Economic policy

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The economic policy of governments covers the systems for setting levels of taxation, government budgets, the money supply and interest rates as well as the labour market, national ownership, and many other areas of government interventions into the economy.

Contents

Most factors of economic policy can be divided into either fiscal policy, which deals with government actions regarding taxation and spending, or monetary policy, which deals with central banking actions regarding the money supply and interest rates.

Such policies are often influenced by international institutions like the International Monetary Fund or World Bank as well as political beliefs and the consequent policies of parties.

Types of economic policy

Almost every aspect of government has an important economic component. A few examples of the kinds of economic policies that exist include: [1]

Macroeconomic stabilization policy

Stabilization policy attempts to stimulate an economy out of recession or constrain the money supply to prevent excessive inflation.

Tools and goals

Policy is generally directed to achieve particular objectives, like targets for inflation, unemployment, or economic growth. Sometimes other objectives, like military spending or nationalization are important.

These are referred to as the policy goals: the outcomes which the economic policy aims to achieve.

To achieve these goals, governments use policy tools which are under the control of the government. These generally include the interest rate and money supply, tax and government spending, tariffs, exchange rates, labor market regulations, and many other aspects of government.

Selecting tools and goals

Government and central banks are limited in the number of goals they can achieve in the short term. For instance, there may be pressure on the government to reduce inflation, reduce unemployment, and reduce interest rates while maintaining currency stability. If all of these are selected as goals for the short term, then policy is likely to be incoherent, because a normal consequence of reducing inflation and maintaining currency stability is increasing unemployment and increasing interest rates.

Demand-side vs. supply-side tools

This dilemma can in part be resolved by using microeconomic supply-side policy to help adjust markets. For instance, unemployment could potentially be reduced by altering laws relating to trade unions or unemployment insurance, as well as by macroeconomic (demand-side) factors like interest rates.

Discretionary policy vs policy rules

For much of the 20th century, governments adopted discretionary policies like demand management designed to correct the business cycle. These typically used fiscal and monetary policy to adjust inflation, output and unemployment.

However, following the stagflation of the 1970s, policymakers began to be attracted to policy rules.

A discretionary policy is supported because it allows policymakers to respond quickly to events. However, discretionary policy can be subject to dynamic inconsistency: a government may say it intends to raise interest rates indefinitely to bring inflation under control, but then relax its stance later. This makes policy non-credible and ultimately ineffective.

A rule-based policy can be more credible, because it is more transparent and easier to anticipate. Examples of rule-based policies are fixed exchange rates, interest rate rules, the stability and growth pact and the Golden Rule. Some policy rules can be imposed by external bodies, for instance the Exchange Rate Mechanism for currency.

A compromise between strict discretionary and strict rule-based policy is to grant discretionary power to an independent body. For instance, the Federal Reserve Bank, European Central Bank, Bank of England and Reserve Bank of Australia all set interest rates without government interference, but do not adopt rules.

Another type of non-discretionary policy is a set of policies which are imposed by an international body. This can occur (for example) as a result of intervention by the International Monetary Fund.

Economic policy through history

The first economic problem was how to gain the resources it needed to be able to perform the functions of an early government: the military, roads and other projects like building the Pyramids.

Early governments generally relied on tax in kind and forced labor for their economic resources. However, with the development of money came the first policy choice. A government could raise money through taxing its citizens. However, it could now also debase the coinage and so increase the money supply.

Early civilizations also made decisions about whether to permit and how to tax trade. Some early civilizations, such as Ptolemaic Egypt adopted a closed currency policy whereby foreign merchants had to exchange their coin for local money. This effectively levied a very high tariff on foreign trade.

By the early modern age, more policy choices had been developed. There was considerable debate about mercantilism and other restrictive trade practices like the Navigation Acts, as trade policy became associated with both national wealth and with foreign and colonial policy.

Throughout the 19th Century, monetary standards became an important issue. Gold and silver were in supply in different proportions. Which metal was adopted influenced the wealth of different groups in society.

The first fiscal policy

With the accumulation of private capital in the Renaissance, states developed methods of financing deficits without debasing their coin. The development of capital markets meant that a government could borrow money to finance war or expansion while causing less economic hardship.

This was the beginning of modern fiscal policy.

The same markets made it easy for private entities to raise bonds or sell stock to fund private initiatives.

Business cycles

The business cycle became a predominant issue in the 19th century, as it became clear that industrial output, employment, and profit behaved in a cyclical manner. One of the first proposed policy solutions to the problem came with the work of Keynes, who proposed that fiscal policy could be used actively to ward off depressions, recessions and slumps. The Austrian School of economics argues that central banks create the business cycle. After the dominance of monetarismry [2] and neoclassical thought that advised limiting the role of government in the economy in the second half of the twentieth century, the interventionist view has once more dominated the economic policy debate in response to the 2007-2008 financial crisis [3] ,

Evidence-based policy

A recent trend originating from medicine is to justify economic policy decisions with best available evidence [4] . While the previous approaches have been focused on macroeconomic policymaking aimed at sustaining promoting economic development and counteracting recessions, EBP is oriented towards all types of decisions concerned not only with anti-cyclical development but primarily with the growth-promoting policies. To gather evidence for such decisions, economists conduct randomized field experiments. The work of Banerjee, Duflo, and Kremer, the 2019 Noble Prize laureates [5] exemplifies the gold type of evidence. However, the emphasis put on experimental evidence by the movement of evidence-based policy (and evidence-based medicine) results from the narrowly construed notion of intervention, which encompasses only policy decisions concerned with policymaking aimed at modifying causes to influence effects. In contrast to this idealized view of evidence-based policy movement, economic policymaking is a broader term that includes also institutional reforms and actions that do not require causal claims to be neutral under interventions. Such policy decisions can be grounded in, respectively, mechanistic evidence and correlational (econometric) studies [6] .

See also

Related Research Articles

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Macroeconomics branch of economics that studies aggregated indicators

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In economics, stagflation, or recession-inflation, is a situation in which the inflation rate is high, the economic growth rate slows, and unemployment remains steadily high. It presents a dilemma for economic policy, since actions intended to lower inflation may exacerbate unemployment.

Inflation increase in the general price level of goods and services in an economy over a period of time

In economics, inflation is a sustained increase in the general price level of goods and services in an economy over a period of time. When the general price level rises, each unit of currency buys fewer goods and services; consequently, inflation reflects a reduction in the purchasing power per unit of money – a loss of real value in the medium of exchange and unit of account within the economy. The opposite of inflation is deflation, a sustained decrease in the general price level of goods and services. The common measure of inflation is the inflation rate, the annualized percentage change in a general price index, usually the consumer price index, over time.

Monetarism is a school of thought in monetary economics that emphasizes the role of governments in controlling the amount of money in circulation. Monetarist theory asserts that variations in the money supply have major influences on national output in the short run and on price levels over longer periods. Monetarists assert that the objectives of monetary policy are best met by targeting the growth rate of the money supply rather than by engaging in discretionary monetary policy.

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This aims to be a complete article list of economics topics:

Fiscal policy use of government revenue collection and spending to influence the economy

In economics and political science, fiscal policy is the use of government revenue collection and expenditure (spending) to influence a country's economy. The use of government revenues and expenditures to influence macroeconomic variables developed as a result of the Great Depression, when the previous laissez-faire approach to economic management became unpopular. Fiscal policy is based on the theories of the British economist John Maynard Keynes, whose Keynesian economics theorized that government changes in the levels of taxation and government spending influences aggregate demand and the level of economic activity. Fiscal and monetary policy are the key strategies used by a country's government and central bank to advance its economic objectives. The combination of these policies enables these authorities to target the inflation and to increase employment. Additionally, it is designed to try to keep GDP growth at 2%–3% and the unemployment rate near the natural unemployment rate of 4%–5%. This implies that fiscal policy is used to stabilize the economy over the course of the business cycle.

Deficit spending Spending in excess of revenue

Deficit spending is the amount by which spending exceeds revenue over a particular period of time, also called simply deficit, or budget deficit; the opposite of budget surplus. The term may be applied to the budget of a government, private company, or individual. Government deficit spending is a central point of controversy in economics, as discussed below.

Monetary policy subclass of the economic policy

Monetary policy is the policy adopted by the monetary authority of a country that controls either the interest rate payable on very short-term borrowing or the money supply, often targeting inflation or the interest rate to ensure price stability and general trust in the currency.

Money creation, or money issuance, is the process by which the money supply of a country, or of an economic or monetary region, is increased. In most modern economies, most of the money supply is in the form of bank deposits. Central banks monitor the amount of money in the economy by measuring the so-called monetary aggregates.

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Policy mix

The policy mix is the combination of a country's monetary policy and fiscal policy. These two channels influence growth and employment, and are generally determined by the central bank and the government respectively.

Inflationism is a heterodox economic, fiscal, or monetary policy, that predicts that a substantial level of inflation is harmless, desirable or even advantageous. Similarly, inflationist economists advocate for an inflationist policy.

Monetary policy is the monitoring and control of money supply by a central bank, such as the Federal Reserve Board in the United States of America, and the Bangko Sentral ng Pilipinas in the Philippines. This is used by the government to be able to control inflation, and stabilize currency. Monetary Policy is considered to be one of the two ways that the government can influence the economy – the other one being Fiscal Policy. Monetary Policy is generally the process by which the central bank, or government controls the supply and availability of money, the cost of money, and the rate of interest.

Fiscal policy and monetary policy are the two tools used by the state to achieve its macroeconomic objectives. While for many countries the main objective of fiscal policy is to increase the aggregate output of the economy, the main objective of the monetary policies is to control the interest and inflation rates. The IS/LM model is one of the models used to depict the effect of policy interactions on aggregate output and interest rates. The fiscal policies have a direct impact on the goods market and the monetary policies have a direct impact on the asset markets; since the two markets are connected to each other via the two macrovariables output and interest rates, the policies interact while influencing output and interest rates.

David I. Meiselman

David I. Meiselman was an American economist. Among his contributions to the field of economics are his work on the term structure of interest rates, the foundation today of the implementation of monetary policy by major central banks, and his work with Milton Friedman on the impact of monetary policy on the performance of the economy and inflation.

This glossary of economics is a list of definitions of terms and concepts used in economics, its sub-disciplines, and related fields.

References

Notes
  1. Walter Plosila, "State Science- and Technology-Based Economic Development Policy: History, Trends and Developments, and Future Directions," Economic Development Quarterly, Vol. 18, No. 2, May 2004, pp. 113-126
  2. Friedman, Milton (1982). "Monetary Policy: Theory and Practice". Journal of Money, Credit and Banking. 14 (1): 98–118. doi:10.2307/1991496. ISSN   0022-2879.
  3. Screpanti, Ernesto; Zamagni, Stefano (2005-05-26). An Outline of the History of Economic Thought. OUP Oxford. ISBN   978-0-19-164776-5.
  4. Cartwright, Nancy; Hardie, Jeremy (2012-09-27). Evidence-Based Policy: A Practical Guide to Doing It Better. Oxford University Press. ISBN   978-0-19-984160-8.
  5. Wearden, Graeme (2019-10-14). "Nobel Prize in Economics won by Banerjee, Duflo and Kremer for fighting poverty - live updates". The Guardian. ISSN   0261-3077 . Retrieved 2020-04-07.
  6. Maziarz, Mariusz (2020). The Philosophy of Causality in Economics: Causal Inferences and Policy Proposals. London & New York: Routledge.