The role of the state in the economy; Review of Chapter II

In a market economy the state regulates the economy not by orders but through the market mechanism, in two main ways. Fiscal policy changes taxes, state spending and transfers to influence aggregate demand (the total value of goods and services people need and can afford) and aggregate supply (the total value that can be produced and brought to market). If taxes rise, people and firms keep less money, demand falls and output and employment may fall; if taxes fall, the opposite happens; if state spending rises, demand grows, which may raise employment or speed up inflation. Monetary policy is run by the state through the Central Bank: it manages the money supply and the credit interest rate. If the Central Bank raises its lending rate (the key rate), commercial banks also raise loan interest, borrowing falls, money in circulation shrinks and inflation slows, but business activity may weaken; lowering the rate does the opposite. The reserve ratio is the percentage of commercial banks’ funds that must be kept at the Central Bank: raising it reduces banks’ ability to lend, lowering it increases it. Ways of reducing a budget deficit are cutting spending, finding extra revenue and borrowing; issuing money not backed by goods creates the risk of inflation.