Econ: Fiscal and Monetary Policies Review



Fiscal policy is carried out by Congress and the President. The two main instruments of discretionary fiscal policy are government expenditures and taxes. The government collects taxes in order to finance expenditures on a number of public goods and services such as highways and national defense. Expansionary fiscal policy used to combat a recession is defined as an increase in government expenditures, a decrease in taxes, or both increase in government expenditures and decrease in taxes, that causes the government’s budget deficit to increase and its budget surplus to decrease. Contractionary fiscal policy used to combat inflation is defined as a decrease in government expenditures, an increase in taxes, or a decrease in government expenditures and an increase in taxes, which causes the government’s budget deficit to decrease and its budget surplus to increase.

The Fed has a number of monetary tools available to change the money supply and interest rates to affect real output, employment, and price levels. Open market operations are the most frequently used tool of monetary policy because of their flexibility and immediate effects. Open market operations are the Fed’s purchases and sales of government bonds with member banks and the public. The Fed increases the money supply when it buys bonds, and it reduces the money supply when it sells bonds. The reserve requirement is the most powerful tool of monetary policy, so it is only rarely used. A change in the percentage of deposits the banks must hold in reserve directly impacts the bank’s ability to increase loans and, therefore, the money multiplier. If the Fed increases the reserve requirement, banks cannot loan as much and the money supply falls. A reduction in the reserve requirement increases the potential growth of the money supply. A third important tool of monetary policy is the discount rate, which is the interest rate the Fed charges member banks for loans. A reduction in the discount rate encourages banks to borrow from the Fed and, in turn, increase loans to their customers. As a result, the money supply increases. An increase in the discount rate discourages banks from borrowing from the Fed, reducing loans and the money supply.

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