Macroeconomic Policy: Meaning, Types, How It Works

Macroeconomic policy is a government plan and action to influence the economy as a whole. The policy is to achieve macroeconomic targets such as:

• Healthy and sustainable economic growth
• Low and stable inflation rate
• Equilibrium in the balance of payments
• Full employment

 Macroeconomic policy differs from the microeconomic policy. The latter focuses on specific economic agents, for example, raising excise in the tobacco product.

Types of macroeconomic policy 

The three main types of macroeconomic policies are:

1. Fiscal policy
2. Monetary policy
3. Supply-side policy

The first two influence the economy through the aggregate demand side. While the last affects aggregate supply.

Fiscal policy uses budget instruments. Governments can change taxes and their spending to influence the economy. 

Meanwhile, the monetary policy focuses on the money supply. The key tools of monetary policy include policy rates, reserve requirements, and open market operations. 

The supply-side policy seeks to improve the competitiveness and efficiency of the free market. To do this, the government introduces privatization, deregulation, and antitrust policies. Other policies enhance the quality and quantity of the productive capacity of the economy, for example, by improving education, research and development of advanced technology, and infrastructure.

Contractionary and expansionary policies

In general, monetary and fiscal policy can be expansionary or contractionary policies. Both policies ensure the economy to operate close to its potential level. By doing so, the economy avoids the adverse effects of the business cycle, such as hyperinflation and recession.

Expansionary policies drive up economic growth. Governments usually do it when economic growth is weak or recession. To do this, governments could launch several options, such as:

• Reducing tax rates
• Increasing government spending
• Cutting interest rates
• Lowering reserves requirement ratio
• Conducting open market operations by buying government securities.

Those options increase aggregate demand and stimulate economic growth. For example, when interest rates fall, the cost of new loans becomes cheaper. That should encourage households to increase the consumption of goods and services. Increasing demand helps businesses to increase their output. 

Conversely, contractionary policies seek to overcome the adverse effects of high inflationary pressures. High inflation usually accompanies strong real GDP growth. The economy operates above its potential output. During this period, the economy experiences overheated.

High inflation is endangering the economy because the purchasing power of money is falling. It requires government intervention. To moderate inflation, the government can take several alternatives, including:

• Raising tax rates
• Cutting its spending
• Raising interest rates
• Increasing the mandatory reserve ratio
• Open market operations by selling government securities.

Those alternatives reduce aggregate demand and diminish the real GDP growth and inflation rate. 

Discretionary and automatic stabilizer policies

Economists divide fiscal policy into two: discretionary policy and automatic stabilizer. Discretionary policies require explicit intervention. 

In contrast, automatic stabilizer policy does not require explicit government action. It works countercyclical, which decreases during economic expansion and increases during economic contraction.

Transfer payments, such as unemployment benefits, are examples of automatic stabilizer instruments. During a recession, unemployment benefits increase as the unemployment rate rises. In contrast, as the economy expands, unemployment benefits decrease because of a low unemployment rate.