5.7: The role of macroeconomic policy

In Chapter 4, performance of the economy was evaluated based on the standard of living, measured as the real GDP per capita, it provided. Recessionary gaps reduce the standard of living in the economy by reducing employment, real GDP, and per capita real GDP.

Inflationary gaps reduce standards of living in more subtle ways. They push up the price level, raising the cost of living. But the rise in the cost of living affects different people in different ways. Those on fixed money incomes suffer a reduction in their standards of living. People holding their wealth in fixed price financial assets like bank deposits and bonds suffer a loss in their real wealth. On the other hand, inflation reduces the real value of debt, whether it is mortgage debt used to finance the purchase of a house, or a student loan used to finance education. The money repaid in the future has a lower purchasing power than the money borrowed. In these and other ways, the costs of inflation are distributed unevenly in the economy, making decisions about employment, household expenditure, and investment more difficult.

We have also seen, in Figure 5.6, that output gaps have been persistent in the Canadian economy despite the possibility that flexible wages and prices might automatically eliminate gaps. These observations raise two questions:

1. Why are output gaps, especially recessionary gaps, persistent?
2. Can government policy work to eliminate output gaps?

To answer the first question, we need to think about two issues. The first is the flexibility or rigidity of wages and prices both up and down. The second is the strong possibility of asymmetry between adjustment effects of absolute increases and absolute decreases in wages and prices. These are topics for later discussion.

The important immediate policy question is: When wages and prices are sticky, should government wait for the self-adjustment process to work, accepting the costs of high unemployment or rising inflation that it produces? This was a very serious and widely debated question since 2008 in the face of growing international recessions as a consequence of serious government debt problems and continued international financial market uncertainty.

Government has policies it can use to reduce or eliminate output gaps. In Chapter 7 we will examine fiscal policy, the government expenditures and tax policy that establish the government's budget and its effect on aggregate demand. Government can use its fiscal policy to change the AD curve and eliminate an output gap without waiting for the economy to adjust itself. Chapters 9 and 10 discuss monetary policy, actions by the monetary authorities designed to change aggregate demand and eliminate output gaps by changing interest rates, money supply, and the availability of credit. Both fiscal and monetary policy work to change aggregate demand and eliminate output gaps, which reduce the standard of living the national economy provides for its citizens.

Fiscal policy: government expenditure and tax changes designed to influence AD.

Monetary policy: changes in interest rates and money supply designed to influence AD.