Economics Governments Influence the Economy in Many

Economics

Governments influence the economy in many ways, but the two most often discussed in economics are fiscal policy and monetary policy (another might a trade policy, for example). Fiscal policy reflects the use of government spending and taxation to influence the economy (Weil, 2008). Thus, the level of spending, the amount of revenue collected, and how the money is spent are all things that must be taken into consideration in fiscal policy. Fiscal policy also frequently has an effect on the decisions that businesses and individuals make. Consider the debate about taxes and the "Buffet Rule" -- the tax polices we have now are designed to encourage specific behaviors. This is why capital gains are taxed at a different rate than dividends, and why dividends are taxed at a different rate than interest income. So fiscal policy does affect the way some people behave, as they attempt to maximize their wealth.

Monetary policy is the policy set by the central bank with respect to interest rates and the money supply (FRBSF, 2012). According to the Federal Reserve, the objective of monetary policy is to "influence the performance of the economy as reflected in such factors as inflation, economic output, and employment. It works be affecting demand across the economy."

Among other things, Keynes argued that because government spending affects the aggregate demand in the economy. Thus, he made the point that a government can increase its spending temporarily in order to offset declines in investment and consumer spending. He also made the point that if such deficit spending is to be used in a down economy, that the government must also decrease its spending during strong economic times. Hayek, writing at a time when the industrial world faced what felt like a binary choice between capitalism and communism, took a dimmer view of any form of government involvement in the economy. Hayek outlined his theory about recessions and government in ten points. He argued that government spending would only stimulate the deficit, but that regulation was required to allow the market to function. He noted that economic planning does not work -- though this discussion seen through the lens looking eastward at Communism caused Hayek to fail to consider that what government spends on does matter. He made the point, however, that in general economic forecasting is fraught with difficulty and that there are often unintended consequences to actions (Azerrad, 2011). Even with regulation, he was aware that corporations have incentive to seek government conferred advantages, so surely he would have wanted whatever regulation was required to not involve corporate lobbying efforts.

The Federal Reserve uses three main tools for monetary policy. The Federal Open Market Committee sets the overnight rate, which is the rate that all other interest rates are based on (ok, not all, as credit card companies do whatever they feel like). Lower interest rates reduce the cost of capital for companies, encouraging them to take on more projects. Open market operations involve the Fed either buying or selling government securities on the open market. This directly increases or decreases the supply of money in the economy. The reason it does this is because banks have reserve requirements, which is the third major form of monetary policy. Banks take in deposits, and how much they can lend back out into the economy is dependent on their reserve requirements (the amount they are not allowed to lend). Increasing the reserve requirements reduces the money supply.

4a. This is not explicitly fiscal policy. It might involve a small amount of government spending, but this more a public health initiative.

b. Increasing the DoD budget is fiscal policy, because it affects government spending levels.

c. This is not fiscal policy or monetary policy. This regulation will affect how automakers spend their money.