More often than not, both economists
and politicians are constantly worried about high unemployment and high inflation.
Whenever a government tries to prevent these it has two ways of doing so: fiscal policy
and monetary policy. These are tools used to expand or slow economic growth. Let’s start
by exploring the differences between the two. The type of government involvement you’re likely
more familiar with is fiscal policy. Put simply, fiscal policy is the use of government spending
and taxation to influence the economy. Just like any business or household, each year the
government has a budget. It has bills to pay, and it has to figure out how to get the
money to pay them. Politicians around the world routinely debate not only how
they will pay their government’s bills, but also how money should be spent for
its citizens. They debate how much should be spent on specific programs such as defense
or education, and they also consider how much should be spent in total. Naturally, increases
and decreases in government spending can have a big effect on a country’s total economic output.
In other words, fiscal policy is a powerful tool. The key to its power is the multiplier effect.
The multiplier effect in fiscal policy is the idea that each dollar spent or not taxed by
the government creates a change that is much greater than one dollar in the national income.
Essentially, any effect of a change in fiscal policy is multiplied. Any time the government
tries to increase output in an economy, or speed up economic growth, that’s known as expansionary
policy. The main reason why a government would want to increase output is to keep unemployment
low. Any time it tries to decrease output, it’s called contractionary policy. The reason
why a government would want to decrease output, or slow down an economy, is to fight inflation.
As we learned in the previous tutorial, both supply-side economics and Keynesian economics
focus on different parts of fiscal policy. Supply-side economists like Milton Friedman
thought it was better for governments to reduce taxes and limit its own public spending. When
Friedman advised President Ronald Reagan during the 1980s, he supported a constitutional amendment
to balance the federal budget. It’s worth noting, however, that inflation was a much bigger concern
in the United States than it was back in the 1960s. That’s when Keynesian economists like
John Kenneth Galbraith had more influence on the government. Galbraith was a big supporter
of public spending, even if it was deficit spending. Deficit spending is when governments
spend more money than is coming in as revenue, meaning it has to borrow more to pay the bills.
Galbraith advised President Lyndon Johnson and greatly influenced Johnson’s costly Great
Society welfare programs. Taxes were also higher during the Johnson administration
compared with the Reagan administration two decades later. To summarize, the basic tools
of fiscal policy are either to raise taxes, lower taxes, raise spending, or lower spending.
While both raising taxes and lowering spending are contractionary fiscal policy, lowering taxes and
raising spending are expansionary fiscal policy. In addition to fiscal policy, governments can
guide economies through monetary policy. Monetary policy is the way central banks influence the
economy through the management of the money supply and interest rates. First of all, governments can
influence how money is created. It’s important to understand that money creation does not mean
the government prints new coins and paper bills. Banks do this not by printing or minting
money, but by simply going about their business. Let’s look at an example. Say you want to
take out a loan of $10,000. You decide to deposit that money into a checking account at your
local bank. Once you have deposited that money, you now have a balance of $10,000. Anytime you
want that money you can access it. Therefore, it’s part of the overall money supply.
Now, banks make money by charging interest on loans. Your bank will lend part of that $10,000
you deposited. The maximum amount that a bank can lend is often determined by a required reserve
ratio, which is the fraction of deposits that banks are required to keep in reserve. Say
that ratio is 0.1 or 10 percent. That means it is required to keep 10 percent of your $10,000
demand deposit balance, or $1,000, in reserve. It can lend the rest out to whomever qualifies.
Banks can also influence how much money is in circulation by controlling how high
or low interest rates are. In general, the higher interest rates are, the less people
are borrowing money, since that means they’d have to pay back more interest down the
road. However, if interest rates are low, more people would be willing to take out loans,
and therefore more money would be in circulation. So how can the government influence how much
money banks are loaning out? Well they can establish and regulate a central bank that helps
get money into circulation. Let’s look at the United States as an example. The Department of the
Treasury is responsible for creating money in the form of currency. The Federal Reserve System,
or central bank system of the United States, is in charge of putting that money into
circulation. The Federal Reserve System, or “Fed,” can influence all banks in the country by
establishing a nationwide required reserve ratio, and raising or lowering the interest rates
on loans to banks. Whatever the Fed does, the banks have to respond accordingly. For
this reason, the Fed yields tremendous power over the American economy. A third way
the Fed can influence monetary policy is through the buying and selling of government
securities. This is also known as open market operations. A security is a financial asset you
can trade. The most common government security the Fed trades is bonds, which, in this case, is
an “IOU” issued by the government. In other words, the Fed is constantly loaning money to and
collecting money from the federal government. To summarize, monetary policy includes money
creation, managing the discount rate for the loaning out of money to banks, and open market
operations. All three monetary policy tools are also meant to be either contractionary or
expansionary. In general, whenever less money is in circulation, that is contractionary monetary
policy, and whenever more money is in circulation, that is expansionary monetary policy. We
will examine the Federal Reserve System in more depth in the next tutorial.
In conclusion, the two main goals for both fiscal policy and monetary policy are to
keep unemployment low and to curb inflation. Economists have discovered that achieving
both usually leads to steady economic growth and can help consumers and producers
survive the busts of business cycles.
