- Economic policy
Economic policy refers to the actions that
governments take in the economic field. It covers the systems for setting interest rates and government deficitas well as the labour market, national ownership, and many other areas of government.
Such policies are often influenced by international institutions like the
International Monetary Fundor World Bankas well as politicalbeliefs and the consequent policies of parties.
Types of economic policy
Economic policy is a complicated area and can be broken down into three principal areas:
Fiscal policyis the size of the government deficitand the methods it uses to finance it.
Fiscal stance: The size of the deficit
**Tax policy: The taxes used to collect government income.
Government spendingon just about any area of government
Monetary policyis concerned with the amount of moneyin circulation and, consequently, interest rates and inflation.
Interest rates, if set by the Government
Incomes policieswhich aim at imposing non-monetary controls on inflation
Bank regulations which affect the money multiplier
*Trade policy refers to
tariffs, trade agreements and the international institutions that govern them.
Almost any aspect of government has an economic aspect and so many terms are used. However, they can usually be seen to apply to one of these areas. For instance,
agricultural policyis generally a matter of the burden of taxationand of trade in agricultural goods.
Tools and goals
Policy is generally directed to achieve particular objectives, like targets for
inflation, unemployment, or economic growth. Sometimes other objectives, like military spendingor nationalizationare 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 rateand money supply, taxand government spending, tariffs, exchange rates, labour marketregulations, and many other aspects of government.
The government's economic policy determines the tools and hopes that they will achieve its goals.
electing 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-sidepolicy to help adjust markets. For instance, unemployment could potentially be reduced by altering laws relating to trade unionsor 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 managementdesigned to correct the business cycle. These typically used fiscal and monetary policy to adjust inflation, output and unemployment.
However, following the
stagflationof 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 pactand the Golden Rule. Some policy rules can be imposed by external bodies, for instance the Exchange Rate Mechanismfor 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 Englandand Reserve Bank of Australiaall 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
taxin kind and forced labourfor their economic resources. However, with the development of moneycame 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 Egyptadopted a closed currency policy whereby foreign merchants had to exchange their coin for local money. This effectively levied a very high tariffon foreign trade.
By the early modern age, more policy choices had been developed. There was considerable debate about
mercantilismand 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 standardsbecame an important issue. Goldand silverwere 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 marketsmeant that a government could borrow money to finance war or expansion while causing less economic hardship.
This was the beginning of modern
The same markets made it easy for private entities to raise bonds or sell
sharesto fund private initiatives.
business cyclebecame a predominant issue in the 19th century, as it became clear that industrial output, employment, and profit behaved in a cyclical manner. The first real policy solution 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.
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