Glossary of Economic Policy Concepts

This glossary includes the main concepts of economic policy that students are expected to know and understand.

Cyclical Regulatory Policy

Cyclical regulatory policy is characterized by a set of short-term interventions aimed at correcting certain imbalances related to cyclical movements of expansion and recession, such as unemployment and inflation, which disrupt the search for full employment and balanced growth.

Conjunctural policies aim to act in the short term on the economic situation to regularize certain existing imbalances. Fiscal policy and monetary policy are the two most used components in state action. The theoretical justifications for economic policies have been the subject of intense debates since the 1930s, which pit two major schools of thought against each other.

Thus, during the thirty glorious years, the golden age of Keynesian policy, the debate focused on the means of economic stabilization (stimulus through demand), the role of the public sector in resource allocation, and the instruments of redistribution necessary to support consumption and investment.

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The goal of full employment and unemployment management were at the heart of economic policy. Its legitimacy lies in the failure of price coordination.

Structural Policy

Structural policy aims to establish harmonious growth by influencing the evolution of economic structures in the long term. In general, the instruments used in conjunctural regulatory policy relate to fiscal policy, monetary policy, and income policy. Structural interventions concern industrial policy.

Structural policy seeks to improve the foundations and structures of the economy. It thus acts more durably than conjunctural policy and focuses particularly on the productive fabric of the economy (sectors, companies, etc.). To simplify this presentation, we will limit ourselves to analyzing the structural policy conducted by the state in terms of industrial policy.

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Main Objectives of Economic Policy

The main objectives of economic policy are growth, full employment, price stability, and balance of external trade.

The specific instruments of economic policy are the budget, regulation of the money supply, action on interest rates and the exchange rate, intervention in income formation and redistribution, and regulation.

Nicholas Kaldor’s Magic Square

When defining the objectives of economic policy, reference is often made to the magic square of the Keynesian economist Nicholas Kaldor (1908-1988). This graphical representation of the objectives of economic policy summarizes a country’s conjunctural situation based on four indicators: the GDP growth rate, the unemployment rate, the inflation rate (the growth rate of consumer prices), and the balance of current account transactions (as a percentage of GDP). These four indicators correspond to the four fundamental objectives of economic policies.

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The junction of the four points shows the ideal economic situation.

The square is called magic because such a balance is almost impossible to achieve in reality. However, the distance of the points from the ideal square makes it possible to assess the level of deterioration of the economic situation or the effectiveness of the policies implemented.

From this square, two important relationships in macroeconomics can be distinguished:

• The relationship between inflation and unemployment is also known as the Phillips curve. This curve reveals the dilemma of Keynesian economic policies: increasing inflation reduces unemployment, but fighting inflation leads to higher unemployment.
• The relationship between growth and unemployment is expressed as follows: the stronger the growth, the lower the unemployment.

Economic Role of the State (Main Actor of Economic Policy)

The most commonly used typology to describe the role of the state in economic life is based on the three functions proposed by Richard Musgrave (The Theory of Public Finance, 1959): allocation, stabilization, and distribution.

A- Allocation Function

B- Stabilization Function

Stabilization policies attempt to regulate the evolution of macroeconomic variables to avoid or limit major imbalances that could affect the national economy.

In this domain, four objectives are most often retained (the « magic square » of Nicholas Kaldor): economic growth, full employment, price stability, and external balance.

1. Growth
2. Full employment
3. Price stability
4. External balance

C- Distribution Function

Fiscal Policy

Fiscal policy refers to the set of measures that a government can take that have consequences on the level and composition of its revenues and expenditures.

Fiscal policy, along with monetary policy, is one of the main levers of the state’s economic policy. It consists of using certain fiscal instruments (public spending, public debt, and tax revenues) to influence the economic situation. Fiscal policy encompasses spending policy and tax policy while taking into account budget balances.

To clearly distinguish spending policy from tax policy, the term fiscal policy is occasionally restricted to spending management, but this specific designation is the exception rather than the rule.

Main Instruments of Fiscal Policy

The main instruments of fiscal policy are:

1. Public spending, which includes operating expenses (remuneration, rental, training, travel, etc.), transfer payments (various aids and subsidies to individuals, companies, or local governments), investment expenditures (equipment and infrastructure of all kinds), and debt service.
2. Public revenues refer to all levies (taxes, fees, and social security contributions) and exceptional revenues (mining, oil, or gas royalties, dividends, asset sales, etc.) that form the state’s resources.
3. The budget balance is the positive (surplus) or negative (deficit) gap between revenues and expenditures. This gap may result from a deliberate decision to increase spending, reduce levies, build up some reserves, or compensate for certain conjunctural imbalances.

Budgetary Rules

A budgetary rule is a permanent restriction imposed on fiscal policy. It consists of setting a limit or a numerical objective for the main aggregates of public finances (revenues, expenditures, budget balance, debt). This facilitates the maintenance of budgetary discipline, and the resulting budgetary consolidation efforts are more readily accepted.

Pursuing various objectives, these budgetary rules can take different forms but generally aim to ensure the long-term viability of public finances.

Examples of Budgetary Rules

• Balanced budget rules specify a global balance objective for revenues and expenditures, structurally or cyclically adjusted, with or without an explicit reference to the relative weight of debt in GDP.
• Debt-related rules establish a precise limit or target for the relative weight of debt in GDP but provide little budgetary framework when debt is below this ceiling.
• Spending rules set permanent limits on public spending in absolute terms, growth rates, or as a percentage of GDP. As such, they are not linked to debt since they do not constrain revenues.
• Revenue rules impose a ceiling or floor on revenues, allowing for maximum collection and avoiding excessive tax burdens, without, however, linking to debt.

Sustainability of Public Finances

The sustainability of public finances is a corollary to the success of any budgetary policy. It is defined as the ability of a government to meet its long-term financial commitments.

Among the factors that raise questions about the viability of public finances are the significant increase in government debt, the rigidity of certain public expenditures, and the aging of populations. These worrying elements suggest that the preservation over time of the programs and benefits currently granted by governments may not be definitively acquired.

Automatic Fiscal Stabilizers

Revenues and public spending function as « automatic stabilizers » as they help dampen conjunctural variations in economic activity.

Thus, public revenues and expenditures spontaneously exert a countercyclical action on economic activity, i.e., they attenuate the vagaries of the economic situation.

Indeed, while a large part of public spending is independent of short-term variations in economic activity (e.g., remuneration and retirement expenditures for civil servants), some of it is, however, mechanically linked to the economic situation. This is particularly the case for unemployment compensation or social benefits paid under condition of resources, which increase when the economic situation deteriorates.

When economic activity slows down, public spending tends to accelerate, while revenue collection slows down mechanically, leading to a deterioration in the budget balance. Thus, tax revenues decrease, and the volume of public spending increases.

The deterioration in economic activity then results in a transfer of income from public administrations to households and businesses, which mechanically mitigates the effect of the economic slowdown on the income of the latter.

Conversely, in a period of strong economic expansion, fiscal and social levies increase mechanically, while spending decreases, tending to slow the growth of domestic demand.

However, this automatic stabilization mechanism only works fully if households and businesses do not modify their consumption behavior and if interest rates are not affected by the growth of public spending in a recession.

Keynesian Multiplier of Public Spending

In the event of a severe deterioration in the economic situation, governments may be tempted to pursue a voluntarist fiscal policy. Such a policy consists of supporting economic activity in the short term by using the « Keynesian multiplier. »

The « Keynesian multiplier » is the macroeconomic mechanism highlighted by Keynes, which makes it possible to compensate for the weakness of private spending by increasing public spending.

Indeed, an increase in public spending generates additional income, which is partly consumed, partly saved, and partly recovered by public administrations in the form of taxes and social security contributions.

Governments can also support economic activity by reducing tax charges and thus increasing the income of private individuals.

This policy stimulates economic activity but to a lesser extent than public spending, as part of this additional income is immediately saved by households and businesses.

Monetary Policy

Monetary policy consists of acting on economic activity through the quantity of money in circulation and/or the interest rate. Monetary policy must both avoid an excess of money creation and a shortage of liquidity that could slow down economic activity (neither too much nor too little).

The amount of money in circulation in an economy should not be too low, as economic agents will then be forced to limit their economic activities: consumption, investment, and production. Conversely, too much money puts purchasing power well above the quantity of goods available, which can lead to higher prices and generate inflation.

Monetary policy has a countercyclical role in the short term, reducing conjunctural fluctuations. In the long term, it can prevent inflation by discouraging inflationary expectations and behaviors in the financial and real sectors.

Objectives of Monetary Policy

The objectives of monetary policy coincide with the objectives of economic policy (growth, full employment, price stability, and balance of external trade).

However, monetary policy cannot directly influence these objectives. Instead, it can effectively act on certain variables in the economy that, in turn, influence the objectives of growth and price stability. These variables, such as the money supply, are called « intermediate objectives. » Monetary authorities therefore set themselves « intermediate objectives » on which they have a direct influence.

Intermediate Objectives of Monetary Policy

The intermediate objectives are:

1. Quantitative objectives
2. Interest rate objectives
3. Exchange rate objectives
4. The monetary aggregate instrument can be considered an intermediate objective.

Expansionary Monetary Policies

Expansionary or accommodative monetary policies consist of increasing the money supply, lowering the interest rate, and depreciating the currency (exchange rate).

For Keynesians, monetary policy should not only aim at fighting inflation but also pursue objectives of economic growth, production, and employment.

Thus, in times of crisis, an expansionary monetary policy is likely to stimulate aggregate demand. It translates into lower interest rates and increased bank liquidity, leading to increased credit supply, higher consumption and investment, and, consequently, higher aggregate demand.

This policy must be conducted with caution, as it can generate inflation.

Restrictive Monetary Policies

Anti-inflationary or restrictive monetary policies consist of reducing the growth rate of the money supply, raising interest rates, and appreciating the currency.

Monetary policy is expansionary in the low phase of the cycle (to get out of the recession) and restrictive in the high phase (to prevent inflation).

Rules of Action in Monetary Policy

The golden rule of Paul A. Samuelson: The real long-term interest rate should remain below the GDP growth rate. It is justified by theory and balanced growth models. The long-term neutral real interest rate is equal to the economy’s growth potential, and investors must be able to borrow at a rate below their profitability expectations.

The rule of John Taylor (short-term rates): Pragmatic, it is based on the American experience of the 1980s and 1990s: the short-term nominal or real interest rate of the central bank should depend on the inflation/norm gap and the growth/potential gap (output gap).

Monetary conditions also depend on the exchange rate: a depreciation of the currency has an expansionary and therefore inflationary effect, and vice versa; the monetary conditions indicator is a weighted average of interest rates and the exchange rate.

Channels of Transmission of Monetary Policy

Economic agents face financing needs for consumption and investment. Monetary policy sets the conditions under which these agents will be able to obtain financing.

Monetary policy has effects on the activity and behavior of economic agents through four channels of transmission: the interest rate, credit, the wealth effect, and the exchange rate.

Interest Rate

This is the traditional channel of action of monetary policy.

When the central bank raises or lowers its key rates, the cost of credit increases or decreases. Lower interest rates boost business investment and household consumption. A rate that is too low provides a double incentive to over-indebtedness for households and the state. A rate that is too high can block growth in the real sector.

Credit

By making access to credit easier or more difficult and cheaper or more expensive, monetary policy acts on the supply and demand for goods and services.

Wealth Effect

The wealth effect reflects the change in demand following a change in the value of the assets of economic agents. When assets record losses, it encourages economic agents to consume less and save more. Conversely, when assets record gains, it encourages them to consume more and save less.

Exchange Rate

Exchange rate fluctuations have a direct influence on the costs of imports and exports.

A depreciation of the exchange rate makes imports more expensive and can stimulate exports by lowering their prices.

In financial terms, the price of stock and real estate assets, the wealth effect, affects final demand: rising rates lower stock prices, impoverishing households and businesses, and vice versa, a rate that is too low encourages the formation of financial and real estate bubbles.

Instruments of Monetary Policy

To make the appropriate amount of money available to the economy, monetary authorities have a set of intervention means that can be grouped into two categories:

Direct Instruments

These instruments act on the distribution of credit:

• Credit control: Monetary authorities directly limit the credits granted. This measure consists of setting a credit growth rate that banks must respect, which limits the creation of money by banks. However, this credit control policy has only increased interest rates and thus discouraged productive investment and slowed economic growth.
• Credit selectivity: Through this measure, monetary authorities direct credit to particular sectors considered strategic or priority for the country’s economic and social development.

Indirect Instruments

These instruments act on bank liquidity:

• Rediscount rate: When banks do not have sufficient liquidity, they can refinance themselves with the central bank by rediscounting the trade effects they hold at a rediscount rate. By modulating the rate and level of rediscount, the central bank influences the creation of money and the level of liquidity in the national economy.
• Open market: The central bank intervenes in the money market to buy and sell securities. The objective is to influence market liquidity. By buying securities, the central bank provides liquidity and raises security prices, causing interest rates to fall.

So the central bank buys treasury bills to inject money into the economy. Conversely, by selling securities, the central bank reduces the volume of liquidity, raises interest rates, and increases the cost of refinancing for second-tier banks. This policy is applied in an inflationary economic situation.

• Reserve requirement: The system of reserve requirements consists of requiring second-tier banks to deposit non-remunerated reserves in the central bank’s currency, based on their deposits. It artificially creates a flight to central bank money to limit the possibilities of money creation.

By playing with the reserve requirement ratio or the base on which these reserves are calculated, the central bank can control credit. Through the reserve requirement, the central bank aims to make ordinary banks more or less liquid to encourage or discourage the granting of credit. The reserve requirement varies with the economic situation.

• Key rates: These are the short-term interest rates set by the central bank of a country or monetary union, which allow it to regulate economic activity. There are three key rates: the reserve rate, the refinancing rate, and the rediscount rate.

Key rates help regulate economic investment and thus encourage economic activity during downturns or curb overinvestment during inflationary overheating.

Key rates influence growth and the exchange rate. An increase in key rates can lead to a new appreciation of the currency concerned.

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