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An introduction to the primary objectives of fiscal and monetary policy, focusing on the business cycle and economic indicators.
Imagine you are the pilot of a massive commercial jet. If you fly too high, the engines might stall; if you fly too low, you risk a crash. How do governments 'pilot' an entire economy to keep it at the perfect altitude?
To maintain a healthy economy, policymakers pursue three main goals. First is Price Stability, which means keeping inflation (the general rise in prices) low and predictable, usually around 2%. Second is Full Employment, which does not mean 0% unemployment, but rather reaching the Natural Rate of Unemployment (around 4-5%) where everyone who wants a job can find one. Third is Sustainable Growth, measured by a steady increase in Real GDP (Gross Domestic Product). If growth is too slow, we face poverty; if it is too fast, we risk 'overheating' the economy, leading to a massive price spike.
Quick Check
Why is 'Full Employment' not defined as 0% unemployment?
Answer
Because there will always be 'frictional' unemployment (people between jobs) and 'structural' unemployment (skills not matching jobs), which are natural in a dynamic economy.
The economy does not move in a straight line; it moves in a Business Cycle. This cycle has four phases: Expansion (rising GDP), Peak (maximum output), Contraction (falling GDP, often called a Recession if it lasts two quarters), and Trough (the lowest point). Policy intervention is like a shock absorber. During a recession, the government uses Expansionary Policy to boost spending. During a peak where inflation is high, they use Contractionary Policy to cool things down. The goal is to minimize the 'output gap'—the difference between what the economy is producing and what it could produce at full capacity.
Suppose a country reports the following data over three years: 1. Year 1: GDP grows by 3%, Unemployment is 4%. 2. Year 2: GDP grows by 0.5%, Unemployment rises to 6%. 3. Year 3: GDP shrinks by 2%, Unemployment hits 9%.
In this scenario, the economy has moved from an Expansion in Year 1 to a Contraction (Recession) by Year 3. Policymakers would likely intervene in Year 3 to stimulate growth.
Quick Check
At which point of the business cycle is the 'Output Gap' typically the largest and most negative?
Answer
The Trough, because the economy is operating far below its potential capacity.
Imagine an economy where Real GDP is growing at 6% (very fast), but inflation has jumped to 8%. 1. The goal of Sustainable Growth is being met (and exceeded). 2. The goal of Price Stability is being failed. 3. To fix this, the Central Bank might raise interest rates to slow down spending, even if it means GDP growth drops to 3% and unemployment rises slightly. This is the 'balancing act' of macroeconomics.
The most difficult scenario for stability is Stagflation—a combination of stagnant growth (high unemployment) and high inflation. This breaks the typical inverse relationship. In a normal recession, prices fall; in stagflation, prices rise while the economy shrinks. This usually happens due to a Supply Shock, such as a sudden spike in oil prices. Traditional fiscal and monetary policies struggle here because fixing inflation (by cooling the economy) makes unemployment worse, while fixing unemployment (by stimulating the economy) makes inflation worse.
Scenario: - Country A: Inflation = 2%, Unemployment = 5% (Index = 7) - Country B: Inflation = 10%, Unemployment = 12% (Index = 22)
Country B is experiencing a severe crisis. Even if Country B's GDP is growing, the high Misery Index suggests the 'Three Pillars' of stability have collapsed, requiring aggressive, non-traditional policy intervention.
If the economy is in the 'Expansion' phase of the business cycle, what is most likely happening to the unemployment rate?
Which of the following best describes 'Price Stability'?
Stagflation occurs when an economy experiences both high inflation and high unemployment at the same time.
Review Tomorrow
In 24 hours, try to sketch the four phases of the business cycle from memory and list which of the 'Three Pillars' is most at risk during a 'Peak'.
Practice Activity
Look up the current GDP growth rate and Inflation rate for your country. Based on these numbers, which phase of the business cycle do you think your country is in?