Understanding Types of Economic Policy

By Manzur Rashid, Peter Antonioni

Part of Macroeconomics For Dummies Cheat Sheet, UK Edition

Our lives are constantly being influenced by economic policy. But for many, the policy is just lots of words, with no real meaning. This should help you understand what is behind the policy. Policy makers undertake three main types of economic policy:

  • Fiscal policy: Changes in government spending or taxation.

  • Monetary policy: Changes in the money supply to alter the interest rate (usually to influence the rate of inflation).

  • Supply-side policy: Attempts to increase the productive capacity of the economy.

Fiscal and monetary policy comes in two types:

  • Expansionary: Intended to stimulate the economy by stimulating aggregate demand.

    • Expansionary fiscal policy involves increasing government spending or reducing taxes. Increasing government spending increases aggregate demand directly, whereas decreasing taxes increases aggregate demand indirectly by increasing consumption and investment.

    • Expansionary monetary policy involves increasing the money supply, which decreases the interest rate and stimulates consumption, investment and net exports.

    • Consumption increases because borrowing is now cheaper, but also because people need to spend less on things such as mortgage interest payments.

    • Investment increases because the opportunity cost of investment (the return from sticking the money in a savings account) has fallen.

    • Net exports increase because a fall in the interest rate makes holding the domestic currency less attractive, which causes it to depreciate, making exports cheaper and imports more expensive.

  • Contractionary: Intended to slow the economy down by decreasing aggregate demand. It’s the opposite of expansionary policy, in that it involves reducing government spending, increasing taxes or reducing the money supply.

Supply-side policies are designed to increase the natural level of output, for example, by making markets work better, increasing the level of investment or increasing the rate of technological progress. Examples are making the labour market more flexible, giving firms incentives to invest or engaging in research and development.