Gov: Domestic Policy

___________________________________________________________________

Content Objective:

Understand how government responds to problems in the economy (rapid inflation or rising unemployment) with fiscal and monetary policies.

Language Objectives:

• Understand, learn, and use new vocabulary that is introduced and taught directly through informational text and direct instruction.
• Identify and/or summarize main ideas, facts, supporting details, and opinions in an informational and/or practical selection.
• Read and synthesize information found in various parts of charts, tables, or diagrams to reach supported conclusions.

Learning Target:

Students will explain how government responds to problems in the economy (rapid inflation or rising unemployment) with fiscal policy.

___________________________________________________________________

Domestic policy is a type of public policy overseeing administrative decisions that are directly related to all issues and activity within a country’s borders. Domestic policy covers a wide range of areas, including business, education, energy, healthcare, law enforcement, money and taxes, natural resources, social welfare, and personal rights and freedoms.

Cultural policy pertains to the arts and creative endeavors of a government or its citizens. A state’s cultural policy is used to “channel both aesthetic creativity and collective ways of life” through a bureaucratic process. Cultural policy defines many of the fundamental aspects of a nation’s existence, such as the national language. These policies may be influential in forming a national identity, fostering civic responsibilities, and defining ethical behavior. Many countries have a ministry of culture that oversees the government’s cultural policy. Arts policy, language policy, sports policy, and museum planning are all policy areas governed by cultural policy.

Social policy pertains to the well-being of society and the response to societal challenges. Civil and political rights, education policy, drug policy, health policy, housing policy, and public security are all policy areas governed by social policy.

Economic policy pertains to a country’s economy and treasury. Monetary policy governs the supply of money and interest rates in the economy, while fiscal policy governs how the government raises funds and decides how they are spent. Developed nations typically have a central bank that regulates monetary policy semi-independently of political actors. Tax policy, regulation, monetary systems, corporate law, public works, competition law, incomes policy, food policy, energy policy, and natural resource management are all policy areas governed by economic policy.

The economic role of the government stresses its promotion and regulation of economic interests and its fiscal and monetary policies that affect economic growth. Business benefits from government’s promotional efforts which take place largely in the context of group politics. Through regulation, government imposes restraints on business activity that are designed to promote economic efficiency and equity.  Through fiscal and monetary policies, the federal government attempts to maintain a strong and stable economy characterized by high productivity, high employment, and low inflation. Fiscal policy is based on government decisions in regard to spending and taxing. Monetary policy is based on the money supply and works through the Federal Reserve System.

The goal of economic theory is to advance the stabilization of the economy. Some of the major disputes over macro theory and policy is the disagreement on three questions. What causes instability? Is the economy self-correcting? Should government adhere to rules or use discretion in setting economic policy?

The classical theory of economics, which dominated in the 18th and early 19th centuries, laid the foundation for much of modern economics. Sometimes referred to as laissez faire economics, classical theory emphasized growth, free trade, and competition, as free from government regulation as possible. Classical theory argues for the self-regulating market. Under this viewpoint, the concern for profit ensures that society’s resources are used in the most beneficial manner, without direction by government.

Keynesian theory believes it is the government’s job to smooth out the bumps in business cycles. This theory asserts that free markets have no self-balancing mechanisms that lead to full employment. Therefore, intervention would come in the form of government spending and tax breaks in order to stimulate the economy and government spending cuts and tax hikes in good times, in order to curb inflation.

Monetarist theory focuses on the macroeconomic effects of the supply of money and central banking and contends that changes in the money supply are the most significant determinants of the rate of economic growth and the behavior of the business cycle.

The rational expectations theory holds that people generally correctly anticipate the economic effect of events and act on their expectations. According to this view, government policy actions that are correctly anticipated will often fail to achieve their intended effect. Rational expectations theory holds that attempts to stimulate the economy by increasing the rate of growth of the money supply will be ineffective as agents anticipate increased inflation. When monetary authorities loosen policy, firms raise prices and workers demand wage increases, which undermines the attempt to stimulate the economy.

Americans benefit from economic stability. In a stable economy, jobs are secure, goods and services are readily available, and prices are predictable. Producers, consumers, and investors can plan for the future without having to worry about sudden upheavals in the nation’s economy. The government promotes economic stability by creating a widely accepted currency that maintains its value. The government also promotes stability by stimulating business activity during economic slowdowns. It does this through tax incentives, which encourage businesses to invest in new capital equipment, and through tax rebates, which encourage consumers to spend more money.

Before the 1930s, the federal government generally followed a hands-off policy toward the economy. Then came the stock market crash of 1929, which plunged the United States into the worst economic crisis in its history. The crash triggered a financial crisis that forced thousands of banks to go out of business. Millions of depositors lost their savings. Consumers slowed their spending, and firms cut back production or shut down. The economy took a nosedive, and the Great Depression began.

At first the government did little, assuming that the economy would stabilize on its own. But as the economy worsened, many people looked to the government for help. In 1932, Franklin D. Roosevelt won the presidency by promising a different approach, a New Deal for the American people. The New Deal greatly expanded the federal government’s role in the economy. It created dozens of new programs and agencies aimed at reforming the banking system, helping businesses, and providing jobs. The Depression ended when World War II began. But the federal government did not return to its traditional hands-off role. Instead, it took charge of the wartime economy, overseeing industries as they converted from consumer to military production. To pay for the war effort, the government also sharply increased individual and corporate income taxes. When the war ended, the federal government ended its supervision of industrial production. But many Americans feared a return to hard times and widespread unemployment. Congress responded to those fears by passing the Employment Act of 1946. This act gave the federal government an active role in managing the nation’s economy. To carry out that role, the act established the Council of Economic Advisers. This council helps the president formulate sound economic policies. The act also established a Joint Economic Committee that includes members from both houses of Congress. The committee’s job is to review the state of the economy and advise Congress on economic policies.

Fiscal Policy

Fiscal policy is carried out by the government (Congress and the President). The goals of fiscal policy is to achieve or maintain full employment, to achieve or maintain a high rate of economic growth, and to stabilize prices and wages. The two main instruments of discretionary fiscal policy are government expenditures and taxes. There are two types of expenditures: goods and services, and transfer payments.

The government buys many public goods, such as highways, tanks, planes, ships, space vehicles, office buildings, land for parks, and capital goods for schools and laboratories. This spending affects the distribution of income and competes with the private sector for scarce resources. As a result, this spending has a large impact on the nation’s economy.

Government Spending

Congress and the president work together to prepare an annual budget showing federal expenditures and revenues for the year. The largest components of the federal budget are Social Security, national defense, income security, and health care services. Most years, the government spends more than it collects in taxes, causing a budget deficit. The budget deficit is the amount that the government borrows for a given year. The national debt is the total amount of debt for the federal government. Each year’s budget deficit adds to the national debt. The national debt affects the distribution of income and transfers purchasing power from the private to the public sector. Attempts to control the deficit have taken the form of mandated deficit targets and pay-as-you-go provisions.

Taxes

The government collects taxes in order to finance expenditures on a number of public goods and services. Each year governments raise billions of dollars in revenues in a variety of ways, including taxes, license fees, tuition fees, and customs duties, to name just a few. Taxes and other governmental revenues influence the economy by affecting resource allocation, consumer behavior, and the nation’s productivity and growth. The three criteria used to determine if a tax is effective are equity, simplicity, and efficiency. The benefit-received principle of taxation and the ability-to-pay principle of taxation are used to help decide the group or groups that should bear the burden of the tax. Taxes can be proportional, progressive, and regressive, depending on the way the average tax per dollar changes as taxable income changes.

Recent talk of tax reform has centered around a Value Added Tax, which is a tax on consumption rather than income, and a flat tax, which would replace all tax brackets with a single tax rate.

Monetary Policy

Monetary policy consists of decisions made by a central bank about the amount of money in circulation and interest rates. In the United States, the Federal Reserve makes such decisions. The Fed controls monetary policy to help the economy grow steadily with full employment and stable prices. The Fed has a number of monetary tools available to change the money supply and interest rates to affect real output, employment, and price levels.

Open Market Operations

Open market operations are the most frequently used tool of monetary policy because of their flexibility and immediate effects. The Fed can inject money into the economy or pull it out using open market operations. The Fed’s open market operations involve buying and selling of government securities in the bond market. The securities can be Treasury bonds, notes, bills, or other government bonds. The Fed increases the money supply when it buys bonds, and it reduces the money supply when it sells bonds to member banks and the public.

Open market operations are relatively easy to carry out. They allow the Fed to make small adjustments in the money supply without new laws or banking regulations. For this reason, the sale and purchase of securities is the monetary tool the Fed uses most to stabilize the economy.

Discount Rate

An important tool of monetary policy is the discount rate, which is the interest rate the Fed charges member banks for loans. Banks sometimes need to borrow money to keep their reserve requirement at the proper level. This might happen because a bank has made too many loans or it could be a result of an unexpectedly large withdrawals. Whatever the reason, banks can borrow money from the Fed to shore up their reserves. A low discount rate makes it less costly for banks to borrow from the Fed.

A reduction in the discount rate encourages banks to borrow from the Fed and, in turn, increase loans to their customers. As a result, the money supply increases. Raising the discount rate has the opposite effect by discouraging banks from borrowing from the Fed. With money tight, banks make fewer loans, keeping the money supply in check.

The federal funds rate is the rate at which commercial banks borrow and lend their excess reserves to each other overnight. Banks can then use that money to make loans to customers thereby expanding the money supply.

Reserve Ratio

The reserve ratio is the most powerful tool of monetary policy, so it is only rarely used. The Fed could expand or contract the money supply by adjusting the required reserve ratio. This ratio is the minimum percentage of deposits the banks must keep at all times. A change in the percentage of deposits the banks must hold in reserve directly impacts the bank’s ability to increase loans and, therefore, the money multiplier. Lowering the ratio would allow banks to make more loans and create more money. Raising the reserve ratio would force banks to keep more cash in reserve and out of the money supply. This in turn would leave banks with less money to lend, slowing money creation.

_____________________________________________________________________________________________

Disclaimer

The views and opinions expressed here are those of the students and speakers of our government classes and do not necessarily reflect the views or positions of this website, institution, or organization. Any views or opinions are not intended to malign any religion, ethnic group, club, organization, company, or individual.