Governments have a variety of tools at their disposal to maintain economic stability and promote growth. By adjusting policies related to taxation, spending, money supply, and trade, they aim to manage inflation, reduce unemployment, and ensure balanced economic growth. Understanding the core instruments of fiscal and monetary policy, along with the role of trade regulations, is essential to grasp how governments navigate economic challenges and steer the economy toward stability and prosperity.

Economic Policy

Governments influence the state of their economy through actions such as taxation, interest rate decisions, public spending, and regulations, collectively known as economic policy. These attempts are all targeted to promote economic growth, control inflation, reduce unemployment, and ensure a stable balance of payments.

Economic policy is broadly divided into two main categories. Fiscal policy involves government spending and taxation. Monetary policy centers around controlling the money supply in circulation, and interest rates.  Trade policy is an additional part of economic policy, focusing on regulation and agreements concerning international trade.

Collectively, these policies play a fundamental role in maintaining a country’s economic stability and growth.

Monetary Policy

Typically employed to manage inflation levels and stimulate economic growth,  governments mainly apply monetary policy through the use of three instruments.

Fiscal Policy

Fiscal policy decisions relate to government spending, taxation, and borrowing. There are various reasons why a government may need to borrow funds.

Trade Policies

The term ‘trade barriers’ refers to an overarching concept concerning trade restrictions or penalties between different economies. A trade policy represents a government’s predetermined reaction to specific trade-related actions according to a set of criteria.

The Main Instruments of Monetary Policy

Interest Rates

The adjusting of interest rates is a widely used tool in government attempts to stabilise an economy. By influencing borrowing costs central banks, generally in collaboration with the government’s finance ministry, act to either stimulate or suppress economic activity.

By increasing the cost of borrowing, central banks attempt to slow down spending. Conversely, lower interest rates during a recessionary period serve to encourage borrowing and spending, therefore stimulating economic activity.

Open Market Operations (OMOs)

The buying and selling of government securities in the open market is another tool to regulate the money supply. When the central bank buys government securities, the payment constitutes bulk money received into the banking system. The sale of government securities on the open market will have the opposite effect. This will reduce the money supply, being the level of money in circulation.

OMOs are often simultaneously applied with interest rate adjustments. With the simultaneous reduction in the money supply through the sale of government securities, interest rates may also be raised to discourage lending. Let us ponder here for a moment. Imagine the scenario of a reduced money level in the economic system, implying limited access to money. Relative to the available supply, the shortage or scarcity now creates competition and an increased demand for money. Referring to our course in economic insight, shortages generally push prices up.  Subsequently, as the price of money manifests as an interest rate, which constitutes the cost of borrowed money, interest rates will rise.

Reserve Requirements

Although the central bank may less frequently adjust reserve requirements compared to interest rates and OMOs, it remains a vital monetary policy mechanism. Reserve requirements allude to the minimum level of reserves that banks must hold against deposits. To simplify, a 10% reserve requirement would mean that 90% of a deposit entrusted to a bank may be applied for further lending. The remaining 10%, however, would be required to be kept in a reserve account.

Reserve requirements are mainly attributed to sustained liquidity levels and precautions against bank runs. That said, raising or reducing reserve requirements may also prove an effective tool for regulating the money supply in circulation.

Fiscal Policy Mechanisms

Government Spending

The role of effective government intervention is crucial. Governments engage in income redistribution through public spending. Their primary responsibilities revolve around public welfare, driving economic growth while securing economic stability. A government’s enormous commitments include investing in infrastructure, social security, job creation, healthcare, education, law enforcement, and national defense.

Taxation

Although it may employ alternative ways of generating additional income, a government’s main source of revenue commonly comes from tax collection. Some of the most well-known types of direct taxes are individual income taxes and corporate taxes, based on company profits.  Further tax forms may include estate duty, property transfer taxes, and indirect taxes, such as customs, excise duties, and value-added tax.

A government needs money to maintain its own administration and fulfil its public duties and obligations. It should be unwavering in its commitment to act responsibly with the money, entrusted to it by its people in good faith, ensuring it is used for the betterment of society.

Borrowing

When the national budget for the upcoming year shows a deficit, the government typically borrows funds to cover the shortfall. A budget deficit occurs when the projected public spending level exceeds the anticipated tax revenue amount together with other potential government income sources.

Borrowing, however, incurs a debt the government would need to repay at some stage in the future. The most common method of funding a deficit budget, remains the issuance of government bonds. Essentially, bond investors loan their money to the bond issuer, being the government. Investors receive a fixed interest payment, called a coupon, on their investment until the bond matures and the government returns the initial investment. Discover how bonds work in our innovative online course on Financial Markets.

There are additional avenues a government may pursue to obtain the needed funds, like direct borrowing from financial institutions. In addition to foreign loans, multilateral organisations like the International Monetary Fund (IMF) or the World Bank also remain an option.

Government funding from its own central bank, however, may be avoided due to the potential for creation of new money. This situation may lead to inflationary pressures, caused by the imbalance of too much money in the economy with not enough goods to spend it on. Furthermore, increasing the money supply without matching an increase in economic output, will weaken the local currency.

Trade Barriers through Trade Policies

Trade policies can take many forms within the trade barrier toolkit of tariffs, quotas, trade agreements, and other measures. That said, tariffs remain the most common tool used to control the flow of goods and services across borders.

There are several types of tariffs a government may implement. Tariffs provide further tax revenues, often applied to shield local producers from foreign rivals vying for the same domestic market. Governments may sometimes use tariffs to negotiate more beneficial trade agreements. However, regardless of the ultimate goal, policymakers should consider these decisions carefully to avoid a potentially costly backlash in global trade relations. Let us explore a few tariff types:

• Ad valorem tariffs:  Calculated as a percentage of the value of imported goods.

• Specific tariffs: Normally imposed as a fixed fee per unit of an imported commodity.

• Compound tariffs:  Combining the criteria requirements of both ad valorem and specific tariffs.

• Revenue tariffs: These tariffs aim to generate government revenue on luxury imports, not locally produced.

• Anti-dumping tariffs: The government imposes tariffs on cheap imported goods when it believes their prices are below realistic production costs. The objective is to protect local industries from unfair competition.

When to Apply What Policy?

Picking the most appropriate monetary policy instrument to effectively address specific economic challenges, is equally important as the timing of its implementation. Different situations may call for different outcomes. Therefore, a deep understanding of each policy and its potential effects is of the utmost importance to policymakers.

Monetary Policy

• Interest Rates: An overheating economy and rising inflation commonly warrant interest rate hikes to discourage spending and investment, and stabilise the economy. Conversely, central banks may decide to boost a sluggish economy by lowering interest rates to increase economic activity.

• Open Market Operations (OMOs): There are several early economic indicators that may assist central banks in their decision of when to engage in the buying and selling of government securities to influence the money supply and maintain economic stability.  Some main indicators include a steadily rising rate of inflation which could call for the potential sale of government securities in the open market to reduce the money supply. A declining GDP growth rate coupled with a high unemployment rate, may warrant buying back securities to increase the money in circulation and stimulate growth. Central banks often apply OMOs alongside interest rate adjustments to achieve the desired result.

•Reserve Requirements: Central banks generally only revert to adjusting these levels during periods of substantial economic shifts or crises.

Fiscal Policy

•Fiscal Stimulus: This term directly relates to the actions of a government during an economic downturn. The ultimate aim is to stimulate economic recovery by boosting economic activity through releasing more money into the system. These actions typically involve increased public spending and tax cuts.

•The Liquidity Trap: Situations where interest rates are already near zero, may lead to what is known as a liquidity trap. A liquidity trap occurs when people prefer to hold onto their cash rather than invest or spend it. In the absence of the prospect of earning interest, people frequently regard hoarding or saving the safest option. This situation commonly arises during severe recessionary or deflationary periods. Even though the central bank might inject more money into the economy, it doesn’t lead to increased borrowing or spending. This type of economic climate creates the ideal opportunity to implement fiscal stimulus measures.

Trade Policies

Governments often implement trade policies reactively or on an “as-needed” basis. That said, they can also proactively align with long-term national interests.

Conclusion: Navigating the Complex Economic Landscape

A well-run economy relies on effectively applying the available tools in the government’s economic policy arsenal. This ongoing process of action and reaction demands a well-defined strategy, regardless of the economic policies in place.  

The growing challenges of a dynamic and interrelated global economy emphasise the need for broader economic literacy.  A basic economic understanding is a crucial starting point for younger generations to gain insight into their government’s economic policies. Knowledge and awareness of the direction of these policies are crucial for both informed decision-making and taking charge of their own financial future.