Question

Example of Macroeconomic policy tradeoffs? Interpret it.(200-300 words)

Answer 1

Definition of Macroeconomics

Macroeconomics is that specialized field of economics which focuses on the overall economy. It works on the aggregate value of the various individual units, to determine its more substantial impact on the whole nation. All the prominent reforms and policies are based on this concept.

For instance; the nation’s income is computed as the per capita income, which is nothing but the average of the total earning of all the citizens in that country.

Importance of Macroeconomics:

Trade Cycle Analysis

It is beneficial for timing the economic fluctuations to avoid or be prepared for any financial crises or adverse situations.

Economic Policies Formulation

Framing of the monetary and fiscal policies majorly depends upon the study of prevailing macroeconomic conditions in the country.

Downsizes the Effect of Inflation and Deflation

Macroeconomics also helps the government and the financial bodies to be prepared for the situations of economic instability.

Facilitates Material Welfare

This stream of economics gives a broader perspective of social or national issues. Therefore, the ones who look forward to contributing to the welfare of society needs to study macroeconomics.

Regulates Economic System

It ensures or keeps a check over the proper functioning of the country’s economy and actual position.

Resolves Economic Issues

The analysis of macroeconomics theories and issues helps the economists and the government to figure out the causes and possible solutions of such macro-level problems.

Economic Development

Dealing with different economic conditions by making use of macroeconomics research, opens up the way towards the country’s growth

1. Introduction

Poverty is a multidimensional problem that goes beyond economics to include, among other things, social, political, and cultural issues. Therefore, solutions to poverty cannot be based exclusively on economic policies, but require a comprehensive set of well-coordinated measures. Indeed, this is the foundation for the rationale underlying comprehensive poverty reduction strategies. So why focus on macroeconomic issues? Because economic growth is the single most important factor influencing poverty, and macroeconomic stability is essential for high and sustainable rates of growth. Hence, macroeconomic stability should be a key component of any poverty reduction strategy.

Macroeconomic stability by itself, however, does not ensure high rates of economic growth. In most cases, sustained high rates of growth also depend upon key structural measures, such as regulatory reform, privatization, civil service reform, improved governance, trade liberalization, and banking sector reform, many of which are discussed at length in the Poverty Reduction Strategy Sourcebook, published by the World Bank. Moreover, growth alone is not sufficient for poverty reduction. Growth associated with progressive distributional changes will have a greater impact on poverty than growth that leaves distribution unchanged. Hence, policies that improve the distribution of income and assets within a society, such as land tenure reform, pro-poor public expenditure, and measures to increase the poor’s access to financial markets, will also form essential elements of a country’s poverty reduction strategy.

To safeguard macroeconomic stability, the government budget, including the country’s poverty reduction strategies, must be financed in a sustainable, noninflationary manner. The formulation and integration of a country’s macroeconomic policy and poverty reduction strategy are iterative processes. Poverty reduction strategies need first to be articulated (i.e., objectives and policies specified), then costed, and finally financed within the overall budget in a noninflationary manner. The amount of finance, much of which will be on concessional terms, is, however, not necessarily fixed during this process: if credible poverty reduction strategies cannot be financed from available resources, World Bank and IMF staff should and will actively assist countries in their efforts to raise additional financial support from the donor community. Nonetheless, in situations where financing gaps remain, a country would have to revisit the intermediate objectives of their strategy and reexamine their priorities. Except in cases where macroeconomic imbalances are severe, there will usually be some scope for flexibility in setting short-term macroeconomic targets. However, the objective of macroeconomic stability should not be compromised.

2. The Links Between Macroeconomic Policy and Poverty Reduction: Growth Matters

Economic growth is the single most important factor influencing poverty. Numerous statistical studies have found a strong association between national per capita income and national poverty indicators, using both income and nonincome measures of poverty. One recent study consisting of 80 countries covering four decades found that, on average, the income of the bottom one-fifth of the population rose one-for-one with the overall growth of the economy as defined by per capita GDP (Dollar and Kraay, 2000). Moreover, the study found that the effect of growth on the income of the poor was on average no different in poor countries than in rich countries, that the poverty–growth relationship had not changed in recent years, and that policy-induced growth was as good for the poor as it was for the overall population. Another study that looked at 143 growth episodes also found that the “growth effect” dominated, with the “distribution effect” being important in only a minority of cases (White and Anderson, forthcoming). These studies, however, establish association, but not causation. In fact, the causality could well go the other way. In such cases, poverty reduction could in fact be necessary to implement stable macroeconomic policies or to achieve higher growth.

Macroeconomic Stability Is Necessary for Growth

Macroeconomic stability is the cornerstone of any successful effort to increase private sector development and economic growth. Cross-country regressions using a large sample of countries suggest that growth, investment, and productivity are positively correlated with macroeconomic stability (Easterly and Kraay, 1999). Although it is difficult to prove the direction of causation, these results confirm that macroeconomic instability has generally been associated with poor growth performance. Without macroeconomic stability, domestic and foreign investors will stay away and resources will be diverted elsewhere. In fact, econometric evidence of investment behavior indicates that in addition to conventional factors (i.e., past growth of economic activity, real interest rates, and private sector credit), private investment is significantly and negatively influenced by uncertainty and macroeconomic instability (see, for example, Ramey and Ramey, 1995).

Macroeconomic Instability Hurts the Poor

In addition to low (and sometimes even negative) growth rates, other aspects of macroeconomic instability can place a heavy burden on the poor. Inflation, for example, is a regressive and arbitrary tax, the burden of which is typically borne disproportionately by those in lower income brackets. The reason is twofold. First, the poor tend to hold most of their financial assets in the form of cash rather than in interest-bearing assets. Second, they are generally less able than are the better off to protect the real value of their incomes and assets from inflation. In consequence, price jumps generally erode the real wages and assets of the poor more than those of the non-poor. Moreover, beyond certain thresholds, inflation also curbs output growth, an effect that will impact even those among the poor who infrequently use money for economic transactions.

Composition and Distribution of Growth Also Matter

Although economic growth is the engine of poverty reduction, it works more effectively in some situations than in others.Two key factors that appear to determine the impact of growth on poverty are the distributional patterns and the sectoral composition of growth.

If the benefits of growth are translated into poverty reduction through the existing distribution of income, then more equal societies will be more efficient transformers of growth into poverty reduction

3. Macroeconomic Stability and Economic Growth

Broadly speaking, two considerations underlie macroeconomic policy recommendations. First, there needs to be an assessment of the appropriate policy stance to adopt in a given set of circumstances (i.e., should fiscal and/or monetary policy be tightened or loosened?). Second, there is the choice of specific macroeconomic policy instruments that would be beneficial for a country to adopt (e.g., the use of a nominal anchor, a value-added tax (VAT), etc.). In practice, these two considerations are closely linked. Adjusting a policy stance is often done via the adoption of a new instrument (or the modification of an existing one). More important, both considerations are essential to efforts to enhance an economy’s stability

Sources of Instability

There are two main sources of economic instability, namely exogenous shocks and inappropriate policies. Exogenous shocks (e.g., terms of trade shocks, natural disasters, reversals in capital flows, etc.) can throw an economy into disequilibrium and require compensatory action. For example, many low income countries have a narrow export base, often centered on one or two key commodities. Shocks to the world price of these commodities can therefore have a strong impact on the country’s income. Even diversified economies, however, are routinely hit by exogenous shocks, although, reflecting their greater diversification, shocks usually need to be particularly large or long-lasting to destabilize such an economy. Alternatively, a disequilibrium can be “self-induced” by poor macroeconomic management. For example, an excessively loose fiscal stance can increase aggregate demand for goods and services, which places pressure on the country’s external balance of payments as well as on the domestic price level. At times, economic crises are the result of both external shocks and poor management.

Stabilization

In most cases, addressing instability (i.e., stabilization) will require policy adjustment; whereby a government introduces new measures (possibly combined with new policy targets) in response to the change in circumstances. Adjustment will typically be necessary if the source of instability is a permanent (i.e., systemic) external shock or the result of earlier, inappropriate macroeconomic policies. However, if the source of instability can be clearly identified as a temporary shock (e.g., a one-time event) then it may be appropriate for a country to accommodate it. Identifying whether a particular shock is temporary or is likely to persist is easier said than done. Since there is often a considerable degree of uncertainty surrounding such a judgment, it is usually wise to err somewhat on the side of caution by assuming that the shock will largely persist and by basing the corresponding policy response on the appropriate adjustment.

Elements of Macroeconomic Stability

Macroeconomic policies influence and contribute to the attainment of rapid, sustainable economic growth aimed at poverty reduction in a variety of ways. By pursuing sound economic policies, policymakers send clear signals to the private sector. The extent to which policymakers are able to establish a track record of policy implementation will influence private sector confidence, which will, in turn, impact upon investment, economic growth, and poverty outcomes.

Prudent macroeconomic policies can result in low and stable inflation. Inflation hurts the poor by lowering growth and by redistributing real incomes and wealth to the detriment of those in society least able to defend their economic interests. High inflation can also introduce high volatility in relative prices and make investment a risky decision. Unless inflation starts at very high levels, rapid disinflation can also have short-run output costs, which need to be weighed against the costs of continuing inflation.

Growth-Oriented Macroeconomic Policies and Poverty Outcomes

Since the emphasis of this pamphlet is on the role of macroeconomic policy in supporting a country’s poverty reduction strategy, the discussion of macroeconomic policies in this section focuses on countries that have broadly achieved macroeconomic stability. Recent data indicate that many developing countries are presently in a state of macroeconomic stability (see Tables 1–3 at the end of this pamphlet). When formulating a country’s poverty reduction strategy, policymakers will need to assess and determine what is the most appropriate combination of key macroeconomic targets that would preserve macroeconomic stability in their particular circumstance.

Three key issues are discussed in this section:

(1) how to finance poverty-reducing spending in a way that doesn’t endanger macroeconomic stability;

(2) what specific policies can be adopted to improve macroeconomic performance; and

(3) policies to protect the poor from domestic and external shocks.

Financing Poverty Reduction Strategies

Once a country has developed a comprehensive and fully costed draft of its poverty reduction strategy, it will need to ensure that the strategy can be pursued and financed in a manner that does not jeopardize its macroeconomic stability and growth objectives. To do so, policymakers need to integrate their poverty reduction and macroeconomic strategies into a consistent framework. The following paragraphs present a conceptual framework that could be useful to policymakers in determining whether their poverty reduction strategy is consistent with their macroeconomic objectives.

Fiscal Policy

Fiscal policy can have a direct impact on the poor, both through the government’s overall fiscal stance and through the distributional implications of tax policy and public spending. Structural fiscal reforms in budget and treasury management, public administration, governance, transparency, and accountability can also benefit the poor in terms of more efficient and better targeted use of public resources. As indicated above, there is no rigid, pre-determined limit on what would be an appropriate fiscal deficit. An assessment would need to be based on the particular circumstances facing the country, its medium-term macroeconomic outlook, and the scope for external budgetary assistance. The terms on which external assistance is available are also important. There is a strong case, for instance, for allowing higher grants to translate into higher spending and deficits, to the extent that those grants can reasonably be expected to continue in the future, and provided that the resources can be used effectively.

Monetary and Exchange Rate Policies

Monetary and exchange rate policies can affect the poor primarily through three channels: inflation, output, and the real exchange rate. As mentioned above, inflation hurts the poor because it acts as a regressive tax and curbs growth. Fluctuations in output clearly have a direct impact upon the incomes of the poor, and monetary and exchange rate policies affect these fluctuations in two ways: first, changes in the money supply can have a short-run effect on real variables such as the real interest rate, which in turn affect output; and second, a country’s chosen exchange rate regime can buffer, or amplify, exogenous shocks. Finally, the real exchange rate can affect the poor in two ways.First, it influences a country’s external competitiveness and hence its growth rate. Second, a change in the real exchange rate (through, for example, a devaluation of the nominal rate) can have a direct impact on the poor.

Given that monetary and exchange rate policies affect the poor through their impact on inflation, output, and the real exchange rate, it might seem, at first glance, that such policies should therefore be used to target all three of these variables. However, although monetary and exchange rate policies may affect the poor through all of these channels, the monetary authorities cannot necessarily control the size and nature of the resulting impact. For example, changes in the money supply may affect output and employment in the short run, but they do so in a way that is at best uncertain and imperfectly understood. As a result, monetary authorities are typically unable to exploit this impact systematically. Similarly, monetary and exchange rate policies are unable to manipulate the real exchange rate beyond a short period of time. Therefore, actively using these policies to pursue a particular short-run exchange rate goal, which may be inconsistent with underlying economic fundamentals, could introduce instability improving inflation performance.

In some cases, it may be desirable to target a lower rate of inflation. What policies can help meet this objective? Ultimately, this question has to be answered on a case-by-case basis. However, policymakers should consider two general policies that are essential parts of any effort to improve inflation performance: strong and sustained fiscal adjustment; and the use of a nominal anchor and other measures (e.g., inflation targeting) to enhance policy credibility.

Fiscal Adjustment

A loose fiscal stance can put upward pressure on prices through two channels: aggregate demand and financing. Such a fiscal stance increases the demand for domestic goods, which, in the absence of a corresponding increase in supply, puts upward pressure on their prices. It can also increase demand for imports, putting downward pressure on the value of the domestic currency and, hence, (in a flexible exchange rate regime) upward pressure on the prices of imported goods. Further, if the fiscal stance is financed by printing money, this expands the money supply and tends to increase inflation.

Removing Market Distortions and Distortive Policies

In addition to pursuing favorable economic policies and putting in place appropriate social safety nets, there are specific structural reforms that governments can undertake to insulate the poor from the adverse consequences of shocks. Most of these have to do with addressing the mechanisms through which macroeconomic shocks are transmitted to the poor

Finally, and most important, governments can do a lot to reduce the pro-cyclical nature of their fiscal policies by saving rather than spending windfalls following positive shocks and ideally using those savings as a buffer for expenditures against negative shocks. A cautious approach would be for the government to “treat every favorable shock as temporary and every adverse one as permanent,” although judgment would also depend on, among other things, the availability of financing (Little, and others, 1993). However, even this rule of thumb may not be enough. Governments need to find ways of “tying their hands” to resist the pressure to spend windfall revenues (Devarajan, 1999). For example, when the source of revenue is publicly owned, such as oil or other natural resource, it may be appropriate to save the windfall revenues abroad, with strict rules on how much of it can be repatriated. Countries such as Colombia, Chile, and Botswana have tried variants of this strategy, with benefits not just for overall macroeconomic management, but also for protecting the poor during adverse shocks, since saved funds during good times can be applied to financing of safety nets during crisis.