HGov: Fiscal and Monetary Policy


Spend v Taxes
Fiscal policy consists of decisions made by the government regarding how much money to spend and how much to collect in taxes.At the national level, Congress makes these decisions based on recommendations from the president. Fiscal policy is used to pursue a number of economic goals. These goals include low unemployment, stable prices, and economic growth. The tools that fiscal policymakers use to achieve these goals are aimed at expanding or contracting economic activity.

Stimulus checks are just one tool the government can use as part of an expansionary fiscal policy. The goal of this policy is to promote economic activity by increasing government spending, cutting taxes, or both. These tools can be used to help businesses grow by increasing government spending on goods and services. Or they can be aimed at boosting consumer spending which was the purpose of sending stimulus checks.

The goal of contractionary fiscal policy is to cool an overheated economy. When buyers demand more goods and services than the economy can produce, overall prices tend to rise. When this happens, Congress can use the same tools to slow excessive demand. Congress can cut spending, increase taxes, or both. As demand drops, prices tend to stabilize.

There is a debate over how tax cuts might best be used to encourage economic growth. On one side of the debate are supporters of Keynesian economics. This school of thought is also known as demand-side economics. Demand-siders believe that the best way to deal with a sluggish economy is to stimulate overall demand by cutting individual income taxes. As consumers spend their tax savings on goods and services, business will pick up and the economy will begin to grow.

On the other side of the debate were advocates of a theory called supply-side economics. Supply-siders hold that the best way to deal with an economy slow-down is to stimulate overall supply.This can be done by cutting taxes on businesses and high income tax-payers. As businesses and investors use their tax savings to expand production, the supply of goods and services will increase, spurring economic growth.

When government spends money on goods and services, the impact on the economy is generally greater than the amount of money spent would suggest. The reason is that each dollar spent encourages still more spending, sending a ripple of economic activity through the economy. Economists call this rippling action the multiplier effect. The multiplier effect works two ways. It can help the economy grow when the government increases spending. Or it can slow economic growth when the government cuts spending.

federalreserve_building

Monetary policy consists of decisions made by a central bank about the amount of money in circulation and interest rates. In the United States, the Federal Reserve makes such decisions. The Fed controls monetary policy to help the economy grow steadily with full employment and stable prices.

The Fed adopts an expansionary monetary policy when it believes the economy is in danger of sliding into a recession. Also known as easy-money policy, an expansionary monetary policy is intended to speed the growth of the money supply. As the amount of money flowing into the economy increases, interest rates decreases and borrowing becomes cheaper and easier. With loans easier to get, households and business firms spend more on goods and services. Demand increases, leading to more production, stronger economic growth, and a decrease in the jobless rate.

On the other hand, the Fed pursues a contractionary monetary policy when rising prices threaten to trigger and inflationary wage-price spiral. Also known as a tight-money policy, a contractionary policy intended to slow the growth of the money supply. With less money flowing into the economy, interest rates increase and loans become costlier and harder to get. Households and business firms cut back on borrowing as well as spending. Demand shrinks, leading to less production, weaker economic growth, and a decrease in the inflation rate.

The Fed can inject money into the economy or pull it out using open-market operations. The Fed’s open-market operation  involve buying and selling of government securities in the bond market. The securities can be Treasury bonds, notes, bills, or other government bonds. When the Fed adopts an easy-money policy, the Fed’s bond traders buys government securities. Every dollar the Fed pays for bonds increases the money supply. When the Fed adopts a tight-money policy, its bond traders sell securities in the bond market. The public pays for these bonds with cash or money taken out of banks. As the money goes out of circulation, the money supply shrinks. Additionally, banks end up with smaller deposits, they have less money to lend, which also slows the growth of the money supply.Open-market operations are relatively easy to carry out. They allow the Fed to make small adjustments in the money supply without new laws or banking regulations. For these reasons, the sale and purchase of securities is the monetary tool the Fed uses most to stabilize the economy.

Banks sometimes need to borrow money to keep their reserve requirement at the proper level. This might happen because a bank has made too many loans or it could be a result of an unexpectedly large withdrawals.Whatever the reason, banks can borrow money from the Fed to shore up their reserves. The interest rate on such loans is known as the discount rate. A low discount rate makes it less costly for banks to borrow from the Fed. Banks can then use that money to make loans to customers thereby expanding the money supply. Raising the discount rate has the opposite effect by discouraging banks from borrowing from the Fed. With money tight, banks make fewer loans, keeping the money supply in check.

The Fed’s least used monetary tool is the required reserve ratio. The Fed could expand or contract the money supply by adjusting the required reserve ratio. This ratio is the minimum percentage of deposits the banks must keep at all times.Lowering the ratio would allow banks to make more loans and create more money. Raising the reserve ratio would force banks to keep more cash in reserve and out of the money supply. This in turn would leave banks with less money to lend, slowing money creation. 

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