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15.2 Theories of Economic Policy

It is difficult to define precisely the economic system on which Americans rely for the satisfaction of material needs. The economists propound several theories regarding the working of the economy, on the basis of which, government officials develop an economic policy.

15.2a Laissez-faire Economics

The doctrine of ’Laissez-faire’ meaning ’to leave alone’ developed from Adam Smith’s Wealth of Nations, in which Smith opposed all government activities that restricted free enterprise. However, he favored government activities to promote the general welfare. The essentials of a laissez-faire economy are government enforcement of contracts by which men, materials, and facilities are organized in the production system, the maintenance of patent rights, and the provision of a stable money system. Competition is the great economic stimulus according to the laissez-faire theory.

15.2b Keynesian Economic Theory

In his General Theory of Employment, Interest and Money (1936), John Maynard Keynes, an English economist, analyzed the impact of government spending on the course of economic development. The theory of compensatory spending was advocated by Keynes during the Depression.

Keynes stated that national income would fall, if people did not consume enough or invest enough. In order to increase national income, it was necessary to spend money on consumption goods (like clothes or food), or on investment goods (like steel mills and dock facilities), or on both. It was necessary for government to do the spending, and investing, if private enterprises did not or could not do so. The Keynesian approach was linked to concepts requiring governmental influence on public works, wages, prices, credit and taxation. The general objective was to spend public money in such a way as to put funds in the hands of people so that it could be used to buy the things they required for immediate use. This was expected to lead to expanded production to meet consumer demands. Congress accepted the Keynesian approach by passing the Employment Act of 1946.

President Franklin Roosevelt’s New Deal incorporated several idea of Keynes in order to relieve the suffering of the American people, through programs like the Civilian Conservation Corps (CCC). The Roosevelt administration also undertook the famous Works Progress Administration (WPA), spending billions of dollars on local projects.

15.2c Monetarism

According to some economists, led by Milton Friedman, a healthy economy could be created by controlling the supply of money. They concluded that the Keynesian theory led to excessive government intervention. They Federal Reserve system, established in 1913, was an existing institution designed to assure American business of a flow of credit to guarantee its further expansion and to regulate the money supply.

Under the Federal Reserve Act of 1913, the U.S. is divided into 12 districts, with a Federal Reserve Bank, located in each. These banks do not function as commercial banks serving the public. They are depositories and fiscal agents of he national government they assist in the issue and redemption of government bonds, and carry out several other fiscal functions. They also serve as clearing houses and collection agents for the member banks of the Reserve System. They hold or deposit the reserve balances required of member banks as well as discount notes, draft and other commercial paper offered as security for loans. The Federal system is broadly supervised by a Board of Governors composed of seven members appointed by the president, with the consent of the Senate, for fourteen-year terms. Thus the main function of the system was to maintain monotony and credit conditions favorable to sound business activities, and to influence financial stability through controls exerted over the credit policies of banks.

15.2d Supply-side Economics

Since Keynesian economics did not succeed in dealing with high rates of inflation and unemployment during the early 1980s, there was a proposal to cut taxes and deregulate the economy, by supply-side economist such as Arthur Laffer. It was felt that stimulation of the business sector would provide companies with capital for expansion. They would be able to hire more workers and develop new products. And when more people were employed with higher wages, it would lead to an increase in taxable income, it would offset the tax cuts and provide government with the required revenue. Since this approach was accepted by the Reagan administration, it came to be referred to as Reaganomics.

However supply-side policies did not meet with much success, as the Reagan administration increased defence expenses, which the theory did not take into account. Thus increased expenses along with tax cuts resulted in a massive budget deficit. Besides, though theory stated it, businesses were not under any obligation to convert their economic profits into the production of new capital expenditure. The rate of unemployment also did not decrease.


15.0 - Introduction
15.1 The Goals of Economic Policy
15.2 Theories of Economic Policy
15.3 The Federal Budget
15.4 Taxation and Spending
15.5 International Economic Policy

Chapter 16

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