Possible conflicts between macroeconomic aims: full employment and balance of payments stability

Published by Patrick Mutisya · 14 days ago

Government Macro‑economic Intervention – Conflicts between Full Employment and Balance of Payments Stability

Government Macro‑economic Intervention

Key Aims of Macro‑economic Policy

In the IGCSE syllabus the government is expected to pursue several macro‑economic objectives. Two of the most important are:

  • Full employment – keeping unemployment low.

  • Balance of payments (BOP) stability – avoiding large deficits or surpluses in the current account.

Why the Aims Can Conflict

Policies that move the economy toward one aim may move it away from the other. The main source of conflict is the effect of fiscal and monetary policy on aggregate demand (AD) and on the external sector.

Typical Policy Tools

Policy ToolEffect on ADEffect on BOP
Expansionary fiscal policy (increase G or cut taxes)↑ AD → higher output and employment↑ imports → current‑account deficit
Contractionary fiscal policy (decrease G or raise taxes)↓ AD → lower output, higher unemployment↓ imports → current‑account surplus
Expansionary monetary policy (lower interest rates)↑ AD via cheaper credit↓ exchange rate → exports rise, imports fall → improves BOP
Contractionary monetary policy (higher interest rates)↓ AD↑ exchange rate → exports fall, imports rise → worsens BOP

Illustrative Scenarios

  1. Scenario A – High Unemployment, Current‑Account Deficit

    The government wants to reduce unemployment. An expansionary fiscal stance (higher G) shifts AD right, raising output and jobs. However, higher income raises import demand, widening the current‑account deficit. The conflict is evident.

  2. Scenario B – Large Current‑Account Deficit, Low Inflation

    To correct the deficit, the government may adopt contractionary fiscal policy or raise interest rates. This reduces AD, risking higher unemployment. The trade‑off must be managed.

  3. Scenario C – Use of Exchange‑Rate Policy

    If the country has a flexible exchange rate, a depreciation can improve the BOP while also stimulating AD (through a net‑export boost). This can help both aims simultaneously, but only if the depreciation does not trigger imported inflation.

Key Concepts to Remember

  • The policy mix (combination of fiscal and monetary tools) determines the net effect on both aims.

  • Short‑run vs long‑run: In the short run, policy may produce a trade‑off; in the long run, supply‑side measures (e.g., improving productivity) can shift the economy outward, allowing both aims to be met.

  • Open‑economy multiplier: \$\Delta Y = \frac{1}{1 - MPC + m}\,\Delta G\$ where \$m\$ is the marginal propensity to import. A high \$m\$ reduces the impact of fiscal expansion on output and worsens the BOP.

Possible Examination Questions

  1. Explain why an expansionary fiscal policy can improve full employment but worsen the balance of payments.

  2. Discuss how a depreciation of the exchange rate can help a country achieve both full employment and BOP stability.

  3. Using a diagram, illustrate the conflict between the two objectives when the government pursues an expansionary monetary policy.

Suggested diagram: AD–AS model showing a right‑ward shift of AD to achieve full employment, with a simultaneous increase in imports leading to a current‑account deficit.

Summary

Governments often face a trade‑off between achieving full employment and maintaining balance of payments stability. The direction and magnitude of fiscal and monetary policies affect both domestic demand and the external sector. Understanding the interaction of these policies helps students evaluate policy choices and predict likely outcomes.