Economic policy
The economy of governments covers the systems for setting levels of taxation, government budgets, the money supply and interest rates as well as the labour market, national ownership, and many other areas of government interventions into the economy.
Most factors of economic policy can be divided into either fiscal policy, which deals with government actions regarding taxation and spending, or monetary policy, which deals with central banking actions regarding the money supply and interest rates.
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.
Almost every aspect of government has an important economic component. A few examples of the kinds of economic policies that exist include:[1]
Stabilization policy attempts to stimulate an economy out of recession or constrain the money supply to prevent excessive inflation.
Discretionary policy vs policy rules[edit]
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 that are imposed by an international body. This can occur (for example) as a result of intervention by the International Monetary Fund.