previous CHAPTER 2

Chapters 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20 21 22 23 24 25 26

Chapter 1
General Economic Concepts
Chapter 2
What is Policy?
Chapter 3
History of Macroeconomic Policies in the United States
Chapter 4
Policy Goals: Maximum Employment
Chapter 5
Policy Goals: Maximum Production
Chapter 6
Policy Goals: Price Stability
Chapter 7
Policy Goals: External Balance
Chapter 8
Subsidiary Policy Goals
Chapter 9
Conflicting Policy Goals
Chapter 10
The Policy Makers
Chapter 11
The Policy Instruments
Chapter 12
The Decision-Making Processes
Chapter 13
The Policy Indicators
Chapter 14
The General Economic Model
Chapter 15
Monetarist Monetary and Fiscal Policies
Chapter 16
Keynesian Monetary and Fiscal Policies
Chapter 17
Debt Management Policies
Chapter 18
Incomes Policies
Chapter 19
Supply Management Policies
Chapter 20
The Long Wave
Chapter 21
Contemporary Issues
"The ideas of economists and political philosophers, both when they are right and when they are wrong, are more powerful than is commonly understood. Indeed the world is ruled by little else. Practical men, who believe themselves to be quite exempt from any intellectual influences, are usually the slaves of some defunct economist. Madmen in authority, who hear voices in the air, are distilling their frenzy from some academic scribbler of a few years back."

John Maynard Keynes
British Economist
The General Theory of Employment, Interest and Money (1936)

  1. Policy and Its Component Parts
  2. Theory and Its Component Parts
  3. Types of Policies
  4. Taxonomy of Macroeconomic Policies and Decision Makers
  5. Relevance of Macroeconomic Policies for Different Production Economies
  6. Criteria for Selecting the "Best" Policy
  7. Summary
top    I. Policy and Its Component Parts

A policy is a set of rules and regulations which decision-makers establish to achieve a stated goal. Thus, policy concerns four things: the decision-makers, the means, the ends, and the theoretical and empirical linkages between the means and the ends. The success of a policy is measured by how close an observed outcome is to the desired goal.

Taxonomy of Macroeconomic Policy

Means   Ends

Decision Makers

Decision Makers
Fiscal authority: federal government
Monetary authority: central bank (Federal Reserve)

Natural means: land, labor, and capital (resources or factors of production)
Artificial means: fiscal policies, monetary policies, incomes policies, debt management policies, and supply-side policies

Ends (performance, outcomes, targets, objectives, goals)
Maximum employment
Maximum growth
Price stability
External balance

Keynesian theories
Monetarist theories

The decision makers are the individual or individuals who formulate the policies to achieve society's goals. In an anarchy, the decision-maker is the individual; in a monarchy, it is the king; in a representative democracy, they are the elected officials. There is no right or wrong presumption of the best decision maker. The people collectively determine who will be the decision maker(s). In the United States, the federal government and the central bank (Federal Reserve) are the macroeconomic policy makers.

The means are the resources which society has available at the current time to use to achieve its goals. The means are either natural or artificial.

Natural means resources, assets, or other endowments exist independently of any arbitrary rules or regulations. They include land and other natural resources, labor, capital, and entrepreneurial ability. For example, a country with huge oil reserves or one with a highly skilled labor force is "naturally" endowed, regardless of its political or social organization.

Artificial means are man-made structures, systems, or other rules and regulations which are established to organize or coordinate the natural means. For example, society generally provides for a political organization to oversee the administration of the system. This political organization is one type of artificial means. The rules and regulations promulgated by the political officials are also artificial means. Therefore, policy is an artificial means. In the United States, fiscal policy, monetary policy, incomes policy, debt management policy, and supply-side policy are artificial means to achieve macroeconomic goals.

Ultimate goals: Major or principal goals; ultimate ends.

Subsidiary goals: Secondary or supplementary goals to be accomplished simultaneously.

Conflicting goals: Goals which cannot be accomplished simultaneously.
The ends are the performance, outcomes, targets, objectives, or goals that society wants to achieve. These goals may be political, social, religious, psychological, or economic. Derivation of goals, however, extends beyond the boundaries of the social sciences into the field of ethics. The social scientist can study what people say they want, what they think they may want, and may even infer from their behavior what they really want, but the job of a social scientist does not include a determination of whether people want the right things. Any discussion of what are the right things to want is more in the province of the philosophical, ideological, theological, or political vein.

The difference between the goals of the Republican Party and the goals of the Democrat Party epitomizes this dilemma. Republicans consistently believe that price stability is the nation's number one goal, while Democrats consistently believe that reducing unemployment is the nation's number one goal. There is no right or wrong presumption of the appropriate goal. It changes as the electorate expresses its preferences by selecting one or another administration. In the end, goals are given to social scientists whose job is to evaluate how these goals can be achieved quickly, easily, and economically.

In the United States, maximum employment, maximum growth, price stability and external balance are the ultimate macroeconomic goals.

The linkages are the networks, processes, and transmission mechanisms through which policies are effectuated. Most policy works only indirectly through a chain of events. In order to predict the outcome of a policy measure, the social scientist must identify this chain of events. This chain of events can be deduced from patterns and regularities in economic behavior. The linkages are the sum total of the chains of cause and effect. The search for linkages is called theory.

top    II. Theory and Its Component Parts

Theory is a body of logical arguments based on certain assumptions about the "state" of the real world and from which certain conclusions are drawn as to the operational relationships of the real world. The real world is much too complicated and complex to analyze as a whole. Therefore, social scientists abstract or simplify real world phenomena by looking at different pieces separately to identify these operational relationships. This abstraction or simplification is theory. Theory has five parts: assumptions, theoretical model, theoretical conclusion, empirical testing, and empirical conclusion.


Assumptions are definitions, relationships, and other statements which define the "state" of the economy in which the linkages are to be identified and developed.

Definitions are the meanings of words. Different fields of study use different words. Since a word can have more than one meaning, students must learn the precise meaning of a word for use in a particular field, if they are to master the subject matter of that field. Definitions make the "language" of the field recognizable and precise. They must be explicitly stated so that confusion in communication is avoided and subsequent development of the logic is consistent. Definitions are necessarily antecedent to any significant dialogue in developing the logic of relationships and the analysis of complex problems.

Relationships are a priori conditions which are imposed on the analysis, generally and simply stated in mathematical terms. These mathematical terms are identities, functional relationships, and behavioral relationships.

Identities are tautologies or truisms. An identity sets two or more things equal by definition; that is, two terms are equal (identity) simply because they are defined to be equal. Identities derive from the fundamental proposition that the whole is equal to the sum of its parts. They define the realm of possibilities and they limit the universe to a certain set of possibilities. In so doing, identities also define what is not possible. Neither side of an identity is dominant. An identity has no definitive cause-and-effect and either side may influence the other.

Macroeconomic theory is built on two identities: the National Income Accounting Identity (GNP identity GNI) and the Equation of Exchange (MsV identity PT). The National Income Accounting Identity states that "Expenditure" must always be equal to income "Income" (E identity Y). It does not say for certain whether a change in income changes expenditure, or whether a change in expenditure changes income. It merely states that if one changes, the other must change also.

Within the limits of the possible, empirical relationships — the observed relationships — serve to separate the probable from the improbable. These are the functional and behavioral relationships.

Functional relationships are dependencies which show the cause-and-effect. In a functional relationship, one or more independent or exogenously determined variables create the values for the dependent variable. For example, as a functional relationship, E = Y implies that E = f(Y) and that a change in income (Y) causes a change in expenditure (E).

Behavioral relationships are parametric functional equations which show the direction and magnitude of the cause-and-effect. For example, as a functional relationship, E = C + I + G + Xn = .65Y + .20Y + .30Y - .15Y, where the trade balance is in deficit.

Other statements are any other conditions which define the state of the economy for purposes of the analysis, e.g., full employment, short-run period, fixed technology, no government, etc.

Theoretical Model

The theoretical model is a body of logical arguments that follow from the assumptions. In economics, these arguments connect economic behavior to economic activity in a systematic fashion. In order to be logically "correct," all theory must have two properties: transitivity and consistency.

Transitivity is the property that ensures that one statement passes to the next in such a way that each successive statement is subsequent to all preceding statements and is not causal of or to a preceding statement. For example, if A, then B. If B, then C. If C, then D; not A or B.

Consistency is the property that ensures that the connection is logical and does not violate any preceding arguments or any of the assumptions. For example, if A > B and B > C, then A > C. C can never be greater than or equal to A.

Theoretical Conclusion

A theoretical conclusion is the hypothesis, law, or principle which is derived from the body of logical arguments. The theoretical conclusion is the last of the series of arguments, usually preceded with "therefore."

Empirical Model

The empirical model is the observed or actual linkages derived from testing the theoretical model. To determine the applicability of the theory, the social scientist performs any number of tests. Empirical models verify the theoretical model with experiments or experience.

Laboratory tests are repetitive experiments, which can be conducted under controlled conditions. Laboratory testing occurs principally in the pure sciences. Generally, the factors under investigation have no intelligence and do not "learn" from successive repetitions of the same experiment. In repeating the experiment, the scientist can determine the validity of the theoretical conclusions. For example, combining two parts hydrogen to one part oxygen always produces water.

Statistical tests are probabilistic estimates. Statistical testing occurs principally in the social sciences, where theory is predicated on human behavior. Humans, unlike other factors, have brains. They learn from the past and will modify their behavior to improve outcomes or to avoid disappointing outcomes. For example, touching a hot iron. Consequently, testing becomes an exercise in statistical manipulation or "number crunching" to determine what individuals can be expected to do "on average." The Law of Large Numbers states that as the sample size increases, extreme deviations in behavior will tend to cancel out so that the mean (average) behavior of the sample will approximate the mean (average) behavior of the population.

Empirical Conclusion

An empirical conclusion is the result of quantitative testing. The empirical conclusion from a laboratory test can be certified with 100% confidence because the same result can be obtained over and over again from the same set of controlled conditions. The empirical conclusion from a statistical test, however, can never be certified 100% of the time. Such result can only be stated within some confidence interval less than 100%. For example, 95% of the time the unemployment rate will be 6.0% +/- .4%; or there is a 95% chance that a specific event will occur.

top    III. Types of Policies

Economic policy is the set of rules and regulations concerning economic means and economic ends. It covers the entire material sphere as it relates to the production and distribution of goods and services and to the efficient use of land, labor, capital, and entrepreneurial ability in these processes. Economic policy may be either private or public; either fiscal or regulatory; and either macroeconomic or microeconomic.

Private versus Public Economic Policies

Private economic policy is the set of rules and regulations established by households and businesses to facilitate the mutual exchange of resources and commodities. It includes rules and regulations governing the organization of resources in production and distribution of the final product.

Public economic policy is the set of rules and regulations established by the government to achieve established economic ends. Its purposes may be many, depending on the private sector climate. Some public policies are adopted solely for ensuring order and consistency in the market place, for example, laws governing right to contract, breach of contract, corporate chartering, and bankruptcy laws. Some public policies are designed specifically to affect particular markets, for example, minimum wage and rent control laws. Some public policies are directed at developing the country's infrastructure or raising its living standard. Still other public policies seek stabilization of economic activity to ensure maximum employment, maximum growth, and price stability. Public policies may be either fiscal or regulatory policies. They may also be either macroeconomic policies or microeconomic policies.

Fiscal versus Regulatory Economic Policies

Fiscal policy is the set of rules and regulations governing changes in tax revenues and/or expenditures which affect the overall balance in the government's budget. Imposition of a windfall profits tax, an increase in personal income tax rates, elimination of the investment tax credit, the purchase of 10 new Stealth bombers, a cut back in the space program, a reduction in veteran's benefits, and increased revenue sharing with the states are examples of fiscal policies.

Regulatory policy is the set of rules and regulations establishing codes of behavior (the "do's" and "don'ts"). Although some regulatory policies might involve expenses for regulatory commissions and enforcement agencies or the imposition of fees or fines on individuals for compliance or violations, the expenditure and revenue collection only incidental to achieving the legislated behavior. The expenditure and revenue collection are not specifically designed to affect the government's budget. Wage and price controls, safety standards, environmental protection laws, import quotas, and minimum wage are examples of regulatory policy.

Macroeconomic versus Microeconomic Policies

Macroeconomic policy is the set of rules or regulations designed to influence or control macroeconomic variables. These variables include aggregate income, total unemployment (unemployment), growth, and the general level of wages, prices, and interest rates. Regulatory policy is macroeconomic policy when it is aimed at the general level of economic activity. Contract laws and national wage and price controls are examples of macroeconomic regulatory policies. Fiscal policy is macroeconomic policy when the government alters its aggregate expenditures and tax collections to run deficit, surplus, or balanced budgets. The direction and magnitude of the budget deficit or surplus are of paramount importance in influencing macroeconomic activity. Monetary policy is macroeconomic policy when the central bank changes the amount of money supply in circulation and/or the general level of interest rates. Debt management policy is macroeconomic policy when the government finances a federal budget deficit. Incomes policy is macroeconomic policy when the government rearranges income shares so that the whole economy expands. Supply-side policy is macroeconomic policy when the government provides across-the-board incentives to expand the economy's potential output.

Microeconomic policy is the set of rules or regulations designed to influence microeconomic variables. These variables include, the distribution of income, the composition of output, employment in the steel industry, the price of automobiles, and T-bill rates. Regulatory policy is microeconomic policy when it is aimed at specific economic behavior and activity. The imposition of quotas or protective tariffs (as opposed to revenue raising tariffs) on specific imports, agricultural price ceilings, minimum wage, usury laws, and emission standards are examples of microeconomic regulatory policies. Fiscal policy is microeconomic when the government allocates specific expenditures or levies specific taxes. Expenditures on the space shuttle, federal judges, and manpower training programs for labor-specific development, and neutral income tax rate changes, revenue-raising tariffs, end excise taxes on cigarettes are microeconomic fiscal policies, since they affect specific markets and types of economic behavior or activities. Monetary policy is microeconomic policy when the central bank sets maximums or minimums on interest rates to affect specific credit markets. Debt management policy is microeconomic policy when the government finances a federal budget deficit with a particular type or maturity of debt. Incomes policy is microeconomic policy when the government rearranges income shares so that a particular segment of society benefits at the expense of another segment. Supply-side policy is microeconomic policy when the government provides incentives to particular individuals or businesses to redirect production in the economy.

top    IV. Taxonomy of Macroeconomic Policies and Decision Makers

Central Bank Central Bank Central Bank Quasi-Gov't Agencies Planning Board
Other Statutory/Regulatory Bodies Other Statutory/Regulatory Bodies Note Issuance Facility |
Public Enterprise
Regulatory Bodies
Regulatory Policies Demand Management Policies Supply Management Policies
Monetary Policies Fiscal Policies Planning Policies
Debt Management Policies |
Debt Management Policies Public Production
Incomes Policies
Supply-side Policies
Oversight Interest Rate Management Money Supply Management Velocity Management Input/Output Management
Financial Assets (lenders)
Money Supply (buyers)
Real Assets
Direct and Indirect Claims    | ↑
(buyers) |  | (sellers)
↓ |
  Newly Produced Final Goods
Financial Intermediaries Capital Sinks

Resale Goods, Land, Relics, Rare Objects, Precious Metals, Sacred Cows, Prostitution, Drugs, Gambling, Foreign Exchange and Accounts
Intermediate Goods
Financial Markets Raw Materials
 | ↑
(buyers) |  | (sellers)
↓ |
Financial Speculation

Demand Management Policies

Demand management policies are policies that are designed to operate on the demand side of markets to achieve macroeconomic goals. These policies affect either the amount of money buyers have or the velocity at which they are spending their money.

Fiscal policies are budgetary policies that influence the income velocity of money. The authority for fiscal policy is generally the federal government, because only the federal government has unilateral ability to affect broad-based economic change across a country at one time. State and local or provincial governments have limited fiscal powers. They cannot print money, they have only regional influence, and they are constrained by their constitutions to run balanced budgets.

The tools of fiscal policy are federal government tax collections and federal government expenditures. The federal government can manipulate its tax collections and expenditures to achieve a certain deficit, surplus, or balance in its budget. Then, according to Keynesians, bottom line balance influences the income velocity of the money supply. A deficit budget increases velocity, a surplus budget decreases velocity, and a balanced budget has no impact on velocity.

In the U.S., the federal government is a very complex organization. It includes the President, the Congress (the House of Representatives and the Senate), and their appointed agencies. Some other departments and agencies involved with making fiscal policy are the Council of Economic Advisers (CEA), the Office of Management and the Budget (OMB), the Treasury Department (DOT), and the Congressional Budget Office (CBO). Hence, making fiscal policy can be a very tedious and time-consuming chore.

Monetary policies are money supply and interest rate polices that influence of the amount of money supply in circulation. The authority for monetary policy is the federal government and/or its appointed agencies such as a central bank or note issuance facility. England established the first central bank in 1694. The U.S. and other countries were much slower at creating a central bank or note issuance facility. The U.S. did not get a central bank until 1913, when Congress passed the Federal Reserve Act, 12 U.S.C. § 221 et seq., as amended, establishing the Federal Reserve Bank System.

The tools of monetary policy are classified as general tools and selective tools. The general tools operate pervasively and indiscriminately throughout all markets in the economy. They include reserve requirements, liquidity ratios, interest rates on reserve deposits, discount rates, credit facilities, liquidity facilities, open market operations, swaps, and foreign exchange operations. The selective tools are tailored to affect specific segments of the economy. They include moral suasion, loans to non-banks, and interest rate, credit, foreign exchange, and margin controls.

The Federal Reserve is a complex organization. It includes the Board of Governors in Washington, D.C., the Federal Open Market Committee (FOMC), twelve District Banks, and several advisory and liaison committees. However, the organization is not so complex as the federal government. Therefore, decision-making procedures are more compact and efficient and the Board of Governors is ultimately responsible for the conduct of monetary policy.

Debt management policies are financing policies that may influence both the amount of money supply in circulation and the income velocity of the money supply. The authority for debt management policies is the Secretary of the Treasury Department (a position within the President's Cabinet) in consultation with the Federal Reserve. Together, they determine the timing, amount, and maturity schedule of a securities offering to finance a budget deficit and/or rollover (refund) maturing debt.

The tools of debt management are Treasury securities. These securities have different maturities at issue. Treasury bills (T-bills) have short-term maturities (up to one year), Treasury notes (T-notes) have medium-term maturities (between one and ten years), and Treasury bonds (T-bonds) have long-term maturities (beyond ten years). Borrowing with securities of different maturities influences short-term, medium-term, and long-term interest rates.

The term structure of interest rates (the yield curve) shows the yield to maturity of securities of different maturities. The Treasury can manipulate the term structure by issuing securities of different maturities. A change in the term structure of interest rates changes the current costs of production and expectations about the cost of capital formation in the near future. By changing production costs and expectations of the future, the Treasury influences spending and the income velocity of the money supply.

The Treasury may also use debt management policies to influence the amount of money supply in circulation. By issuing securities of different maturities, the Treasury can change relative interest rates among countries and foreign exchange rates. If U.S. securities, in general, and different U.S. securities, in particular, are more attractive to foreigners, money flows into the U.S. and the U.S. money supply increases. If U.S. securities, individually or collectively, become less attractive, money flows out of the U.S. and the U.S. money supply decreases.

Supply Management Policies

Supply management policies are policies that are designed to operate on the supply side of markets to achieve macroeconomic goals. The authority for such policies is invariably the federal or national government or one of its appointed agencies. The government intervenes to influence the level and composition of income and output either directly or indirectly through control of production and distribution processes or indirectly through tax incentives.

Income/Output management policies are management policies where the government intervenes directly in the resource and product markets to control the level and composition of income and output. It dictates what resources will be used to produce what products and, often, but not necessarily, dictates who gets the products.

National economic planning is a policy that controls the usage and allocation of inputs and the volume and composition of output by way of a plan. The authority for national economic planning is the federal or national government or one of its appointed agencies, generally called a national economic planning commission. The tool is a master blueprint for economic activity and is generally called a national economic plan. Plans may be formal (legal) or informal (non-legal) documents. They may vary from broad, general guidelines for input/output activity to extremely complex blueprints, detailing exact input requirements for achieving specific output targets. Indicative planning uses projected market prices to guide inputs and outputs into their most profitable production activities. The plan is generally voluntary. Material balance planning uses technical coefficients of production to determine real or physical input requirements for established output targets. The plan is mandatory. The U.S. has no national economic planning.

Public production is a policy that controls the usage and allocation of inputs and the volume and composition of output through government ownership and management of the means of production. The authorities for public production are the federal, state, and local (or provincial) governments and/or their appointed agencies, such as industry boards and commissions. The tools are ownership (property rights) and management of capital and land. The U.S. has some, but not a lot of public production. Most U.S. public production occurs at the state and local levels, except for mammoth enterprises like the Hoover Dam Project and the Tennessee Valley Authority.

Incomes policies are policies that control the usage and allocation of inputs and the volume and composition of output by directly or indirectly controlling income shares. The authority for incomes policies is the federal or national government or one of its appointed agencies, such as a wage and price board or commission. The tools of incomes policies are across-the-board wage and price controls, tax incentive plans, and indexing. Even though the fixing of income shares or distribution is considered to be a microeconomic problem, incomes policies are applied across-the-board on an impersonal, non-discriminatory basis. Since they are generally all-pervasive and designed to attack the macroeconomic problem of price stability, they are considered to be macroeconomic policies rather than microeconomic policies. Agencies may have extremely broad powers to establish wages and prices and any increase therein, or they may simply monitor economic agents for compliance. The U.S. has adopted incomes policies in the past, but currently it has no incomes policies.

Regulatory policies are policies that control the usage and allocation of inputs and the volume and composition of output with legislation and rules and regulations that control economic behavior. The authorities for regulatory policies are the federal, state, and local (or provincial) governments and/or their appointed agencies. Only governments have the ability to pass laws, but power may be vested in the regulatory agencies to establish rules and regulations, to monitor compliance, and to impose penalties for violation. The tools are laws and rules and regulations that delineate the desired behavior and enforce compliance with a system of penalties and rewards. The laws and rules or regulations may be established for many different purposes: safety (seat belt laws), social (DWI laws), or environmental (emissions standards) purposes. They may be established to ensure safety and solvency of enterprise and the delivery of services: chartering and licensing laws, property rights' laws, contract laws, bankruptcy laws, anti-trust laws, and reporting requirements. They may be established to influence the pricing, production, and profitability of different goods and services: quotas, regulatory taxes, protectionist tariffs, and export subsidies.

Supply-Side economic policies (Reaganomics) are policies that indirectly control of the level and composition of output through a hybrid or combination of budgetary and regulatory policies by the government and monetary policies by the monetary authority. The policies operate on the principle that economic participants are driven by incentives and that they adjust their behavior and asset portfolios in response to relative prices and changes therein. The authority for supply-side economic policies is the federal government and/or its appointed agencies, especially the central bank. The tools of supply-side economic policies are the structure of taxes and tax rates, the composition of government expenditure, the money supply and interest rates, and the regulatory environment.

top    V. Relevance of Macroeconomic Policies for Different Production Economies

The Barter Production Economy

Without money, government has virtually no role. Since it is all but impossible for a government to tax and spend real assets, its role is reduced to supply management policies or direct intervention in the production and distribution process through national economic planning, public production, incomes policies, and regulation.

The Monetary Production Economy

The introduction of money creates several roles for government.

Obtaining the correct amount of money to support a given amount of real output Income and output depend upon the absolute amount of money supply in circulation. Economies need a sufficient amount of money supply to meet the needs of trade, but not too much or inflation destroys the credibility of the money supply.

Y = PQ = f(Ms)|Vy

If the money supply is too large, the general level of prices rises (inflation). Nominal income increases, but real income does not.

+Y = (+P)Q = (+Ms)Vy

In the short-run, inflation may induce more rapid spending and an increase in velocity. Both nominal income and real income increase.

+Y = (+P)(+Q) = (+Ms)(+Vy)

However, when the money supply grows too rapidly, the inflation rate rises. As the inflation rate rises, individuals lose faith in the monetary unit. They resort to barter, and economic growth and development slow. Income and employment fall.

-Y = (+P)(-Q) = (+Ms)(-Vy)

If the money supply is too low, the general level of prices falls (deflation). Nominal income decreases, but real income does not.

-Y = (-P)Q = (-Ms)Vy

However, falling prices discourage production, and economic growth and development slow. Income and employment fall.

-Y = (-P)(-Q) = (-Ms)Vy

Accumulating money balances in anticipation of use Money balances must be accumulated through saving before investment can occur and how much investment occurs depends upon how fast money balances are accumulated and transferred.

Y = PQ = Vy|Ms

During the accumulation stage, velocity falls. As velocity falls, spending falls. As spending falls, so does profitability and the incentive to invest. As investment falls, income and employment fall.

-Y = P(-Q) = Ms(-Vy)

During the spending stage, velocity rises. As velocity rises, spending rises. As spending rises, so does profitability and the incentive to invest. As investment rises, income and employment rise.

+Y = P(+Q) = Ms(+Vy)

Withdrawing money balances from the circular flow Money balances can be withdrawn from the circular flow for non-productive purposes (P1Q1) and hoarded (sit idle or deposited abroad in foreign accounts) or plowed into "capital sinks" (P2Q2). This withdrawal (M2) reduces the supply of money balances (M1) available for the purchase of newly produced goods and services. This drain is represented by the Modified Equation of Exchange:

P1Q1 + P2Q2 = M1V1 + M2V2.

Unless velocity (V1) increases to offset this drain, it prevents an economy from growing. Income and employment fall.

Macroeconomic policies In a monetary production economy, the government has two roles. One is to influence the money supply (monetary policy). The other is to influence velocity (fiscal policy). Since it is the buyer who must have money balances to enter the markets for newly produced goods and it is the buyer who determines the velocity or rate at which these money balances are spent, influence of the money supply (monetary policy) and influence of velocity (fiscal policy) are called demand management policies.

However, in a monetary production economy, without credit, the two roles are one in the same. Fiscal policy is monetary policy and monetary policy is fiscal policy. The government is both the fiscal authority and the monetary authority. The government increases and decreases the money supply as it spends and taxes. When the government spends more, it mints coin out of its coffers and puts the coin into circulation. When it taxes, it takes the coin out of circulation and puts it back in its coffers. If prices rise, the government must increase taxes to take money out of circulation. If prices fall, the government must spend more to put the money back into circulation. To be successful, the government must always have spare gold in its coffers. If gold flows out of the country, the government may run out of gold to mint during a downturn in the economy.

The Credit Production Economy

With the introduction of financial instruments, the government is no longer dependent on a real asset for the money supply. Now, the money supply may consist of credit: token coins, paper (currency), checking accounts, and other highly liquid assets, e.g. savings accounts, checkable money market mutual funds, etc. Monetary policy is divorced from fiscal policy. The fiscal authority (government) may no longer be the monetary authority (central bank). Also, the amount of control each authority has is diminished. Control reduces to influence. The monetary authority can now use monetary policy to influence money supply and interest rates and the fiscal authority can use fiscal policies to influence velocity. The government may also use debt management policies and oversight regulations.

Monetary Policies

To manage the volume of money balances in circulation The value of money is its purchasing power. If prices rise, the value of money falls. Extreme price increases reduce the utility of accepting and holding money balances and initially increase velocity. If the inflation rate continues to rise, "hyper-inflation" encourages an eventual return to barter. To prevent this reversion, the monetary authority must withdraw excess money balances from the circular flow. If prices fall, the value of money rises. Extreme price decreases increase the utility of accepting and holding money balances and reduce the velocity of money. If the deflation continues, everybody will try to sell before the next round of price decreases, but nobody will buy. The monetary authority must increase the money supply, to keep the economy from stagnating. In a credit economy, the government can mint token coin or print paper money, or the monetary authority can give banks new reserves, so that the banks can create money supply through the lending process. If banks have more reserves, then they can lend more and the money supply increases. If banks have less reserves, then they cannot lend as much and the money supply decreases.

To manage the income velocity of money balances The monetary authority can influence velocity by changing interest rates. Since the interest rate is simply another "price," albeit the price paid for the use of money balances, it serves as a mechanism for rationing available money balances. If interest rates are too high, people will prefer interest-bearing assets to real assets and income velocity will decrease. If interest rates are too low, people will prefer real assets to interest-bearing assets and income velocity will increase. To influence velocity, the monetary authority raises and lowers interest rates. If the banks' cost of funds rises, then they must raise interest rates to their borrowers. As interest rates rise, the quantity demanded of loans falls, and velocity falls. If the banks' cost of funds falls, then they can lower interest rates for their borrowers. As interest rates fall, the quantity demanded of loans rises, and so does velocity.

The monetary authority can target either the money supply or interest rates, but not both at the same time. If the monetary authority targets the money supply, it loses control of interest rates. If the monetary authority targets the interest rates, it loses control of money supply. Therefore, even though the monetary authority can use its monetary policy tools to influence money supply and income velocity, it can only target one at a time.

Fiscal policies influence the income velocity of money balances The government, on the other hand, can control income velocity by changing the amount of balance in its budget. Because of its unilateral ability to incur arbitrary budget deficits or surpluses, the government is in a unique position to step in and offset adverse movements in income velocity. If income velocity falls, the government can raise it by increasing its own spending. To increase its ability to spend more, the government can obtain money balances either by the involuntary extraction of idle money balances through taxation or by the voluntary extraction of idle money balances by borrowing. If income velocity rises, the government can lower it by reducing its own spending or raising taxes to accumulate idle money balances. While government agencies do not have the ability to tax to influence income velocity, they generally have the power to borrow in the name of the government to circulate idle money balances.

Debt management policies influence the income velocity of money balances between and among sectors of the economy Different sectors have borrowing needs with different maturities depending upon the economic life of the asset for which the borrowing occurs. The government can borrow with debt of varying maturities from 3 months to 30 years. When the government borrows, it increases the demand for money and pulls up interest rates in the maturity of securities it is offering. The increased supply of securities pushes down securities' prices in the affected maturity and raises their yield. Raising interest rates in one maturity of security relative to all interest rates negatively affects desired borrowing for that maturity period.

Regulation and oversight policies influence the flow of money through the financial sector The regulations include chartering, licensing, requirements to promote the safety and solvency of the financial institutions, and a system of penalties to punish violators and award compensation to victims. Requirements include reporting requirements, disclosure requirements, and margin requirements. Oversight includes the enforcement of these regulations by supervising, monitoring, and examining the financial institutions on a timely basis.

Once credit is introduced into a monetary production economy, a part of the money supply may be withdrawn for speculative activities based solely on trading in financial assets (P3Q3). Speculation occurs, because people think that they will get higher returns by guessing on the direction of interest rates rather than lending at the current interest rate. This withdrawal of money supply (M3) further reduces the supply of money balances available for the purchase of newly produced goods and services (M1). Unless velocity (V1) in the production economy increases to offset this drain, speculation prevents an economy from growing. However, speculation is based especially on expectations. If monetary, fiscal, debt management, and regulatory policies fail to reverse expectations, they may be helpless in reducing speculation.

top    VI. Criteria for Selecting the "Best" Policy

Very often, several different policies are available to achieve a given end. Where more than one policy is available, the decision maker must also decide which policy to select. The criteria for selecting the policy are efficiency, neutrality, and equity.

Efficiency refers to the least-cost policy. Economists are concerned with the conservation of scarce resources. Therefore, the "best" policy, according to economists, is that policy which achieves society's goals at the lowest cost. This policy includes selection of the least-cost decision maker as well as the least-cost process for achieving society's ends.

Neutrality refers to the least-distorting policy. Economists are also concerned with the allocation of resources. If policy distorts individual behavior and forces people to do things they would not do without the policy, then resources are reallocated. Unless society's goal is specifically to rearrange its resources, policies which distort are inefficient. Therefore, the "best" policy, according to economists, is that policy which minimizes behavioral changes and resource reallocations.

Equity refers to the fairest policy. Economists are generally not concerned with subjective outcomes, like fairness. What is fair to one person may not be fair to another. Economists have no real standards for measuring fairness, except through a social welfare function. Unfortunately, what is fair for society may adversely affect certain individuals, who then think the policy is unfair. Therefore, economists do not, as a rule, espouse a "best" policy based on equity. In fact, equitable outcomes are generally at odds with efficient or neutral outcomes and available only through a trade-off with efficient and neutral outcomes.

top     Summary

Policy is a system of rules and regulations decision makers establish for the administration of a government or institution to achieve some end. Policy, then, becomes part of the means for achieving certain desirable outcomes. How policy effects these outcomes is either induced or deduced within some theoretical construct that seeks to simplify the real world and to establish basic relationships between all relevant means and the ultimate goals of society. A country's policy makers consist of the various levels of government and their authorized agencies, e.g., the central bank, a planning commissions, a wage and price council, industry boards, etc.

Government policies may be either budgetary or regulatory. Fiscal or budgetary policies seek to achieve certain goals through the manipulation of aggregate tax collections and government expenditures. Regulatory policies are the "do's and don'ts" that are designed to prescribe and proscribe behavior directly and may only indirectly — through fees, fines, tolls, or other monetary penalties, and through expenditures on "watch-dog" agencies — affect budget totals. If the policies are applied in the aggregate or across-the-board, they are called macroeconomic policies. If the policies are designed to affect specific markets or behaviors, they are called microeconomic policies.

Macroeconomic policies include income/output management policies (national economic planning, public enterprise, incomes policies, and regulation), demand management policies (fiscal, monetary, and debt management policies) and oversight policies. Most theories of non-inflationary growth and development are predicated on a set of credible institutions that provide the crucial linkages for success. Success presumes the fabrication, from ground up, of the policy-making structure (the institutions, the instruments, and the linkages) both to stimulate output (demand management policies) and to restructure sectoral imbalances (supply management policies) at the same time.

The use of indirect (demand management) policies is predicated on certain assumptions about the state of development of an economic system and the selfish or selfless behavior of economic participants.

  1. Income must be fully monetized. If it is not, national saving will be hidden in real assets or capital sinks that are inconvertible for use in financing private capital (investment) and social overhead capital (government expenditure on infrastructure). As a result, governments must resort to foreign borrowing and economic assistance or printing money to finance capital formation for growth and development and to offset declines in velocity from spending on capital sinks. If the domestic money supply is increased faster than velocity declines, excessive rates of inflation follow.

  2. Income must flow through organized markets. If income is consumed locally, on a barter basis, fiscal policies — changing tax rates, tax incentives, and overall tax collections — will have little influence on economic participants and governments will be forced to provide fiscal assistance (velocity management) through the expenditure side of their budgets.

  3. Financial markets for government securities must exist and be broad and deep enough so that open market operations by the monetary authority can have the desired impact on interest rates, prices, and investment alternatives to keep velocity stable.

  4. Financial markets for private securities must exist and be broad and deep enough so that the availability of liquid financial instruments reduces risks for savers, increases the pool of funds available for capital, and keeps velocity from falling due to the attractiveness of capital sinks. Both nationals and foreigners are reluctant to place funds where risk is high and retrieval or repatriation of funds is all but impossible. If risk is too high or retrieval/repatriation of funds is all but impossible, velocity falls. (Note: The number of borrowers must be sufficiently large so that borrowing and equity financing needs are sufficiently large to give breadth and depth to the securities markets.)

  5. Access to secondary market liquidity allows financial intermediaries to reduce markups on interest rates over deposit interest rates. This action has a doubly positive effect as lower lending rates encourage private borrowing for much needed capital formation and higher deposit rates encourage monetary (convertible) saving, while disengaging saving from real (inconvertible) assets and keeping velocity stable.

  6. The regulatory environment must be sufficiently comprehensive to guarantee fairness to all parties, but not so overly burdensome that it invites circumvention. It must also have a means for monitoring compliance and a fair system of penalties for violators and rewards for victims to prevent non-compliance.
If the above conditions are not realized, then governments have no alternative but to opt for more direct control (income/output management) of economic activity.

top    Readings

What is Economic Policy, Kenneth E. Boulding, Principles of Economic Policy, Prentice-Hall, Englewood Cliffs, NJ, 1958

Essays in Positive Economics, Milton Friedman, University of Chicago Press, Chicago, 1974: 3-43

The Surrender of Economic Policy, James K. Galbraith, The American Prospect, 25 Mar-Apr 1996: 60-67

Stabilizing an Unstable Economy, Hyman P. Minsky, Yale University Press, New Haven, 1986: 287-293

Monetary Policy in the Cold War Era, Mark S. Sniderman, Economic Commentary (FRBClev), Jun 1997

Identifying Monetary Policy: A Primer, Tao Zha, Economic Review (FRBAtl), 82(2) 2Q1997: 26-43

top    Websites