Anticipating the Impact of Macroeconomic Policies

Instructor: Shawn Grimsley

Shawn has a masters of public administration, JD, and a BA in political science.

Governments use macroeconomic policies in attempts to achieve economic goals such as sustained growth, low unemployment, and low inflation. In this lesson, you'll learn how an economy will typically react to these macroeconomic policies.

Macroeconomics & Macroeconomic Policies

Before diving into how we anticipate an economy will react to the application of macroeconomic policies, let's refresh our recollections on macroeconomics and what macroeconomic policies are. Macroeconomics is the study of the economy as a whole compared to microeconomics, which studies the behaviors of firms and consumers within the overall economy. Macroeconomics is concerned with things like inflation (i.e., rise in the general price level in an economy), unemployment, and whether the economy is growing or contracting.

You can think of macroeconomic policies as tools that are used by governments and central banks in hopes of achieving certain economic policy goals. A central bank is an institution that manages a country's money supply. The Federal Reserve serves as the central bank for the United States. So what exactly are the macroeconomic policies tools at the disposal of the US government and the Federal Reserve?

The two basic macroeconomic tools are fiscal policy and monetary policy. Governments use fiscal policy through its taxing and spending power. The government can try to affect the economy by increasing or decreasing spending and by increasing or decreasing taxes. On the other hand, the Federal Reserve attempts to mold the economy by either increasing or decreasing the supply of money in the economy. The Federal Reserve can affect the supply of money by buying or selling government bonds, changing the interest rate it charges to banks, and by changing the amount of money it requires a bank to hold in reserves that cannot be lent out.

Now, let's take a quick look at how these policies may affect the overall economy according to macroeconomic theory.

Impact of Fiscal Policies

Generally speaking, we'd expect an increase in government spending to stimulate economic growth. Why? If the government is spending money, it's buying products or services which means businesses have extra demand to make products or provide services. Businesses need to employ people to make the stuff and provide the services that the government is buying so they can make a profit from selling it. Thus, an increase in government spending may lead to an increase in employment. An increase in employment means there are more people with paychecks to spend or save. Saved money is usually parked in a bank that turns around and lends it to people and businesses to buy products and services.

Keep in mind, however, that government spending may also lead to increased inflation because the government is competing with other consumers for goods and services. If the demand outpaces supply, prices will increase.

On the other hand, by decreasing government spending we would expect a slowdown in the rate of economic growth, hiring, and inflation. In other words, cutting government spending can be used to put the brakes on an economy that is overheating. How? If the government isn't spending as much, businesses don't have to produce as many goods and services and don't need as many employees. Businesses that earn less money usually spend less as do people who aren't earning as much or have become unemployed because there's less demand for goods and services they were employed to produce.

Spending is only one of the tools in the fiscal policy toolbox; adjusting the tax rate is the other fiscal tool. We generally expect a decrease in the tax rate to stimulate the economy. Why? Simple: lower taxes mean that consumers have more money to spend on goods and services and to save and invest. Moreover, lower taxes mean that businesses have more money to invest in producing goods and services and to research and develop new goods and services that consumers want to buy. This increase in economic activity may lead to lower unemployment, but also an increase in inflation if the demand for goods and services outpace the supply.

As you probably expect, an increase in the tax rate should slow down the rate of economic growth as people and businesses have less money to buy, save, and invest. This also may result in an increase in the unemployment rate as fewer employees are needed to satisfy the demand for goods and services. An increase in taxes may also cause a dip in the rate of inflation as demand for goods and services decreases resulting in less upward pressure on prices.

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