g., lower income tax) | ↑ disposable income → ↑ consumption → ↑ AD | ↑ consumption of imported goods → deficit widens |
| Raise taxes (e.g., higher rates) | ↓ disposable income → ↓ consumption → ↓ AD | ↓ import demand → deficit narrows |
5.3 Open‑Economy Multiplier
When the economy is open, part of any increase in income is spent on imports. The multiplier becomes:
\[
\Delta Y \;=\; \frac{1}{1-\text{MPC}+m}\;\Delta G
\]
where m = marginal propensity to import. A high m reduces the impact of fiscal expansion on output and aggravates the current‑account deficit.
5.4 Example
Country X launches a £2 billion road‑building programme. AD rises, unemployment falls from 7 % to 5 %, but imports increase by £1 billion, widening the current‑account deficit from £0.5 billion to £1.5 billion.
6. Monetary Policy
6.1 What Is Monetary Policy?
- Actions by the central bank that change the money supply (M) and the policy interest rate.
- Transmission mechanism: lower rates → cheaper credit → more consumption & investment → ↑ AD.
6.2 Main Monetary Tools & Their Expected Effects
| Tool | Effect on AD | Effect on Exchange Rate & BOP |
|---|
| Lower policy interest rate (expansionary) | ↑ AD (cheaper borrowing) | ↓ domestic interest rate → capital outflow → depreciation → exports ↑, imports ↓ → BOP improves |
| Raise policy interest rate (contractionary) | ↓ AD (more expensive credit) | ↑ domestic interest rate → capital inflow → appreciation → exports ↓, imports ↑ → BOP worsens |
| Open‑market operations (buying government securities) | ↑ money supply → ↓ rates → ↑ AD | Same channel as rate change – tends to depreciate the currency. |
| Open‑market operations (selling securities) | ↓ money supply → ↑ rates → ↓ AD | Appreciation pressure on the currency. |
6.3 Exchange‑Rate Regimes & Policy Autonomy
- Floating (flexible) rate – market determines the value; monetary policy can influence the rate.
- Fixed (pegged) rate – central bank must buy/sell foreign currency to maintain the peg; domestic monetary policy is largely constrained.
- Managed float (dirty float) – authorities intervene occasionally to smooth excessive volatility.
7. Supply‑side Policies (Long‑run Measures)
- Improve education & training → higher labour productivity.
- Invest in transport, communications and energy infrastructure → lower production costs.
- Deregulation & reduction of red‑tape → encourages entrepreneurship.
- Tax incentives for research & development and for export‑oriented firms.
- Environmental regulations that promote green technology (links to sustainability aim).
These policies shift the long‑run aggregate‑supply (LRAS) curve right. With a higher potential output, the economy can achieve higher employment and a healthier BOP simultaneously, reducing the short‑run trade‑off.
8. Key External‑Sector Concepts
- Current account = Trade balance (exports – imports) + Net income from abroad + Net transfers.
- Marginal propensity to import (m) – proportion of additional income spent on imports.
- Open‑economy multiplier (see §5.3).
- Exchange‑rate effect on AD – depreciation raises net exports (NX) → ↑ AD; appreciation does the opposite.
- Types of unemployment relevant to the “full‑employment” aim:
- Structural – skill‑mismatch.
- Frictional – short‑term job search.
- Cyclical – insufficient AD.
- Inflation can be:
- Demand‑pull – from excess AD.
- Cost‑push – from higher import prices after a depreciation.
9. Illustrative Scenarios (Short‑run Trade‑off)
- High unemployment & current‑account deficit
- Goal: lower unemployment.
- Policy: expansionary fiscal (higher G) or expansionary monetary (lower rates).
- Result: AD rises → jobs created, but import demand rises → deficit widens.
- Large current‑account deficit & low inflation
- Goal: restore BOP balance.
- Policy: contractionary fiscal (cut G) or raise interest rates.
- Result: AD falls → unemployment risk, but imports fall → deficit narrows.
- Flexible exchange rate – depreciation
- Exports become cheaper, imports more expensive.
- Net export component of AD rises → higher output and employment.
- Current‑account improves, but imported inflation may appear.
- Supply‑side reform + moderate fiscal stance
- Invest in vocational training and transport infrastructure.
- LRAS shifts right → potential output grows.
- Higher productivity raises export competitiveness and can reduce import intensity, improving both employment and BOP.
10. Diagrams You May Need to Draw
- AD–AS diagram – show a rightward shift of AD (expansionary policy) and annotate the accompanying rise in imports and current‑account deficit.
- Money‑market diagram (LM curve) – illustrate how a lower interest rate moves the LM curve right, leading to a depreciation of the exchange rate.
- IS‑LM‑BP (Mundell‑Fleming) diagram – under a floating rate, show that an expansionary monetary policy improves the BOP while raising output.
- LRAS shift – keep AD unchanged and move LRAS right to demonstrate simultaneous improvement in employment and BOP.
- Supply‑demand diagram for a market – brief reminder of equilibrium, surplus, shortage and the role of price elasticity.
11. Key Points to Remember (AO1‑AO3)
- Policy mix matters: the net effect on both aims depends on the combination of fiscal, monetary and supply‑side measures.
- Short‑run trade‑off: boosting AD to reduce cyclical unemployment usually worsens the current‑account balance; tightening AD improves the BOP but can raise unemployment.
- Long‑run solution: supply‑side reforms shift LRAS outward, allowing higher output without additional pressure on the BOP.
- Open‑economy multiplier: a high marginal propensity to import reduces the multiplier effect of fiscal expansion and aggravates the current‑account deficit.
- Exchange‑rate regime influences policy freedom: floating rates give the central bank a tool to address the BOP; fixed rates limit monetary autonomy.
- Elasticities matter: if demand for imports is price‑elastic, a depreciation will generate a larger rise in export revenue relative to the fall in import volume, helping both aims.
12. Sample Examination Questions (AO2 & AO3)
- Explain why an expansionary fiscal policy can improve full employment but worsen the balance of payments.
- Discuss how a depreciation of the exchange rate can help a country achieve both full employment and BOP stability. Include possible risks.
- Using an AD–AS diagram, illustrate the conflict that arises when a government pursues an expansionary monetary policy in an economy with high unemployment and a current‑account deficit.
- Evaluate the role of supply‑side policies in reducing the short‑run trade‑off between full employment and BOP stability.
- Compare the effectiveness of monetary policy in a floating‑rate system versus a fixed‑rate system for correcting a current‑account deficit.
- Analyse how a high marginal propensity to import influences the size of the fiscal multiplier and the impact on the balance of payments.
13. Summary
Governments must balance several macro‑economic aims. Policies that raise aggregate demand to achieve full employment tend to increase import demand, threatening balance‑of‑payments stability. Conversely, measures that protect the BOP by restraining demand can raise unemployment. Understanding the mechanisms of fiscal and monetary policy, the role of exchange‑rate regimes, and the long‑run benefits of supply‑side reforms equips students to analyse and evaluate real‑world policy decisions and to answer both knowledge‑based and evaluative exam questions.