Economic policy

Economic policy

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Economic policy refers to the actions that government
Government
Government refers to the legislators, administrators, and arbitrators in the administrative bureaucracy who control a state at a given time, and to the system of government by which they are organized...

s take in the economic field
Economics
Economics is the social science that analyzes the production, distribution, and consumption of goods and services. The term economics comes from the Ancient Greek from + , hence "rules of the house"...

. It covers the systems for setting interest rate
Interest rate
An interest rate is the rate at which interest is paid by a borrower for the use of money that they borrow from a lender. For example, a small company borrows capital from a bank to buy new assets for their business, and in return the lender receives interest at a predetermined interest rate for...

s and government budget
Government budget
A government budget is a legal document that is often passed by the legislature, and approved by the chief executive-or president. For example, only certain types of revenue may be imposed and collected...

 as well as the labor market, national ownership
Nationalization
Nationalisation, also spelled nationalization, is the process of taking an industry or assets into government ownership by a national government or state. Nationalization usually refers to private assets, but may also mean assets owned by lower levels of government, such as municipalities, being...

, and many other areas of government interventions into the economy.

Such policies are often influenced by international institutions like the International Monetary Fund
International Monetary Fund
The International Monetary Fund is an organization of 187 countries, working to foster global monetary cooperation, secure financial stability, facilitate international trade, promote high employment and sustainable economic growth, and reduce poverty around the world...

 or World Bank
World Bank
The World Bank is an international financial institution that provides loans to developing countries for capital programmes.The World Bank's official goal is the reduction of poverty...

 as well as political beliefs and the consequent policies
Policy
A policy is typically described as a principle or rule to guide decisions and achieve rational outcome. The term is not normally used to denote what is actually done, this is normally referred to as either procedure or protocol...

 of parties
Political Parties
Political Parties: A Sociological Study of the Oligarchical Tendencies of Modern Democracy is a book by sociologist Robert Michels, published in 1911 , and first introducing the concept of iron law of oligarchy...

.

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
    Money supply
    In economics, the money supply or money stock, is the total amount of money available in an economy at a specific time. There are several ways to define "money," but standard measures usually include currency in circulation and demand deposits .Money supply data are recorded and published, usually...

     growing, but not so quick that it results in excessive inflation.
  • Trade policy
    Trade
    Trade is the transfer of ownership of goods and services from one person or entity to another. Trade is sometimes loosely called commerce or financial transaction or barter. A network that allows trade is called a market. The original form of trade was barter, the direct exchange of goods and...

     refers to tariffs, trade agreements and the international institutions that govern them.
  • Policies designed to create Economic growth
    Economic growth
    In economics, economic growth is defined as the increasing capacity of the economy to satisfy the wants of goods and services of the members of society. Economic growth is enabled by increases in productivity, which lowers the inputs for a given amount of output. Lowered costs increase demand...

    • Policies related to development economics
      Development economics
      Development Economics is a branch of economics which deals with economic aspects of the development process in low-income countries. Its focus is not only on methods of promoting economic growth and structural change but also on improving the potential for the mass of the population, for example,...

      ,
  • Redistribution
    Redistribution (economics)
    Redistribution of wealth is the transfer of income, wealth or property from some individuals to others caused by a social mechanism such as taxation, monetary policies, welfare, nationalization, charity, divorce or tort law. Most often it refers to progressive redistribution, from the rich to the...

     of income, property, or wealth
  • Regulation
    Regulation
    Regulation is administrative legislation that constitutes or constrains rights and allocates responsibilities. It can be distinguished from primary legislation on the one hand and judge-made law on the other...

  • Anti-trust
  • Industrial policy
    Industrial policy
    The Industrial Policy plan of a nation, sometimes shortened IP, "denotes a nation's declared, official, total strategic effort to influence sectoral development and, thus, national industry portfolio." These interventionist measures comprise "policies that stimulate specific activities and promote...

  • Technology-based Economic Development Policy

Macroeconomic stabilization policy


Stabilization policy attempts to stimulate an economy out of recession or constrain the money supply
Money supply
In economics, the money supply or money stock, is the total amount of money available in an economy at a specific time. There are several ways to define "money," but standard measures usually include currency in circulation and demand deposits .Money supply data are recorded and published, usually...

 to prevent excessive inflation.
  • Fiscal policy
    Fiscal policy
    In economics and political science, fiscal policy is the use of government expenditure and revenue collection to influence the economy....

    , often tied to Keynesian economics
    Keynesian economics
    Keynesian economics is a school of macroeconomic thought based on the ideas of 20th-century English economist John Maynard Keynes.Keynesian economics argues that private sector decisions sometimes lead to inefficient macroeconomic outcomes and, therefore, advocates active policy responses by the...

    , uses government spending and taxes to guide the economy.
    • Fiscal stance: The size of the deficit or surplus
    • Tax policy
      Tax
      To tax is to impose a financial charge or other levy upon a taxpayer by a state or the functional equivalent of a state such that failure to pay is punishable by law. Taxes are also imposed by many subnational entities...

      : The taxes used to collect government income.
    • Government spending
      Government spending
      Government spending includes all government consumption, investment but excludes transfer payments made by a state. Government acquisition of goods and services for current use to directly satisfy individual or collective needs of the members of the community is classed as government final...

       on just about any area of government
  • Monetary policy
    Monetary policy
    Monetary policy is the process by which the monetary authority of a country controls the supply of money, often targeting a rate of interest for the purpose of promoting economic growth and stability. The official goals usually include relatively stable prices and low unemployment...

     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
    Money
    Money is any object or record that is generally accepted as payment for goods and services and repayment of debts in a given country or socio-economic context. The main functions of money are distinguished as: a medium of exchange; a unit of account; a store of value; and, occasionally in the past,...

     in circulation and, consequently, interest rate
    Interest rate
    An interest rate is the rate at which interest is paid by a borrower for the use of money that they borrow from a lender. For example, a small company borrows capital from a bank to buy new assets for their business, and in return the lender receives interest at a predetermined interest rate for...

    s and inflation
    Inflation
    In economics, inflation is a rise in the general level of prices 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 also reflects an erosion in the purchasing power of money – a...

    .
    • Interest rate
      Interest rate
      An interest rate is the rate at which interest is paid by a borrower for the use of money that they borrow from a lender. For example, a small company borrows capital from a bank to buy new assets for their business, and in return the lender receives interest at a predetermined interest rate for...

      s, if set by the Government
    • Incomes policies and price controls
      Price controls
      Price controls are governmental impositions on the prices charged for goods and services in a market, usually intended to maintain the affordability of staple foods and goods, and to prevent price gouging during shortages, or, alternatively, to insure an income for providers of certain goods...

       that aim at imposing non-monetary controls on inflation
    • Reserve requirements which affect the money multiplier
      Money multiplier
      In monetary economics, a money multiplier is one of various closely related ratios of commercial bank money to central bank money under a fractional-reserve banking system. Most often, it measures the maximum amount of commercial bank money that can be created by a given unit of central bank money...


Tools and goals


Policy is generally directed to achieve particular objectives, like targets for inflation
Inflation
In economics, inflation is a rise in the general level of prices 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 also reflects an erosion in the purchasing power of money – a...

, unemployment
Unemployment
Unemployment , as defined by the International Labour Organization, occurs when people are without jobs and they have actively sought work within the past four weeks...

, or economic growth
Economic growth
In economics, economic growth is defined as the increasing capacity of the economy to satisfy the wants of goods and services of the members of society. Economic growth is enabled by increases in productivity, which lowers the inputs for a given amount of output. Lowered costs increase demand...

. Sometimes other objectives, like military spending or nationalization
Nationalization
Nationalisation, also spelled nationalization, is the process of taking an industry or assets into government ownership by a national government or state. Nationalization usually refers to private assets, but may also mean assets owned by lower levels of government, such as municipalities, being...

 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
Interest rate
An interest rate is the rate at which interest is paid by a borrower for the use of money that they borrow from a lender. For example, a small company borrows capital from a bank to buy new assets for their business, and in return the lender receives interest at a predetermined interest rate for...

 and money supply
Money supply
In economics, the money supply or money stock, is the total amount of money available in an economy at a specific time. There are several ways to define "money," but standard measures usually include currency in circulation and demand deposits .Money supply data are recorded and published, usually...

, tax
Tax
To tax is to impose a financial charge or other levy upon a taxpayer by a state or the functional equivalent of a state such that failure to pay is punishable by law. Taxes are also imposed by many subnational entities...

 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 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
Demand-side
The Demand side is a term used in economics to refer to a number of things:* The demand element of a supply and demand partial equilibrium diagram, in microeconomics* The aggregate demand in an economy, in macroeconomics...

) factors like interest rates.

Discretionary policy vs policy rules


For much of the 20th century, governments adopted discretionary policies
Discretionary policy
Discretionary policy is a term used to describe macroeconomic policy based on the ad hoc judgment of policymakers as opposed to policy set by predetermined rules...

 like demand management
Demand management
Demand management is a planning methodology used to manage forecasted demand.-Demand management in economics:In economics, demand management is the art or science of controlling economic demand to avoid a recession...

 designed to correct the business cycle
Business cycle
The term business cycle refers to economy-wide fluctuations in production or economic activity over several months or years...

. These typically used fiscal and monetary policy to adjust inflation, output and unemployment.

However, following the stagflation
Stagflation
In economics, stagflation is a situation in which the inflation rate is high and the economic growth rate slows down and unemployment remains steadily high...

 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
Dynamic inconsistency
In economics, dynamic inconsistency, or time inconsistency, describes a situation where a decision-maker's preferences change over time in such a way that what is preferred at one point in time is inconsistent with what is preferred at another point in time...

: 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 rate
Exchange rate
In finance, an exchange rate between two currencies is the rate at which one currency will be exchanged for another. It is also regarded as the value of one country’s currency in terms of another currency...

s, interest rate rules, the stability and growth pact
Stability and Growth Pact
The Stability and Growth Pact is an agreement among the 27 Member states of the European Union that take part in the Eurozone, to facilitate and maintain the stability of the Economic and Monetary Union...

 and the Golden Rule
Golden Rule (fiscal policy)
The Golden Rule is a guideline for the operation of fiscal policy. The Golden Rule states that over the economic cycle, the Government will borrow only to invest and not to fund current spending. In layman's terms this means that on average over the ups and downs of an economic cycle the government...

. 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
Federal Reserve Bank
The twelve Federal Reserve Banks form a major part of the Federal Reserve System, the central banking system of the United States. The twelve federal reserve banks together divide the nation into twelve Federal Reserve Districts, the twelve banking districts created by the Federal Reserve Act of...

, European Central Bank
European Central Bank
The European Central Bank is the institution of the European Union that administers the monetary policy of the 17 EU Eurozone member states. It is thus one of the world's most important central banks. The bank was established by the Treaty of Amsterdam in 1998, and is headquartered in Frankfurt,...

, Bank of England
Bank of England
The Bank of England is the central bank of the United Kingdom and the model on which most modern central banks have been based. Established in 1694, it is the second oldest central bank in the world...

 and Reserve Bank of Australia
Reserve Bank of Australia
The Reserve Bank of Australia came into being on 14 January 1960 as Australia's central bank and banknote issuing authority, when the Reserve Bank Act 1959 removed the central banking functions from the Commonwealth Bank to it....

 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
International Monetary Fund
The International Monetary Fund is an organization of 187 countries, working to foster global monetary cooperation, secure financial stability, facilitate international trade, promote high employment and sustainable economic growth, and reduce poverty around the world...

.

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
Military
A military is an organization authorized by its greater society to use lethal force, usually including use of weapons, in defending its country by combating actual or perceived threats. The military may have additional functions of use to its greater society, such as advancing a political agenda e.g...

, road
Road
A road is a thoroughfare, route, or way on land between two places, which typically has been paved or otherwise improved to allow travel by some conveyance, including a horse, cart, or motor vehicle. Roads consist of one, or sometimes two, roadways each with one or more lanes and also any...

s and other projects like building the Pyramids.

Early governments generally relied on tax
Tax
To tax is to impose a financial charge or other levy upon a taxpayer by a state or the functional equivalent of a state such that failure to pay is punishable by law. Taxes are also imposed by many subnational entities...

 in kind and forced labor for their economic resources. However, with the development of money
Money
Money is any object or record that is generally accepted as payment for goods and services and repayment of debts in a given country or socio-economic context. The main functions of money are distinguished as: a medium of exchange; a unit of account; a store of value; and, occasionally in the past,...

 came the first policy choice. A government could raise money through taxing its citizens. However, it could now also debase the coinage
Coin
A coin is a piece of hard material that is standardized in weight, is produced in large quantities in order to facilitate trade, and primarily can be used as a legal tender token for commerce in the designated country, region, or territory....

 and so increase the money supply
Money supply
In economics, the money supply or money stock, is the total amount of money available in an economy at a specific time. There are several ways to define "money," but standard measures usually include currency in circulation and demand deposits .Money supply data are recorded and published, usually...

.

Early civilizations also made decisions about whether to permit and how to tax trade
Trade
Trade is the transfer of ownership of goods and services from one person or entity to another. Trade is sometimes loosely called commerce or financial transaction or barter. A network that allows trade is called a market. The original form of trade was barter, the direct exchange of goods and...

. Some early civilizations, such as Ptolemaic Egypt
Ptolemaic Egypt
Ptolemaic Egypt began when Ptolemy I Soter invaded Egypt and declared himself Pharaoh of Egypt in 305 BC and ended with the death of queen Cleopatra VII of Egypt and the Roman conquest in 30 BC. The Ptolemaic Kingdom was a powerful Hellenistic state, extending from southern Syria in the east, to...

 adopted a closed currency policy whereby foreign merchants had to exchange their coin for local money. This effectively levied a very high tariff
Tariff
A tariff may be either tax on imports or exports , or a list or schedule of prices for such things as rail service, bus routes, and electrical usage ....

 on foreign trade.

By the early modern age, more policy choices had been developed. There was considerable debate about mercantilism
Mercantilism
Mercantilism is the economic doctrine in which government control of foreign trade is of paramount importance for ensuring the prosperity and security of the state. In particular, it demands a positive balance of trade. Mercantilism dominated Western European economic policy and discourse from...

 and other restrictive trade practices like the Navigation Acts
Navigation Acts
The English Navigation Acts were a series of laws that restricted the use of foreign shipping for trade between England and its colonies, a process which had started in 1651. Their goal was to force colonial development into lines favorable to England, and stop direct colonial trade with the...

, 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
Gold
Gold is a chemical element with the symbol Au and an atomic number of 79. Gold is a dense, soft, shiny, malleable and ductile metal. Pure gold has a bright yellow color and luster traditionally considered attractive, which it maintains without oxidizing in air or water. Chemically, gold is a...

 and silver
Silver
Silver is a metallic chemical element with the chemical symbol Ag and atomic number 47. A soft, white, lustrous transition metal, it has the highest electrical conductivity of any element and the highest thermal conductivity of any metal...

 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
Fiscal policy
In economics and political science, fiscal policy is the use of government expenditure and revenue collection to influence the economy....

.

The same markets made it easy for private entities to raise bonds
Bond (finance)
In finance, a bond is a debt security, in which the authorized issuer owes the holders a debt and, depending on the terms of the bond, is obliged to pay interest to use and/or to repay the principal at a later date, termed maturity...

 or sell shares to fund private initiatives.

Business cycles


The business cycle
Business cycle
The term business cycle refers to economy-wide fluctuations in production or economic activity over several months or years...

 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
Austrian School
The Austrian School of economics is a heterodox school of economic thought. It advocates methodological individualism in interpreting economic developments , the theory that money is non-neutral, the theory that the capital structure of economies consists of heterogeneous goods that have...

 argues that central banks create the business cycle.

See also

  • Stabilization policy
  • Harris School of Public Policy Studies
    Harris School of Public Policy Studies
    The Irving B. Harris Graduate School of Public Policy Studies is the public policy school of the University of Chicago in Chicago, Illinois, USA. It is one of the top policy schools in the United States. It is located on the University's main campus in Hyde Park...

  • Budget process
    Budget process
    A budget process refers to the process by which governments create and approve a budget, which is as follows:* The Financial Service Department prepares worksheets to assist the department head in preparation of department budget estimates...

  • Constitutional economics
    Constitutional economics
    Constitutional economics is a research program in economics and constitutionalism that has been described as extending beyond the definition of 'the economic analysis of constitutional law' in explaining the choice "of alternative sets of legal-institutional-constitutional rules that constrain the...