Economic policy is what a government does to ensure the economy keeps ticking over, and doesn't overheat or fall into recession. Look back to the page on macroeconomic objectives to remind yourself of government objectives. This section will go further into the reasons for government, and how policy can be applied.
Reasons for Economic Policy
Natural Changes in Economic Activity
Most economies go through cycles of strong economic growth and recession; it is much debated as to why this happens - arguably as a result of government policies, expectations of such cycles or other reasons. However, negative multiplier effects can ensure that an economy left to itself would be incapable of getting out of recession. A demonstration of a negative multiplier effect can be seen in areas that have recently suffered increased unemployment. Those recently unemployed will have less disposable income, causing other industries to suffer a fall in demand, resulting potentially in further layoffs of workers. When this happens on a national scale, targetted government spending may be the only way of getting out of this situation.
Secondly, remember that a macroeconomic objective is stable and sustainable economic growth. Economies, left to themselves, also have a tendency for runaway increases in demand without comparable increases in supply, resulting in high levels of inflation and borrowing and a booming stock market, which will hurt all the more when economic growth slows down.
These are unexpected, sudden changes in the situation of the world economy or domestically. For example, a housing market crash or recently 9/11 are examples where the home/world economy was entirely unprepared. These shocks have an effect on the demand and supply of goods, as a result of changes in consumer confidence, business confidence and expectations of the future. In order for a government to reduce the impact of such blows, it must be able to partially control the demand and supply curves. diagrams of SRAS and D-side shocks
Application of Economic Policy
There are three main method of government macroecnomic intervention in an economy, all of which will be investigated in more detail later in this section (the imbedded links are to wikipedia, the links to the relevant section in the wikibook are in the template on the right):
- Fiscal policy - is the use of government spending and taxation as a means of controlling levels of AD, both directly and indirectly
- Monetary policy - is the use of changing interest rates and the money supply to control the exchange rate, level of borrowing and levels of saving (remember MPC and MPS)
- Supply-side Policies - are a general term for all the other policies the government can employ to aid the level of supply, which is particularly important in increasing the potential output of an economy, and reducing growth-induced inflation