Economic policy facts for kids

When a government makes choices about how money works in a country, that's called its economic policy. It's all about how a country manages its money, jobs, and resources. This includes things like how much people pay in taxes, how the government spends money, and how much money is available to borrow.

Most economic policies fit into two main types:

• Fiscal policy: This is about how the government uses taxes and spending. For example, building new roads or schools.
• Monetary policy: This is about how a country's central bank controls the amount of money in circulation and interest rates. This affects how much it costs to borrow money.

These policies are often influenced by big international groups like the International Monetary Fund or the World Bank. They also depend on what political parties believe is best for the country.

What are the Main Types of Economic Policy?

Almost everything a government does has an economic side. Here are some examples of different economic policies:

• Keeping the Economy Steady: This policy tries to make sure there isn't too much inflation (when prices go up fast) and to smooth out the ups and downs of the business cycle (when the economy grows and shrinks).
• Trade Policy: This deals with rules for buying and selling goods with other countries. It includes tariffs (taxes on imported goods) and trade agreements.
• Making the Economy Grow: These policies aim to help the country's economy get bigger and stronger over time.
• Sharing Wealth: These policies look at how to share income, property, or wealth more fairly among people.
• Other Policies: This includes rules for businesses (regulatory policy), preventing big companies from having too much power (anti-trust policy), and supporting specific industries (industrial policy).

How Do Governments Keep the Economy Stable?

Stabilization policy tries to help the economy when it's slow or stop prices from rising too quickly.

Fiscal Policy: Government Spending and Taxes

Fiscal policy uses government spending and taxes to guide the economy. It's often linked to ideas from Keynesian economics.

• Government's Money Balance: This is about whether the government spends more than it collects in taxes (a deficit) or collects more than it spends (a surplus).
• Tax Rules: These are the different ways the government collects money from people and businesses.
• Government Spending: This is money the government spends on almost anything, like healthcare, education, or defense.

Monetary Policy: Managing Money and Interest Rates

Monetary policy controls the value of a country's money. It does this by changing how much money is available. If there's less money, it can help control inflation. If there's more money, it can help the economy grow.

• Interest rates: These are the costs of borrowing money. If the government or central bank sets them, it affects how much people borrow and spend.
• Rules for Banks: Banks have to keep a certain amount of money in reserve. This affects how much money they can lend out.

What are Economic Policy Goals and Tools?

Economic policies usually aim for specific goals. These might be targets for how much prices go up (inflation), how many people have jobs (unemployment), or how fast the economy grows. Sometimes, other goals like military spending or government ownership of businesses are also important.

These are called the policy goals: what the economic policy wants to achieve.

To reach these goals, governments use policy tools. These are things the government can control. Common tools include interest rates, the amount of money in circulation, taxes, government spending, and rules about jobs.

Choosing the Right Tools and Goals

Governments and central banks can't achieve every goal at once, especially in the short term. For example, a government might want to lower inflation, reduce unemployment, and keep interest rates low, all while keeping its currency strong. But usually, lowering inflation and keeping the currency strong means unemployment might go up and interest rates might rise. This can make policies confusing if too many goals are chosen at once.

Demand-Side vs. Supply-Side Tools

One way to help with this problem is to use policies that affect the "supply side" of the economy. For instance, unemployment might be reduced by changing laws about trade unions or unemployment insurance. These are different from "demand-side" factors like interest rates, which affect how much people want to buy.

Flexible Policies vs. Fixed Rules

For much of the 20th century, governments used flexible policies (called discretionary policies). These were designed to fix problems in the business cycle. They used fiscal and monetary policy to adjust inflation, output, and unemployment.

However, after a period of high inflation and slow growth in the 1970s, policymakers started to like policy rule]]s more.

A flexible policy is good because it lets leaders react quickly to new situations. But it can also be tricky. A government might say it will raise interest rates to control inflation, but then change its mind later. This makes the policy less believable and less effective.

A rule-based policy can be more trusted because it's clearer and easier to predict. Examples include fixed exchange rates (how much one currency is worth compared to another) or specific rules for interest rates. Some rules can even be set by outside groups.

A middle ground between strict flexible policies and strict rules is to give power to an independent group. For example, central banks like the Federal Reserve Bank in the US or the European Central Bank set interest rates without government interference, but they don't follow strict rules.

Sometimes, international groups like the International Monetary Fund can also set policies for a country.

Economic Policy Through History

The first economic challenge for early governments was getting the resources they needed. This included money for the military, roads, and big projects like building the Pyramids.

Early governments often collected taxes in goods or used forced labor. But when money was invented, a new choice appeared. A government could tax its citizens, or it could make more money by changing the value of its coins (like adding less precious metal).

Ancient civilizations also decided whether to allow trade and how to tax it. Some, like Ptolemaic Egypt, had a "closed currency policy." This meant foreign traders had to exchange their money for local money, which was like a high tax on foreign trade.

By the early modern age, more policy choices appeared. There was a lot of discussion about mercantilism, which was a system where countries tried to export more than they imported to gain wealth. Trade policy became linked to a country's wealth and its relationships with other countries.

In the 1800s, what a country used as its monetary standard (like gold or silver) became very important. The choice of metal affected the wealth of different groups in society.

The Start of Modern Fiscal Policy

As private wealth grew during the Renaissance, countries found new ways to pay for things without changing their coins. With the development of capital markets (places where money is invested), governments could borrow money to pay for wars or expansion. This caused less hardship for people.

This was the beginning of modern fiscal policy.

These same markets also made it easier for private businesses to raise money by selling bonds or stock to fund their own projects.

Understanding Business Cycles

The business cycle became a big topic in the 1800s. People noticed that industrial production, jobs, and profits went up and down in a regular pattern. One of the first ideas to fix this came from Keynes. He suggested that fiscal policy could be used to fight off economic downturns like depressions. Other economists, like the Austrian School, believe that central banks can actually cause these cycles. After a period where many thought the government should have a smaller role in the economy, the idea of government intervention became popular again after the 2007-2008 financial crisis.

Evidence-Based Policy Making

A newer idea, inspired by medicine, is to make economic policy decisions based on the best available evidence. This means economists do studies, sometimes even experiments, to see what policies work best. For example, the work of Nobel Prize winners Banerjee, Duflo, and Kremer showed how experiments can provide strong evidence for policies that help economic growth. This approach focuses on making sure policies are effective and help the economy grow, not just on fixing downturns.

See also

In Spanish: Política económica para niños

• Stabilization policy
• Budget process
• Constitutional economics