Essay/Term paper: Conflicting goals in economic growth

Essay, term paper, research paper:  Economics

Conflicting Goals in Economic Growth


Goals of monetary policy are to "promote maximum employment, inflation
(stabilizing prices), and economic growth." If economists believe it's possible
to achieve all the goals at once, the goals are inconsistent. There are
limitations to monetary policy.

The term "maximum employment" means that we should try to hold the
unemployment rate as low as possible without pushing it below what economists
call the natural rate or the full- employment rate. Pushing unemployment below
that level would cause inflation to rise and thereby ruin the other objective--
stable prices, economic growth, which is our objectives in the long run.

Overall financial stability will lead to a better balance between
consumption and saving that will make resources available for investment
purposes, reduce changes in the economy created by the inflation in the past,
and by the reactions of savers, as well as fostering high and sustainable
economic growth; and contribute towards an investor friendly environment that
will attract foreign investors to the country.

Evidence has suggested that economies perform better, in terms of growth,
employment and living standards, in low inflation environments than they do when
inflation is persistently high. This evidence is a comparison across countries
over long periods. The association between economic performance, measured by
growth of output or growth of productivity, and inflation. This indicates a
negative relation; that is, the higher the inflation, the lower the rate of real
growth.

Evidence suggesting that low inflation promotes growth has motivated
recent decisions by a number of central banks and governments, most notably New
Zealand. Canada, the United Kingdom and Sweden also have moved in recent years
to establish monetary policy with official low inflation targets. Decisions to
adopt a policy objective of low inflation suggest that other policy-makers are
reading the evidence pertaining to inflation and growth as we are.

Consistent attempts to expand the economy beyond its potential for
production will result in higher and higher inflation, while ultimately failing
to produce lower average unemployment. Therefore, most economists would argue
that there are no long-term gains from consistently pursuing expansionary
policies.

Monetary policy can determine the economy's average rate of inflation in
the long run. And that's important for the economy, because high inflation can
hinder economic growth. For example, when inflation is high, it also tends to
vary a lot, and that makes people uncertain about what inflation will be in the
future. That uncertainty can hinder economic growth in a couple of ways--it adds
an inflation risk premium to long-term interest rates and it complicates the
planning and contracting by business and labor that are so essential to capital
formation. High inflation also hinders economic growth in other ways. For
example, because the tax system isn't in agreement with inflation, high
inflation arbitrarily helps and hurts different sectors of the economy. In
addition, it makes people spend their time hedging against inflation instead of
pursuing more productive activities.

Because the government can determine the economy's average rate of
inflation, some commentators--and some members of Congress as well--have
emphasized the need to define the goals of monetary policy in terms of price
stability, which is achievable.

One kind of conflict involves deciding which goal should take precedence
at any point in time. For example, the government needs to be careful to avoid
letting short-run temporary successes in preventing employment losses during
recessions lead to longer-run failures in maintaining low inflation. Another
kind of conflict involves the potential for pressure from the political arena.
For example, in the day-to-day course of governing the country and making
economic policy, politicians may be tempted to put the emphasis on short-run
results rather than on the longer-run health of the economy. The government is
somewhat insulated from such pressure, however, by its independence, which
allows it to achieve a more appropriate balance between short-run and long-run
objectives.

When unemployment is high the policy that should take place is inflation
should increase slightly to drive up prices in order to cause increases in
output. When unemployment is below average and nearing full employment the
policy that should take place is to slightly lower the productivity of the
workers and therefore cause a decrease in the output. This would slow the
economy down and into the ideal condition of maximum employment. When the
production is at its maximum and unemployment at a minimum the government must
raise the inflation rate in order to make sure that the situation stays where it
is. It must be sure not to raise inflation too sharply or else everyone will be
afraid to spend their money.

The belief that a 4% unemployment rate and stable prices are inconsistent
is shaped by the widely accepted "natural rate hypothesis." It argues that
monetary policy has no effect on the economy's unemployment rate, which is often
called the natural rate of unemployment. The reason is that, in the long run,
unemployment depends on so-called "real" factors--such as technology and
people's preferences for saving, risk, and work effort; these factors are beyond
the reach of monetary policy. Most current estimates place the natural rate of
unemployment in the range of 5¾-6¾%.

Consistent attempts to expand the economy beyond its potential for
production will result in higher and higher inflation, while ultimately failing
to produce lower average unemployment. Therefore, most economists would argue
that there are no long-term gains from consistently pursuing expansionary
policies.