Macroeconomic Management by the State – how does it work? | Sunday Observer

Macroeconomic Management by the State – how does it work?

12 September, 2021

Macroeconomic management is about how the economy is led towards desirable directions and targets without confronting major volatilities. Markets constantly play a major role in this through their automatic gears connected to prices. However, the subject of macroeconomic management is mainly referred to how the state intervenes in the economy in order to achieve certain public interest targets as the state bureaucracy lines believe desirable for the general public from time to time. How the states do this world over are diverse.

The two opposite extremes of interventions are the free-market system proposed by Adam Smith in the 18th century and the fair income distribution between capitalists and labour proposed by Karl Marx in the 19th century. Countries are seen following diverse points between the two extremes.


The types of state interventions proposed by various activists are diverse. A few examples are cited below.

The state must cut its spending and budget deficit to reduce the public debt and inflationary pressures.

The Central Bank should raise interest rates to reduce the growth of money supply to prevent inflationary pressures in the future.

The Central Bank should keep interest rates low to promote economic growth and employment.

Imports should be controlled while promoting exports to achieve a surplus on foreign trade.

Import tariffs should be raised to protect local producers.

Currency depreciation should be reduced to control the costs of production and living.

The Government should engage in a borrowing program from the IMF to solve the foreign currency problem.

The Government should facilitate the inflow of Foreign Direct Investment (FDIs) to attract non-debt foreign exchange to strengthen the foreign reserve and protect the currency.

The Government should tax the wealthy and channel the proceeds to fund welfare schemes.

The Government should impose maximum prices on basic food items to reduce the cost of living.

The Government should impose minimum prices on domestic agricultural produce to protect the farmers.

One can compile an endless list of such proposals. However, many do not know whether or how such proposals can achieve the intended public objectives. Conversely, there are many instances that such proposals implemented in the past have not achieved the objectives.

To understand the impact or effectiveness of such policy interventions, we must understand the operating mechanism of the economy.

Operating mechanism

The economy produces goods and services (GDP) which generate income (Y) based on its resource base or production capacity. This is the supply side of the economy. The income is spent for consumption and investment (spending). This is the demand side of the economy. Therefore, the GDP is necessarily equal to spending in real terms (equilibrium) in the economy. The savings is only an intermediary act to channel a part of income for investment.

Savings in cash/currency kept idle is negligible in modern monetary economies and, therefore, savings is equal to investment over a period of time.

The main sectors of the economy are the private sector and the Government. Both sectors participate in production (GDP) and spending.

In open economies, domestic spending is more than the GDP due to imports (M) and less than the GDP due to exports (X). Therefore, to calculate the GDP from the domestic spending, imports must be deducted, and exports must be added.

The private sector has to pay taxes (T) and, therefore, its spending, i.e., consumption (C) and investment (I), is equal to its income less taxes.

The Government also spends (G)on consumption and investments financed by taxes and borrowing.

Now, the macroeconomic chemistry is: GDP=Y=C+I+G-T+X-M. This is known as income identity which shows that the domestic income (value of the GDP) is equal to domestic spending. Savings is the amount of income not spent on consumption. Therefore, savings (S) available to the private sector is nearly equal to Y-C. Changes in income, tax and consumption will change the S.

Accordingly, the income identity can be rearranged as: S= I+G-T+X-M. This gives a simple result as (G-T)=(S-I)+(M-X).

This means that the Government budget deficit is equal to the sum of the private sector net savings (S-I) and country’s current account deficit (net imports of goods and services including factors, M-X) in the BOP.

This shows that although the economy’s GDP is equal to its spending (equilibrium of the economy), its sectors, i.e., private, Government and foreign, can run on deficits or surpluses (sectoral disequilibria).

The intuition behind this is as follows. If the state is to run a budget deficit, resources should be provided by the private sector through net savings and by the rest of the world (trade partners) through BOP current account deficits (or net imports) to finance the budget deficit. For example, if the budget deficit is 8 percent of GDP and BOP current account deficit is 2 percent of GDP, the private sector net savings should be roughly 6 percent of GDP.

If the private sector also wants to invest more than its savings (private sector deficit) while the state runs a budget deficit, both deficits should be financed by the net imports or BOP current account deficit. This is the importance of the global economy. A country can import resources, produce incomes and spend exceeding the level of domestic resources.

The deficit in the BOP current account means the inflow of foreign funds or capital by way of foreign loans, business investments and foreign reserves. Therefore, the current account surplus is possible only if the sum of the state and private sector balances is a surplus, i.e., private sector savings is greater than its investments and the budget deficit.

Therefore, the operating fundamental of the economy consists of budget balance, private sector savings-investment gap and the BOP current account balance which add to zero at the equilibrium of the economy.

The above operating mechanism (see diagram) can be expanded to explain how various behaviors of the public and Government affect or determine sectoral balances, demand side and supply side of the economy. This is known as macroeconomic modeling.

(To be continued next week)