What is a policy and why do governments use it to affect consumers' and firms' decisions in a market? Policies are a course of action that is intended to influence or control the behavior of the economy. It is essential to use policies to tackle market failure and ensure the economy runs smoothly. This is especially important in times such as Covid, where there are a lot of uncertainties. Although the policies implemented vary between countries, they generally target both the demand and supply sides. Several different policies are used in Macroeconomics and Microeconomics, but these are the four main ones used:
1. Monetary policy
2. Fiscal policy
3. Regulatory policy
4. Supply Side policy
A monetary policy controls consumer spending and inflation by altering the interest rates. This is the most often used policy to control spending in the economy. During the pandemic, interest rates were cut from 0.75% to 0.1% in 2020 and have only recently been increased by 0.75% in March of this year in response to the 40-year high inflation rate of 8% in the UK, Unlike the other policies, a central bank controls the monetary policy as the objectives are not in line with the macroeconomic objectives set by the government. In the US, the Federal Reserve controls the monetary policy with Jerome Powell as governor. In the UK, the Bank of England holds the monetary policy, and its governor is Andrew Bailey. These Governors are crucial as they announce the changes in interest rates which can impact millions of lives. When the economy is doing well, and there is economic growth, it will lead to inflation. The banks aim to keep inflation levels at -2% to 2%, as any more will damage the value. For example, hyperinflation in Venezuela. If they choose to increase interest rates which the UK is currently doing, it would lead to less borrowing, less disposable income, and therefore less spending, which is terrible for businesses but is an opportunity cost the government makes.
A fiscal policy uses government spending and tax policies to influence economic conditions in the market. In 2017 Trump had cut corporation taxes by over 275 billion dollars to boost business confidence and increase spending within the economy. Another reason he did this was most likely to reduce its widening fiscal deficit (when government spending is more than government income). There are many forms of Fiscal policies such as corporate tax, income tax, etc. taxes tends to be placed on inelastic or damaging externality goods to reduce the deadweight loss and internalize the cost on third parties
Regulatory policies are legislation or regulations set to prevent market failure or the overconsumption of demerit goods. Pollution permits, Mandates, and Age limits are examples of regulatory policies. In addition to this, many governments intervene in a market to prevent big companies from merging and forming monopolies, which benefits smaller businesses as it will decrease competition. They also have cap and trade schemes, for e.g the UKTS controls the level of pollution emitted by firms. The EU recently also announced a significant change by improving legislation that sets rules for how big tech companies such as Facebook should keep users safe on the internet.
Instead of implementing policies on the demand side, the government can also enforce policies on the supply side. These include things such as deregulation, embargoes, and tariffs. Although this sort of protectionism is good for the country as it decreases competition for domestic businesses, it will increase international competition. Bans or tariffs on imports may lead to trade wars with other countries. One of the most notable tariff wars is the US-China trade war, where China and the United States began mutually escalating tariffs on $450 billion in trade flows between 2018-and 2019. This can also be observed currently as many EU countries have put sanctions on Russia. Russia is the third-largest exporter of oil in the world and, due to the Ukraine-Russia war, has seen a decrease in the export of oil. As a result of this, there is a shortage of gas in gas stations globally
More on policies on the Ukraine-Russia war
The UK has also frozen assets on 4 of Russia’s banks, with the EU further excluding key Russian banks from SWIFT (the world’s dominant financial messaging system), meaning many people won't have access to money. There is also a prohibition on investment in and contribution to projects by the Russian Direct Investment Fund, which will decrease the current account. Furthermore, the EU has also banned imports of raw materials such as iron, steel, and wood to the EU, which would drive up the prices of necessities and goods that are derived from these raw materials.
There are also many other policies, for example government provisions, quotas, and Maximum/Minimum prices, that will directly influence the number of goods or businesses in a market. Most of these policies are a form of protectionism. So how does a government decide which policies to use? They consider whether or not they want a long or short-term effect on the economy and whether the government intends to decrease competition or the consumption of demerit goods. Overall, the government will act according to what is best for a country's economy, which usually points towards protectionism.