A Public Policy and Economics Blog
To have a better understanding of this article, it is recommended to read following articles first:-
The objective of any economy is to grow at such a rate which is sustainable in the long run, and inflation, unemployment are kept at a reasonable rate. A good indicator of sustainable growth rate is potential GDP rate which is that GDP growth rate which can be sustained over long-term at a constant inflation rate. There is a limit on potential GDP due to following factors namely natural and institutional such as
In general, Country actual GDP can be above and below potential GDP which causes problems such as inflation when country GDP is above potential GDP and unemployment when GDP is below potential GDP. A country can have a GDP above potential GDP for some time period and a GDP below potential GDP for another time period. This type of cycle of country’s GDP to go above potential GDP in a boom for short period and then go below potential GDP in recession for a short period is called Business Cycle. (For more info visit GDP and Business Cycle)
In the above figure when real GDP (= GDP – inflation) is above potential GDP than, Economy is in the inflationary gap that is inflation is increasing but unemployment is decreasing. And when GDP is below potential GDP than the economy is in recessionary gap meaning there is high unemployment in the economy.
Now as you can see both inflationary gap and recessionary gap are undesirable due to inflation and unemployment respectively. So the aim of economic policy in the inflationary gap should be to reduce inflation by reducing the GDP to make it at par with the potential GDP. Thus following a restrictive policy. Similarly in the recessionary gap, the aim of economic policy is to reduce unemployment by increasing GDP to reach the potential GDP level. Thus following a expansive policy.
In general, a country has four policy tools to match-up its GDP with the potential GDP . They are as follows
Fiscal Policy deals with taxes imposed by the government and spending undertaken by government. By Fiscal policy Govt affects the aggregate demand in the economy.
The monetary policy is implemented by the central bank of the country. Central bank is the bank which has power to print money and generally act as banker’s bank ,i.e. it lends to bank and saves bank money in its lockers. Central bank can be an independent entity or an agent of the government. The main aim of a central bank is to control money supply to keep inflation or/and unemployment under pre-determined level.
Interaction of curve
The Central Bank has following tools to control money supply as follows:-
There is an other tool which is not conventionally used but has been extensively used in the wake of financial crisis of 2008 by central banks all over the world. It is Quantitative Easing. In simple terms it can be said as operation in which central bank creates money and lends to borrower in exchange of securities which in normal times are considered good collateral but due to present turbulent times are not enough or have lost value. Central bank is required to do so because banks are not willing to lend due to already high level of bad loans or are charging a very high interest rate.
It can be defined as the country strategy to control its import and export such as to have restrictive or expansive effect on the economy.
Expansive Exchange Rate Policy
Suppose if a Country is in recessionary gap then it should ideally devaluates its currency such that it exports becomes cheaper and it imports becomes costlier. Devaluation of currency can be termed as loss of value of domestic currency in front of foreign currency for example Rupee has depreciated from Rs 50 per $ to Rs 65 per $ in recent years. It has made country exports cheaper and imports costlier.
Restrictive Exchange Rate Policy
In Inflationary Gap, a country should appreaciates it currency such that its export declines and import increases such that economy cools down and GDP is reduced to potential GDP.
Till now all the policies that we have discussed till now have a major impact on aggregate demand while little impact on aggregate supply. We know that increase in aggregate supply is much better than increase in aggregate demand as increase in AS will lead to increased GDP with reduced inflation whereas increase in AD will lead to increased GDP with increased inflation. The structural policy is much broader than the above 3 policies discussed above and is much more politically charged. It is primarily aimed at reducing production cost or increasing the ease of doing business in the economy with less regulation.
It can be divided as reforms in the following sector as
Legal Structure
Suppose if govt. make its easy for employers to hire/fire workers or increases the working hours of workers then Producers will find they now they have reduced hiring/firing cost or reduced production cost. So such type of reforms which liberalizes labour markets from unionised and welfare laws in general will lead to increase in aggregate supply.
Bureaucratic Structure
Suppose if you go in Country A where you have to go through 15 different government departments to get clearance to do business and in Country B where you have a single window clearance system by which all the required clearances will be given to you at single place in very short period of time. Businesses are more likely to flourish in Country B then Country A, so with more number of producers in the economy of country B, country B will have higher aggregate supply.
Physical Infrastructure
Producers needs certain input in production such as land and energy, if these are available at cheaper rates and have reliable supply than producers don’t need to hire extra generator for electricity or to wait for years to establish a factory as land can’t be procured in time. Having a good public transport facilities such as railways or highways reduces the transportation cost for the producer.
Source
Thinking on India 