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Macroeconomic policy is the attempt to influence the overall economy of a region, nation, or even the entire world. There are generally two different tools that can be used in these efforts. The first is monetary policy, which is the adjustment of interest rates and banks’ currency reserve requirements to control the availability of money. The second is fiscal policy, and consists of setting and financing the government’s budget so as to affect the economy.
Monetary policy is usually controlled by a nation’s central bank, such as America’s Federal Reserve or the Eurozone’s European Central Bank. Central banks govern the banking industry within a country or region. The first tool of monetary policy is the setting of reserve requirements — that is, the amount of cash a bank must have on hand. Raising reserve requirements reduces the amount of money available for lending, making it more costly due to the forces of supply and demand.
In the normal course of business, banks will often pay out so much money, both in customer withdrawals and loans made, that they deplete their reserves below the mandated amount. To meet their reserve requirements, individual banks borrow funds over the short term — often overnight — usually from the central bank. Central banks can also restrict the availability of money by raising the interest charged for such loans; by lowering the rates, on the other hand, they make more money available.
A government’s fiscal policy is the other component of macroeconomic policy, and can have as dramatic an impact on economic activity as the central bank’s monetary policy. The annual budget details the government's projected spending and revenue. All government spending releases large amounts of money into the economy. Much of this is ultimately paid to individuals as wages. When the government increases spending, more money flows into the economy; when spending is reduced, the supply of money to the economy is also reduced.
Another component of fiscal policy is the government’s revenue, primarily taxation. When taxes are raised, money that would otherwise be spent by people and companies is paid over to the government, reducing the amount of money in the economy. Likewise, when taxes are lowered, more money is available for spending.
When governments implement macroeconomic policy, they’re generally interested in preventing or controlling economic trends like inflation or unemployment that can harm large portions of their populations. Controlling both of these trends is a complex undertaking. If money is too easily available, inflationary pressures will be generated. When the supply of money is too limited, however, the prospect of more costly money will put pressure on employers to reduce their workforces, increasing unemployment.
Macroeconomic policy is controversial no matter what approach governments and central banks employ. Part of that controversy is deficit spending. The deficits incurred by some governments, like the United States, cost a great deal to service — that is, the interest paid on the money borrowed is a substantial amount. When a country borrows from a foreign government, the interest paid on that loan is money transferred from the borrowing country’s economy to the lender’s economy. Thus, there’s a long term consequence to borrowing money to balance the budget.
Tax policy is another area of controversy. While raising tax rates seems like an obvious way to increase revenue, many argue that increasing taxes reduces the amount of money available to companies and individuals. This in turn reduces their economic activity, thus dragging down the economy.
Proponents claim that reducing taxes adds money to the economy, generating economic activity and leading to increased tax revenue. They argue that a company whose taxes are reduced may use the savings to hire more workers, who will each pay income taxes. Moreover, the additional workers will increase the company’s production, also generating more tax revenue over the long term.
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