Understanding types of economic policy
Our lives are constantly being influenced by economic policy. But for many, the policy is just lots of words, with no real meaning. This should help you understand what is behind the policy. Policy makers undertake three main types of economic policy:
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Fiscal policy: Changes in government spending or taxation.
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Monetary policy: Changes in the money supply to alter the interest rate (usually to influence the rate of inflation).
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Supply-side policy: Attempts to increase the productive capacity of the economy.
Fiscal and monetary policy comes in two types:
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Expansionary: Intended to stimulate the economy by stimulating aggregate demand.
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Expansionary fiscal policy involves increasing government spending or reducing taxes. Increasing government spending increases aggregate demand directly, whereas decreasing taxes increases aggregate demand indirectly by increasing consumption and investment.
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Expansionary monetary policy involves increasing the money supply, which decreases the interest rate and stimulates consumption, investment and net exports.
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Consumption increases because borrowing is now cheaper, but also because people need to spend less on things such as mortgage interest payments.
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Investment increases because the opportunity cost of investment (the return from sticking the money in a savings account) has fallen.
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Net exports increase because a fall in the interest rate makes holding the domestic currency less attractive, which causes it to depreciate, making exports cheaper and imports more expensive.
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Contractionary: Intended to slow the economy down by decreasing aggregate demand. It’s the opposite of expansionary policy, in that it involves reducing government spending, increasing taxes or reducing the money supply.
Supply-side policies are designed to increase the natural level of output, for example, by making markets work better, increasing the level of investment or increasing the rate of technological progress. Examples are making the labor market more flexible, giving firms incentives to invest or engaging in research and development.
Identifying three key economic statistics
Economics can seem overwhelming, especially when examining statistics. Take a look at the following information to gain a better understanding of those statistics. Macroeconomists look at the following summary statistics to assess the health of an economy:
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Real GDP (or output): The total value of goods and services produced in an economy in one year. Basically, GDP is the size of the whole cake that will then be cut up into (quite unequal) slices, with each person getting a slice.
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Unemployment: The proportion of people who are unemployed out of those who are able and willing to work.
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Inflation: The percentage increase in the average price of goods and services.
Watching the economy over time
How do you know how changes in the economy will affect you? You should observe the change over time. Macroeconomists consider these three timeframes when assessing the impact of a change on the economy:
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Short run: Prices are sticky in the short run, which means that fiscal and monetary policy (or indeed any change in aggregate demand) has real effects. For example, expansionary fiscal policy (increasing government spending or reducing taxes) increases output, as does expansionary monetary policy (reducing the interest rate by increasing the money supply).
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Long run: Prices are flexible in the long run, which means that fiscal and monetary policy (or any change in aggregate demand) has no real effects (unless it also impacts on the supply side of the economy). For example, expansionary fiscal or monetary policy leaves output unchanged and creates only inflation.
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Very long run: Prices are flexible and the emphasis is on economic growth. Policies that increase the quantity and quality of factors of production or encourage technological progress result in economic growth.
