subject: The Tools Of Macroeconomic Policy [print this page] Put yourself in the shoes of the leader of the United States or another market economy. Unemployment is rising and GDP is falling. Or perhaps productivity growth has declined, and you wish to increase potential output growth. Or your country has a balance-of-payments crisis, with high imports and lagging exports. What can your government do to improve economic performance? What policy tools can you put your hands on to reduce inflation or unemployment, to speed economic growth, or to correct a trade imbalance?
Governments have certain instruments that they can use to affect macroeconomic activity. A policy instrument is an economic variable under the control of government that can affect one or more of the macroeconomic goals. That is, by changing monetary, fiscal, and other policies, governments can avoid the worst excesses of the business cycle and can increase the growth rate of potential output.
Fiscal Policy. Begin with fiscal policy, which denotes the use of taxes and government expenditures. Government expenditures come in two distinct forms. First there are government purchases. These comprise spending on goods and services purchases of tanks, construction of roads, salaries for judges, and so forth. In addition, there are government transfer payments, which boost the incomes of targeted groups such as the elderly or the unemployed. Government spending determines the relative size of the public and private sectors, that is, how much of our GDP is consumed collectively rather than privately. From a macroeconomic perspective, government expenditures also affect the overall level of spending in the economy and thereby influence the level of GDP.
The other part of fiscal policy, taxation, affects the overall economy in two ways. To begin with, taxes affect people's incomes. By leaving households with more or less disposable or spendable income, taxes tend to affect the amount people spend on goods and services as well as the amount of private saving. Private consumption and saving have important effects on output and investment in the short and long run.
In addition, taxes affect the prices of goods and factors of production and thereby affect incentives and behavior. For example, the more heavily business profits are taxed, the more businesses are discouraged from investing in new capital goods. From 1962 until 1986, the United States employed an investment tax credit, which was a rebate to businesses that buy capital goods, as a way of stimulating investment and boosting economic growth. Many provisions of the tax code have an important effect on economic activity through their effect on the incentives to work and to save.
Monetary Policy. The second major instrument of macroeconomic policy is monetary policy, which government conducts through the management of the nation's money, credit, and banking system. You may have read how the U. S. central bank, the Federal Reserve System, operates to regulate the money supply. But what exactly is the money supply! Money consists of the means of exchange or method of payment. Today, people use currency and checking accounts to pay their bills. By engaging in central-bank operations, the Federal Reserve can regulate the amount of money available to the economy.
How does such a minor thing as the money supply have such a large impact on macroeconomic activity? By changing the money supply, the Federal Reserve can influence many financial and economic variables, such as interest rates, stock prices, housing prices, and foreign exchange rates. Restricting the money supply leads to higher interest rates and reduced investment, which, in turn, causes a decline in GDP and lower inflation. If the central bank is faced with a business downturn, it can increase the money supply and lower interest rates to stimulate economic activity.
The exact nature of monetary policy the way in which the central bank controls the money supply and the relationships among money, output, and inflation is one of the most fascinating, important, and controversial areas of macroeconomics. A policy of tight money in the United States lowering the rate of growth of the money supply raised interest rates, slowed economic growth, and raised unemployment in the period 1979-1982. Then, from 1982 until 1997, careful monetary management by the Federal Reserve supported the longest economic expansion in American history. Over the last decade, monetary policy has become the major weapon used by the U. S. government to fight the business cycle.
