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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 budget as well as the labor market, national ownership, and many other areas of government interventions into the economy.
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 any aspect of government has an economic aspect and so many terms are used. A few example of types of economic policy include:
Macroeconomic stabilization policy tries to keep the money supply growing, but not so quick that it results in excessive inflation.
Trade policy refers to tariffs, trade agreements and the international institutions that govern them.
Policies designed to create Economic growth
Policies related to development economics,
Redistribution of income, property, or wealth
Regulation
Anti-trust
Industrial policy
Technology-based Economic Development Policy [1]
[edit] Macroeconomic stabilization policy
Stabilization policy attempts to stimulate an economy out of recession or constrain the money supply to prevent excessive inflation.
Fiscal policy, often tied to Keynesian economics, uses government spending and taxes to guide the economy.
Fiscal stance: The size of the deficit or surplus
Tax policy: The taxes used to collect government income.
Government spending on just about any area of government
Monetary policy controls the value of currency by lowering the supply of money to control inflation and raising it to stimulate economic growth. It is concerned with the amount of money in circulation and, consequently, interest rates and inflation.
Interest rates, if set by the Government
Incomes policies and price controls that aim at imposing non-monetary controls on inflation
Reserve requirements which affect the money multiplier
[edit] 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.
[edit] 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.
[edit] Demand-side vs. supply-side tools
This dilemma can in part be resolved by using microeconomics, 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.
[edit] 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.
[edit] Economic policy through history
Main article: Economic 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.
[edit] 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 shares to fund private initiatives.
[edit] 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 argues that central banks create the business cycle.

In economics and political science, fiscal policy is the use of government revenue collection (taxation) and expenditure (spending) to influence the economy.[1] The two main instruments of fiscal policy are government taxation and expenditure. Changes in the level and composition of taxation and government spending can impact the following variables in the economy:
Aggregate demand and the level of economic activity;
The pattern of resource allocation;
The distribution of income.

Stances of fiscal policy
The three main stances of fiscal policy are:
Neutral fiscal policy is usually undertaken when an economy is in equilibrium. Government spending is fully funded by tax revenue and overall the budget outcome has a neutral effect on the level of economic activity.
Expansionary fiscal policy involves government spending exceeding tax revenue, and is usually undertaken during recessions.
Contractionary fiscal policy occurs when government spending is lower than tax revenue, and is usually undertaken to pay down government debt.
However, these definitions can be misleading because, even with no changes in spending or tax laws at all, cyclic fluctuations of the economy cause cyclic fluctuations of tax revenues and of some types of government spending, altering the deficit situation; these are not considered to be policy changes. Therefore, for purposes of the above definitions, "government spending" and "tax revenue" are normally replaced by "cyclically adjusted government spending" and "cyclically adjusted tax revenue". Thus, for example, a government budget that is balanced over the course of the business cycle is considered to represent a neutral fiscal policy stance.
[edit] Methods of funding
Governments spend money on a wide variety of things, from the military and police to services like education and healthcare, as well as transfer payments such as welfare benefits. This expenditure can be funded in a number of different ways:
Taxation
Seigniorage, the benefit from printing money
Borrowing money from the population or from abroad
Consumption of fiscal reserves
Sale of fixed assets (e.g., land)
[edit] Borrowing
A fiscal deficit is often funded by issuing bonds, like treasury bills or consols and gilt-edged securities. These pay interest, either for a fixed period or indefinitely. If the interest and capital requirements are too large, a nation may default on its debts, usually to foreign creditors. Public debt or borrowing : it refers to the government borrowing from the public.
[edit] Consuming prior surpluses
A fiscal surplus is often saved for future use, and may be invested in either local currency or any financial instrument that may be traded later once resources are needed; notice, additional debt is not needed. For this to happen, the marginal propensity to save needs to be strictly positive.
[edit] Economic effects of fiscal policy
Governments use fiscal policy to influence the level of aggregate demand in the economy, in an effort to achieve economic objectives of price stability, full employment, and economic growth. Keynesian economics suggests that increasing government spending and decreasing tax rates are the best ways to stimulate aggregate demand, and decreasing spending & increasing taxes after the economic boom begins. Keynesians argue this method be used in times of recession or low economic activity as an essential tool for building the framework for strong economic growth and working towards full employment. In theory, the resulting deficits would be paid for by an expanded economy during the boom that would follow; this was the reasoning behind the New Deal.
Governments can use a budget surplus to do two things: to slow the pace of strong economic growth, and to stabilize prices when inflation is too high. Keynesian theory posits that removing spending from the economy will reduce levels of aggregate demand and contract the economy, thus stabilizing prices.
Economists debate the effectiveness of fiscal stimulus. The argument mostly centers on crowding out, whether government borrowing leads to higher interest rates that may offset the stimulative impact of spending. When the government runs a budget deficit, funds will need to come from public borrowing (the issue of government bonds), overseas borrowing, or monetizing the debt. When governments fund a deficit with the issuing of government bonds, interest rates can increase across the market, because government borrowing creates higher demand for credit in the financial markets. This causes a lower aggregate demand for goods and services, contrary to the objective of a fiscal stimulus. Neoclassical economists generally emphasize crowding out while Keynesians argue that fiscal policy can still be effective especially in a liquidity trap where, they argue, crowding out is minimal.
Some classical and neoclassical economists argue that crowding out completely negates any fiscal stimulus; this is known as the Treasury View[citation needed], which Keynesian economics rejects. The Treasury View refers to the theoretical positions of classical economists in the British Treasury, who opposed Keynes' call in the 1930s for fiscal stimulus. The same general argument has been repeated by some neoclassical economists up to the present.
In the classical view, the expansionary fiscal policy also decreases net exports, which has a mitigating effect on national output and income. When government borrowing increases interest rates it attracts foreign capital from foreign investors. This is because, all other things being equal, the bonds issued from a country executing expansionary fiscal policy now offer a higher rate of return. In other words, companies wanting to finance projects must compete with their government for capital so they offer higher rates of return. To purchase bonds originating from a certain country, foreign investors must obtain that country's currency. Therefore, when foreign capital flows into the country undergoing fiscal expansion, demand for that country's currency increases. The increased demand causes that country's currency to appreciate. Once the currency appreciates, goods originating from that country now cost more to foreigners than they did before and foreign goods now cost less than they did before. Consequently, exports decrease and imports increase.[2]
Other possible problems with fiscal stimulus include the time lag between the implementation of the policy and detectable effects in the economy, and inflationary effects driven by increased demand. In theory, fiscal stimulus does not cause inflation when it uses resources that would have otherwise been idle. For instance, if a fiscal stimulus employs a worker who otherwise would have been unemployed, there is no inflationary effect; however, if the stimulus employs a worker who otherwise would have had a job, the stimulus is increasing labor demand while labor supply remains fixed, leading to wage inflation and therefore price inflation.