Economic Policy

Mr. StromanAP Government

Economic Theory

• “It’s the economy, stupid!”• 3 main types of economies:• Capitalist economy– Means of production and distribution owned by private

sector– Prices determined by free market forces of supply & demand

• Command economy– Means of production and distribution owned by the

government, government sets prices• Mixed economy– Combination of the two

Rival Camps• 2 main camps:• Laissez-faire – Government should never become involved in economic

issues– Free market is governed by laws of nature and

government shouldn’t interfere with these laws• Keynesian economics– Government should have a role in the economy by

influencing the amount of income individuals can spend on goods and services

– This can be accomplished in 2 main ways: through fiscal policy and through monetary policy

Fiscal Policy

• Fiscal policy is the government action of either raising or lowering taxes– This results in more or less consumer spending or the

enacting of government spending programs• Keynesians believe that during hard times, the

government should spend more to inject money into the economy– Keynesians don’t mind the government running a

deficit, as it will keep the economy prosperous and keep the tax base large, so it will eventually correct itself

– President Obama’s stimulus bill

Fiscal Policy

• Keynesian theory is sometimes called demand-side economics• However, the Reagan-Bush administration argued

for supply-side economics, which said that Keynesian policies caused inflation and called for the government to cut taxes and spending to stimulate the economy– “Reaganomics”– Reaganomics brought inflation under control but greatly

expanded the national budget deficit and national debt

Monetary Policy

• Monetary policy is the process by which the government controls how much money is in circulation (the money supply)

• The Federal Reserve Board (the Fed) is the main vehicle by which the government does this– The Fed can raise or lower interest rates – Raising means that borrowing money is more expensive,

which will cause prices & wages to stabilize or fall– Lowering means that borrowing money is less expensive,

which will cause prices & wages to rise

Monetary Policy

• The Fed can affect monetary policy in three main ways:

• Changing the reserve requirement, which is the amount of money banks must keep on hand– Raising the reserve raises the amount of money available

for borrowing, raising interest rates, and vice versa• Changing the discount rate, which raises or lowers

the interest banks pay to Fed banks for borrowing– Raising this raises the interest rates for consumer loans,

and vice versa

Monetary Policy• The Fed can also manipulate open market operations,

which consists of buying bonds from the government• A bond is an agreement (kind of like a loan) in which the

issuer agrees to pay the buyer back the price of the bond, plus interest– A bond is bought and sold like a stock

• When the Fed sells bonds, interest rates go up, and people withdraw money from banks to take advantage of this

• When the Fed buys bond, interest rates go down, and money flows back into banks, and more is available

• Lower interest rates = more consumer spending = more economic growth

Economic Policymaking

• President’s main economic advisors:– Council of Economic Advisors– National Economic Council– OMB– Secretary of the Treasury

• House Ways & Means Committee– Authorization and appropriations committees

• Congressional Budget Office

Tax Policy

• Progressive tax– The more you make, the more you pay – Income taxes

• Regressive tax– The more you make, the easier it is to pay– Flat taxes, where everyone pays the same, are VERY

regressive – Social Security taxes, Medicare taxes, sales taxes

• US typically has some of the lowest taxes in the developed world

Trade Policy• USA by far richest nation in the world– California would rank as one of the top 10 richest nations

• Ratio of imports to exports is called trade balance– Trade deficit occurs when imports exceed exports– Trade deficits sometimes can cause trade wars when one

country tries to restrict or tax its trade with another • World Trade Organization works to lower tariffs and

reduce unfair trade practices• US, Canada, and Mexico signed NAFTA in 1994, which

effectively ended import tariffs on each other’s products– Some fear NAFTA has caused job losses– Supporters say it improves US economy and helps curb illegal

immigration, and a richer Mexico will purchase US goods