Money illusion

Money illusion is a situation when people are misled by inflation into thinking that they are getting richer, when in fact the value of money is declining. Whether, and how much, people are fooled by inflation is much debated by economists. Money illusion, a phrase coined by Keynes, is used by some economists to argue that a small amount of inflation may not be a bad thing and could even be beneficial, helping to "grease the wheels" of the economy. Because of money illusion, workers like to see their nominal wages rise, giving them the illusion that their circumstances are improving, even though in real (inflation-adjusted) terms they may be no better off. During periods of high inflation double-digit pay rises (as well as, say, big increases in the value of their homes) can make people feel richer even if they are not really better off. When inflation is low, growth in real incomes may hardly register.

Money supply

Money supply is the amount of money available in an economy. In the heyday of monetarism in the early 1980s, economists pounced upon the monthly (in some countries, even weekly) money-supply numbers for clues about future inflation. Central banks aim to manage demand by controlling the supply of money through open-market operations, reserve requirements and changing the rate of Interest (to be exact, the discount rate).

One difficulty for policymakers lies in how to measure the relevant money supply. There are several different methods, reflecting the different liquidity of various sorts of money. Notes and coins are completely liquid; some bank deposits cannot be withdrawn until after a waiting period. M3 (M4 in the UK) is known as broad money, and consists of cash, current account deposits in banks and other financial institutions, savings deposits and time-restricted deposits. M1 is known as narrow money, and consists mainly of cash in circulation and current account deposits. M0 (in the UK) is the most liquid measure, including only cash in circulation, cash in banks’ tills and banks’ operational deposits held at the Bank of England.

Although it is a poor predictor of inflation, monetary growth can be a handy indicator of economic activity. In many countries, there is a clear link between the growth of the real broad-money supply and that of real GDP (gross domestic product).

Fiscal policy

Fiscal policy is one of the two instruments of macroeconomic policy. It comprises public spending and taxation, and any other government income or assistance to the private sector (such as tax breaks). It can be used to influence the level of demand in the economy, usually with a goal of getting unemployment as low as possible without triggering excessive inflation. At times it has been deployed to manage short-term demand through fine tuning, although since the end of the tabilize era it has more often been targeted on long-term goals, with monetary policy more often used for shorter-term adjustments.

For a government, there are two main issues in setting fiscal policy: what should be the overall stance of policy, and what form should its individual parts take?

Some economists and policymakers argue for a balanced budget. Others say that a persistent deficit (public spending exceeding revenue) is acceptable provided, in accordance with the golden rule, the deficit is used for investment (in infrastructure, say) rather than consumption. However, there may be a danger that public-sector investment will result in the crowding out of more productive private investment. Whatever the overall stance on average over an economic cycle, most economists agree that fiscal policy should be counter-cyclical, aiming to automatically tabilize demand by increasing public spending relative to revenue when the economy is struggling and increasing taxes relative to spending towards the top of the cycle. For instance, social (welfare) handouts from the state usually increase during tough times, and fiscal drag boosts government revenue when the economy is growing.

As for the bits and pieces making up fiscal policy, one debate is about how high public spending should be relative to GDP (gross domestic product). In the United States and many Asian countries, public spending is less than 30% of GDP; in European countries, such as Germany and Sweden, it has been as high as 40-50%. Some economic studies suggest that lower public spending relative to GDP results in higher rates of growth, though this conclusion is controversial. Certainly, over the years, much public spending has been highly inefficient.

Another issue is the form that taxation should take, especially the split between direct taxation and indirect taxation and between capital, income and expenditure tax.