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.