Unit 7: Government Macroeconomic Intervention - Part I (Extra Notes)

7.1 Policies to correct BOP deficits

If a country is experiencing persistent BOP deficits, the government would have to intervene to stabilise
the situation. Policy measures that it can employ are of 3 types:
1. Expenditure-dampening policies
Expenditure reducing policies are policies designed to reduce demand for products in general, both Page | 1
domestic and foreign. The idea is that this will reduce imports and by making it more difficult for domestic
firms to sell on the home market, will force them to increase exports. They comprise of:
(a) Fiscal contraction
This involves a cut in government spending and/or a rise in taxation. A drop in the amount that the
government spends would reduce aggregate demand [as revealed by the identity AD = C + I + G + (X –
M)] and hence national output or income. A rise in taxation e.g. income tax, would reduce disposable
income of households, and thus, less income would be available for spending on imports.

(b) Monetary contraction

By raising the interest rate, borrowing would appear expensive while saving would appear more
attractive. Thus, households and firms would borrow less for consumption and investment purposes. A
fall in such expenditures would reduce AD. Ultimately, there would be a downward multiplier effect on
national income. With reduced income, less would be spent on imports. This can also be achieved by
limiting the amount funds that can be loaned up to private economic agents by commercial banks.

Note: A rise in the interest rate also works out to attract short term capital from abroad. This helps to
improve the country’s financial account position.

AS

P0

P1
AD0
AD1
Y1 YF  Y0 Real GDP
 Unit 7: Government Macroeconomic Intervention - Part I (Extra Notes)

The use of contractionary or deflationary fiscal and monetary policies seek to reduce aggregate

expenditure from AD0 to AD1 . Consequently, with reduced expenditure, less output would be realised
and thus, less income would be generated. With reduced income, less would be spent on imported
commodities. Such policies can also reduce inflationary pressures from the economy and make exports
more price-competitive. This would also help to correct a balance of payments deficit. Page | 2

Limitations of expenditure-dampening policies:

 There are limits to cuts in government expenditures: some items are very difficult to reduce like
expenditures on education and health care. Demand for these merit goods are ever-increasing and
reducing expenditures on these would impact negatively on the health of the economy. Besides it is
politically unwise to cut expenditures on these crucial items.

 Disincentive effects of a rise in taxation: raising taxes, particularly, income taxes may have
disincentive effects on productivity, investment and savings. Such a measure is politically unpopular
as well because it reduces purchasing power of people.

 Rise in the exchange rate: a rise in the interest rate may attract short term capital from abroad. This
would raise the demand for the local currency and put pressure on the exchange rate to rise.
However, an appreciation of the domestic currency may erode export competitiveness and make
imports more attractive. This can adversely affect our balance of payments. This explains why
monetary policy is seldom used to correct a BOP deficit.

 Economic stagnation and unemployment- The serious drawback of using such deflationary
demand-management policies is that it is capable of causing a slowdown in economic activity and
possibly a recession. It is not just import-spending that is reduced but also domestic spending. This
would dampen domestic output, and firms may lay off workers, causing a rise in unemployment.

2. Expenditure-switching policies
These are policies aimed at redirecting or switching expenditures from imported goods to home-produced
or domestically produced goods. This includes two main measures:
(a) Trade protectionist measures
Trade protectionist measures like tariffs, quotas, and subsidies, operate to make imports appear more
expensive relative to domestic products. Thus, households may direct their expenditure away from
imports and towards the import-substitutes (home-produced goods if these are available). With a
reduction in import expenditure, the current account may improve.

Limitations of trade barriers: They work against the law of comparative advantage and encourage
inefficiency. Moreover, there is always the risk of inflationary pressures from the use of measures like
tariffs (a tax on imported products). It can also provoke retaliation. (Refer to previous discussion on
arguments against protectionism).
 Unit 7: Government Macroeconomic Intervention - Part I (Extra Notes)

(b) Devaluation (Exchange rate policy)

The government may as a last resort weapon devalue its currency. This represents an official reduction in
the external value of the country’s currency vis-a-vis other currencies. The effect of a devaluation is to
make exports competitive and imports dearer. Eventually, this will boost export demand and discourage
import consumption and hence may improve the current account and hence the balance of payments. Page | 3

Limitations of devaluation policy

 Marshall-Lerner condition & the J-curve effect: a devaluation has the same effects as a
depreciation. Thus, for the devaluation to improve the trade balance, the sum of the elasticities of
demand for exports and imports should be greater than 1 (PEDX + PEDM > 1). This will ensure a rise
in export revenues and/or a fall in import expenditures that would work out to improve the balance of
trade. This is more likely to be the case in the long run when consumers have adjusted their
consumption patterns and more substitute products are made available by producers on the market.
In the short run, however, many would argue that a devaluation would not help to deal with the BOP
deficit as it causes a worsening of the trade balance. The sum of the elasticities of demand for
exports and imports may be less than 1 (PEDX + PEDM > 1), following which export revenues may
fall and/or import expenditures may rise (show using diagrams).

 Non-price factors may be more important: foreign buyers may regard non-price factors like quality,
after-sales service, reliability, durability, design, delivery dates among many others, as more
important than the price reduction brought about by the devaluation.

 Supply Response: The success of the devaluation in improving or reducing the deficit will depend
upon the supply response of the increase in demand induced by the rise in export and import-
substitute competitiveness. Basically, there are two types of supply constraints that an economy can
face and will render devaluation ineffective:

 Physical Constraints: This takes the form of constraints such as poor infrastructure, weak
customs administrations and institutions and corruption, inter alia, which limit the effectiveness of
devaluation in encouraging and satisfying more export demand as well as the demand for import-
substitute goods.

 Capacity/Real Constraints: This refers to the inadequacy of resources in the economy to satisfy
the excess demand situation following the devaluation. In other words, when the currency is
devalued, exports would appear more competitive and imports, dearer. This would bolster
demand for exports as well as the demand for import-substitute goods within the economy. In
turn, AD would rise, induced by greater demand for exports and import-substitutes. If unemployed
resources are available to produce export-oriented and import-substitute goods, then the deficit
problem might be cured. But if the economy is operating at full employment level, i.e. resources
are fully used up, then a devaluation will result in demand-pull inflation. This will eventually entail
an increase in export prices and imports would seem relatively cheaper, thereby worsening the
deficit situation. Hence, decisions to devalue the currency should take into account the current
resource availability of the economy.

 Retaliation/Competitive devaluation/Currency war: devaluation can only be effective if other

countries, particularly major competitors, do not retaliate by devaluing their own currency. If these
 Unit 7: Government Macroeconomic Intervention - Part I (Extra Notes)

countries carry out similar actions then the rate of exchange between them will be unchanged
(assuming they devalue by the same %). In other words, competitive devaluation has no effect and
makes it useless.

 How much to devalue?: a devaluation that goes too far runs the risk of provoking massive
speculation against a currency which may lead to panic selling and capital flight. This would Page | 4
significantly worsen the financial account of the BOP and in turn a BOP deficit may turn into a BOP
crisis.

 Inflationary effect: devaluation also exerts demand-pull and cost-push inflationary pressures on the
domestic economy. With the drive in exports demand and the slow-down in imports demand, AD
would rise. If there are few idle capacity left, the excess demand situation would not be met and this
would put pressure on prices to climb up (demand-pull inflation). Moreover, with the rise in imported
raw materials, domestic firms would face a rise in their costs of production. This is because many of
these inputs have inelastic demands and a rise in their prices would not reduce demand by much.
Instead, domestic producers would be seen spending more on these imported components. This
would set final prices upwards as firms seek to make up for the shortfall (cost-push inflation). There
can also be imported inflation as the prices of imported finished products would be higher. These
count in the measurement of a country consumer price index.

 Negative signal to outside investors: a devaluation hurts the pride of the nation and erodes its
image. The government would also suffer politically. The use of devaluation emits a signal to the
external world that the country has failed and has accepted defeat given that it has used its ‘last
resort weapon’ to correct its BOP deficit. As a result, this may discourage foreign direct investment
into the economy which will eventually worsen the financial account of the BOP and hence
aggravating the situation.

3. Supply-side policies
The most effective way to deal with balance of payments deficits would be to use supply-side policies,
particularly if they are the result of structural weaknesses in the economy. In this context, application of
appropriate supply-side measures would make domestic products more competitive in both the internal
and the external market, thereby raising demand for exports and reducing demand for imports (given that
domestically produced import substitutes appear more competitive). Some of these supply-side measures
include:
 Investment in education and training: this would raise labour productivity and help to clear out
supply-side bottlenecks which raise the price of commodities. Increased education and training also
remain up to date with new techniques of production and this improves product quality. Also, if more
workers undertake courses in marketing or international business, this will promote the way firms
market their products abroad.

 Investment in research and development: this would allow firms to innovate and improve their
product quality.
 Unit 7: Government Macroeconomic Intervention - Part I (Extra Notes)

 Improvement in infrastructures: this would reduce communication and distribution costs; also an
efficient transport system helps firms to maintain their pre-set delivery dates. Moreover, they would be
able to promote their products more effectively.

 Reduction in corporate taxes: this would attract foreign direct investment and improve the country’s Page | 5
financial account balance.

 Trade liberalisation: most economists argue that freer trade improves a country’s balance of
payments as opposed to protectionism. Freer trade gives firms both an incentive and a threat to
innovate by investing in new technologies and seeking new ways to improve product quality. It also
provides a gateway for the transfer of technology and know-how between countries. This helps to
make the country’s products more competitive internationally.

Limitations of supply-side policies

 Costly to implement: Interventionist supply-side policies are costly (so there is an opportunity cost for
the government, as it means that the money cannot be spent on the next best alternative).

 Considerable time lags: Such policies can only be effective over the longer term. For example, it
takes years to reap the benefits of increased investment in education today. In certain cases, such
investments may not even produce the desired effect if they are not skills oriented.

Conclusion
Thus, there are several ways to deal with a BOP deficit but each policy has its own merits and demerits.
Nevertheless, which policy to use and when depends on the causes of the deficit. For example, if the
deficit stands from a currency overvaluation, then a devaluation would help but if the deficit is due to
structural weaknesses, then supply-side measures would be most appropriate.

7.2 Policies to control inflation

The policies that a government can employ to control inflation would depend upon the causes of inflation
in the first place. Inflation is multi-causal. It can be brought about by excess demand, increases in the
costs of production, and excess money supply among the main ones.

1. Contractionary demand-management policies

If inflation is caused by excess demand, the government should seek to reduce demand by employing
contractionary demand-management policies which take the following forms:

(a) Contractionary monetary policy

In practice, monetary policy is now more widely used to control inflation. This principally entails a rise in
the rate of interest. This, in turn, implies a rise in the cost of borrowing and in the return of saving. With an
increase in the cost of borrowing, households and firms would borrow less for consumption and
 Unit 7: Government Macroeconomic Intervention - Part I (Extra Notes)

investment purposes, respectively. Also, with a rise in the return on saving, households would be
encouraged to save more to enjoy more returns. So doing would entail a reduction in consumer spending.
Net exports may also fall (due to a fall in competitiveness) since a rise in the interest rate would attract
‘hot money’ from abroad and put pressure on the exchange rate to rise. Altogether, AD would fall.
Page | 6
Limitations of monetary policy
 There is uncertainty concerning the impact of monetary policy. On one hand, households and firms
may expect prices to rise further in the future and so they may spend more today (inflation
psychology) although the interest rate has increased; on the other hand, they may be highly
responsive to the interest rate hike, and spending may fall more than anticipated. In such a case, the
economy would have a hard landing with unemployment rising.

 It also takes time for a change in interest rates to fully impact on the level of spending in the economy
(impact lag). Economists estimate that it can take up to 18 months for the full effect to be felt.

 A contractionary monetary policy that puts upward pressure on the exchange rate can harm the
country’s international competitiveness and create BOP difficulties.

 Monetary policy is often viewed as a blunt instrument as it is applied to all firms, industries, and
sectors equally, regardless of the different levels of profitability. It is also equally applied to both rich
and poor households. Raising the interest rate would increase the interest payments that firms and
households make on their loan repayments, and that unfairly affects poor households and low-profit
firms such as SMEs more significantly.

(b) Contractionary fiscal policy

This involves a cut in government spending and/or a rise in taxation. Aggregate demand (AD) comprises
of consumption (C), investment (I), government spending (G) and the balance of trade (X – M) i.e., AD =
C + I + G + (X – M). A cut in government spending would directly reduce aggregate demand as revealed
by the aforementioned identity. A rise in taxation e.g. income tax would reduce disposable income of
households. In turn, they would demand less goods and services. Consumption falls, followed by AD.

A fall in AD would put pressure on the price level to fall as shown below:
 Unit 7: Government Macroeconomic Intervention - Part I (Extra Notes)

AS

Page | 7
P0

P1

AD0
AD1
AD2
Y1 YF  Y0 GDP

The use of contractionary fiscal and monetary policies would reduce AD. The AD curve would shift to the

left from AD0 to AD1 . This would put pressure on the price level to fall from P0 to P1 .

Limitations of fiscal policy

 Excessive spending cuts can reduce national output and cause demand-deficient unemployment
along with its negative consequences such as rise in poverty and

 High rates of taxation may impede workers’ incentives to work harder and firms to invest. This would
be bad for economic growth. Also, a policy of raising taxes is politically unpopular as it creates
frustration among the electorate.

 Government spending on certain items like defence, education, health care cannot be reduced since
they directly influence the welfare of people. Other forms of government spending may also be
difficult to reduce because of their long-term nature. For example, once a decision has been
announced that the pay of government employees will be increased it would be difficult to reverse it
and will commit the government to higher spending for some time.

 Fiscal policy suffers from lengthy administrative and decision lags, i.e. it takes time for government
policy measures to be approved by the parliament, and for the government to implement the
measures.

(c) Exchange rate policy

A government or the Central Bank may seek to reduce inflation by encouraging a rise in the exchange
rate. This can be done by aiming for a higher interest rate or by purchasing domestic currencies on the
forex market. A higher exchange rate can reduce inflation in three main ways. It lowers the prices of
imported finished goods which count in the CPI. It also reduces the prices of material costs and hence
domestic prices. In addition, it puts pressure on domestic firms to produce goods and services of better
quality and to lower their own prices so as to remain competitive against cheaper imports.
 Unit 7: Government Macroeconomic Intervention - Part I (Extra Notes)

Limitations: However, a higher exchange rate may have adverse effects on employment and growth given
that it erodes the country’s export competitiveness. It can also lead to balance of payments problems as
exports would appear dearer and imports cheaper.

 Can demand-side policies address cost-push inflation?

Page | 8
Contractionary demand-side policies are not effective in addressing cost-push inflation; they may instead
exert more cost-push pressures on the economy:
 Cutting government spending on education and health care, infrastructure, subsidies would reduce
factor productivity and raise costs, which may in turn contribute to cost-push inflation;

 Higher income tax rates may cause workers to press for wage rises; this may increase labour costs or
may provoke industrial action which can disrupt production and cause cost-push inflation.
 Higher interest rates would raise the interest payments on loans taken by firms, thereby contributing
to higher overall costs.

2. Supply-side policy
In the long run, economists argue that the only effective way to achieve and maintain price stability to
make use of supply-side policy. Such a policy targets the aggregate supply of the economy and is thus
particularly useful to deal with cost-push inflation. But, it also helps to hold demand-pull inflation by
allowing any excess demand to be absorbed by increases in supply. Supply-side policy can take multiple
forms. Those which are more appropriate to control inflation include:
 Massive and continuous investment in education and training/re-training: this would raise labour
productivity and reduce costs of production of firms (as the same amount could be reduced using
fewer labour).

 The government could provide subsidies to private firms to encourage investment in new and
sophisticated technologies. This would raise both capital and labour productivity.

 Reduction in international trade barriers e.g. tariffs: this would promote competition and may result in
lower prices. Also, the removal of tariffs directly reduces the price of commodities on which they were
imposed.

 The state can sell part or whole of its enterprises to the private sector (privatisation) - this would again
serve to promote competition, which may ultimately result in lower prices. Private firms would also be
encouraged to innovate to win over customers and also, to avoid being driven out of the industry.
There would be more efficiency.
 Unit 7: Government Macroeconomic Intervention - Part I (Extra Notes)

 The government could also raise its spending on infrastructures to improve the efficiency of supply
and reduce costs of production.

Altogether, the use of supply-side policy raises aggregate supply, which eventually results in a fall in the
price level as shown below: Page | 9
P

AS 0 AS1

P0

P1

AD0
AD1

Y0 Y1 Real GDPReal

Supply-side policy, if successful, raises the productive potential of the economy. The long run aggregate

supply curve shifts to the right from AS0 to AS 1 . This allows any excess demand to be absorbed by an
increase in supply. Thus, demand-pull inflation is contained. The price level falls from P0 to P1 . Cost-
push inflation is also avoided since the supply-side measures raise productivity and the efficiency of
supply. Costs of production fall.

Limitations: However, note that supply-side policy is effective only in the long run. In the short run, other
counter-inflation policies should be employed. Moreover, the interventionist measures such as investment
in capital and privatisation are expensive to implement. Government would have to divert funds from
other alternative uses to cater for these expenses or funds may have to be borrowed. Also, some of the
proposed measures may have undesired and/or uncertain outcomes, e.g. privatisation may result in
consumer exploitation if the private firm is a monopoly and external costs of production such as pollution
may be ignored. Providing subsidies may encourage firms to become complacent and stifle innovation.

7.3 Policies to control deflation

Deflation refers to a fall in the general price level over a certain time period and is evidenced by
negative inflation rates. It is mainly caused by a large deficiency in AD, a situation often seen during an
 Unit 7: Government Macroeconomic Intervention - Part I (Extra Notes)

economic crisis, e.g. at the time of the Global Financial Crisis (2008-10) in Japan. It is thus accompanied
by a rise in the unemployment rate and falling real GDP (negative growth rates/recession). To deal with
deflation, policymakers need to stimulate the level of AD by using expansionary or reflationary fiscal
and/or monetary policies.

Page | 10

1. Expansionary Fiscal Policy

This involves a rise in government spending and/or a fall in taxation (namely direct taxes) to boost
spending in the economy. An increase in public investment spending such as on infrastructure will have
a positive multiplier effect in the economy and boost AD. A fall in direct taxes will raise disposable
income of households and firms. For instance, a cut in income tax will leave households with more
income to spend on goods and services (rise in consumption spending). Similarly, a cut in corporate tax
will imply more company funds retained for re-investment purposes (rise in investment spending).

Limitations:

a) Adopting an expansionary fiscal stance implies accommodating a worsening budget deficit. This
requires financing, and thus the accumulation of public debt. If the public investment spending is
not productive, returns will not be generated in the future for the repayment of debt.

b) There is considerable decision and implementation lag associated with such fiscal policies. It takes
time for the government to formulate policy and get it passed through Parliament. Once a fiscal
policy has been approved, it takes time to implement the policy given the nature of government
projects e.g., construction of dams, bridges, roads etc.

2. Expansionary Monetary Policy

The Central Bank can also reduce the interest rate to make spending less expensive for households and
firms. Lower interest rate would reduce borrowing cost and increase the demand for loanable funds.
Households and firms may borrow more and spend more on consumption and investment purposes,
respectively. Lower return on savings would also increase the incentive to spend. Such a policy can also
result in an outflow of funds from the country if the domestic interest rate is relatively lower than
foreign interest rates. All else remaining unchanged, there will be less demand for the domestic
currency and higher supply as domestic investors prefer to deposit funds abroad. The outcome – a
currency depreciation – would make export goods and services less expensive to foreigners, and imports
would appear dearer to domestic people. If the Marshall-Lerner condition holds (sum of PED for exports
and imports > 1), AD would increase due to a rise in net exports value.

Limitations:

 There is uncertainty concerning the impact of monetary policy.

 Unit 7: Government Macroeconomic Intervention - Part I (Extra Notes)

 Households and firms may remain insensitive to interest rate cuts if it is insignificant (it was already
at a low rate or it is a very small cut) and/or they are pessimistic about the future. They may prefer
to save as a precaution against unforeseen events, e.g. sudden loss of job.

 If they expect prices to continue falling, they may continue to delay their spending despite interest
Page | 11
rate cuts.

 Households and firms may not expect the cut to last and so will not alter their spending and
investment plans.

 There is considerable impact lag with monetary policy, i.e. the decision to change the interest rate
may be quick but it takes time for the new interest rate policy (particularly when it is of an
expansionary nature) to reach the real sector of the economy. Spending decisions by households
and firms, particularly those which need to be financed out of borrowing are usually one-off or not
recurrent, e.g. borrowing to construct a house or a new factory. They are also big-ticket purchases
and thus need considerable planning before realisation.

In spite of the potential shortcomings, carefully designed and implemented expansionary fiscal and
monetary policies can stimulate AD and correct the deflation problem as illustrated below:

Fig. 1

LRAS
SRAS

P1

P0
AD1
AD0

YF  Y1 Real GDP
Y0

The graph above demonstrates how a rise in AD can reverse the downward pressure on the general
price level. So long as AD is growing in tandem with output, both deflation and inflation would be
avoided. Prices would be rising in a stable manner.
 Unit 7: Government Macroeconomic Intervention - Part I (Extra Notes)

Page | 12

7.4 Policies to stimulate employment

Policies geared to reduce unemployment depend on the cause of unemployment. Unemployment may be
due to the lack of demand in the economy (demand-deficiency unemployment), decline of certain
industries and occupations (structural unemployment), or simply because some workers keep changing
jobs and, in the meantime, they remain unemployed (frictional unemployment).

1. Expansionary demand-management policies

Keynesians believe that if unemployment is due to a deficiency in demand in the economy, the
government should make use of expansionary of reflationary demand-management policies which can
take the following forms:
(a) Expansionary fiscal policy
This involves a rise in government spending and/or a fall in taxation. A rise in government expenditure
raises aggregate demand (or aggregate expenditure) directly as revealed by the identity AD = C + I + G +
(X – M). A fall in taxation e.g. income tax would raise disposable income of households and thus boost
consumption expenditures. Similarly, a decrease in sales tax would raise the purchasing power of
households as it would reduce the price they pay for the goods. A cut in corporate tax would raise after-
tax profits and stimulate private investment. By extension, AD would rise.

(b) Expansionary monetary policy

This policy is usually practiced by lowering the key interest rate in recent years. This would spread over to
all other interest rates in the economy. Hence, such an action would make borrowing appear cheaper and
the return on saving would appear less attractive. This would thus encourage borrowing and discourage
saving. Eventually, spending on the part of both households and firms for consumption and investment
purposes respectively would increase. Net exports would also increase if the fall in interest rate results in
a currency depreciation. On the whole, AD would rise.

In turn, a rise in AD would exert an upward multiplier effect on national output (GDP):
 Unit 7: Government Macroeconomic Intervention - Part I (Extra Notes)

LRAS
SRAS
Page | 13

P1

P0
AD1
AD0

YF  Y1 Real GDP
Y0
To realise extra output, additional workers would be required. Thus, employment would be stimulated in
the economy.

Limitations:
 Danger of inflation: Increased spending may cause prices to rise due to excess demand. However,
inflation has harmful effects on the economy.

 Balance of payments difficulties: A further problem may arise because some proportion of
consumer spending may go towards imported goods and services. In other words, when the
government increases total demand (e.g. by lowering taxation), part of the increased spending may
‘leak out’ of the economy and creates jobs abroad rather than at home.

 Adopting an expansionary fiscal stance implies accommodating a worsening budget deficit. This
requires financing, and thus the accumulation of public debt. If the public investment spending is not
productive, returns will not be generated in the future for the repayment of debt.

 There is considerable decision and implementation lag associated with such fiscal policies. It
takes time for the government to formulate policy and get it passed through Parliament. Once a fiscal
policy has been approved, it takes time to implement the policy given the nature of government
projects e.g., construction of dams, bridges, roads etc.

 There is uncertainty concerning the impact of monetary policy.

 Unit 7: Government Macroeconomic Intervention - Part I (Extra Notes)

o Households and firms may remain insensitive to interest rate cuts if it is insignificant (it was
already at a low rate or it is a very small cut) and/or they are pessimistic about the future. They
may prefer to save as a precaution against unforeseen events, e.g. sudden loss of job.

o If they expect prices to continue falling, they may continue to delay their spending despite interest Page | 14
rate cuts.

o Households and firms may not expect the cut to last and so will not alter their spending and
investment plans.

 There is considerable impact lag with monetary policy, i.e. the decision to change the interest rate
may be quick but it takes time for the new interest rate policy (particularly when it is of an
expansionary nature) to reach the real sector of the economy. Spending decisions by households and
firms, particularly those which need to be financed out of borrowing are usually one-off or not
recurrent, e.g. borrowing to construct a house or a new factory. They are also big-ticket purchases
and thus need considerable planning before realisation.

2. Supply-side policy
Monetarists and New Classical economists believe that if the economy is suffering from frictional and
structural unemployment, the government should employ supply-side policy to deal with the problem.
Such a policy would help to improve the workings of the labour market (i.e., remove imperfections in the
labour market) and therefore serve to reduce such unemployment. Appropriate supply-side measures
include:
 Job centers should be set up where people could obtain information and advice on the job
opportunities available on the market; once established, people should be persuaded to make good
use of them. The government could also make use of informative advertising to inform people about
the various job opportunities available.

 Job fairs could be organised to create a platform where potential employers could interact with
potential employees; these job fairs can take place at a physical place or virtually as well via the
internet.

 Organise government-funded training programs to update the skills of workers who have lost their
jobs in certain industries, enabling them to work in a different industry. The government could
encourage private firms to continuously train and educate their workforce so that they adapt
accordingly to the changing and competitive environment. Subsidies can be given for that purpose.
 Unit 7: Government Macroeconomic Intervention - Part I (Extra Notes)

 Government can also slow down the rate of decline of an industry by granting subsidies to firms in it
so as to reduce structural unemployment.

 Some people might prefer to remain unemployed voluntarily because unemployment benefits are
higher compared with what they would have earned from being in low-paid jobs. Thus, by reducing Page | 15
unemployment benefits, those who do not wish to work would be encouraged to find employment.

 If the firms dismissing workers are concentrated in a particular region, it is necessary to persuade
other firms to move into that area to avoid regional unemployment (a form of structural
unemployment). This can be done by according tax holidays to them or by providing them with the
necessary infrastructures.

 A high income tax may also encourage some people to remain unemployed. They believe that the
after-tax earnings would be lower than the unemployment benefits. Hence, a fall in income tax should
be encouraged to increase the return from working.

 Reducing the power of trade unions through legislation – in doing so, they would be less able to push
up wages above equilibrium levels and engage in restrictive practices.

 Improve labour flexibility, making it easier to ‘hire and fire’ workers, and using less rigid work patterns,
including part-time and casual employment, will also encourage employers to recruit more workers.

All these measures are aimed at increasing the economy’s LRAS and lowering the natural rate of
unemployment as shown below:
 Unit 7: Government Macroeconomic Intervention - Part I (Extra Notes)

P
LRAS0 LRAS1

SRAS0
SRAS1
Page | 16

AD1
AD0

Real GDP
Y 0F Y 1F

A shift in the LRAS curve to the right will serve to raise the economy’s potential GDP level. It is
noteworthy that measures to raise the LRAS also increase the SRAS. Also, for such measures to reduce
unemployment, AD should rise adequately alongside. Then only actual output will rise to the new full
potential level and in the process reducing unemployment without causing inflation.

Thus, supply-side and demand-side measures are complementary in reducing unemployment. This is
accepted by most economists now. Improving the quality of the workforce and making people more willing
to take up employment will not be effective if demand for goods and services is insufficient to create an
adequate number of jobs. Similarly, increasing demand without ensuring that the unemployed have the
necessary skills and willingness to take up the vacancies created would be likely to cause inflation and a
balance of payments deficit rather than a reduction in unemployment.

Limitations:
 Supply-side measures are associated with considerable time lags, i.e. they are effective in the long
run.

 Some supply-side measures require massive upfront public investments that require huge financing
– this may worsen the budget deficit and in the short term, the inflation problem may aggravate
because of the spending effect.

 Some of supply-side measures may not bring the desired results if not carefully implemented. For
example, increased spending on education and training may not make labour more productive if
they are not skill oriented.