Fiscal and Monetary Policies

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Fiscal policy is a government policy that looks to influence the economy through changes in government spending and/or taxes, and is contrasted with the other tool used by the government, called monetary policy, which attempts to stabilize economy by regulating interest rates and the supply of money.  Fiscal policy deals with government expenditures, debt, and taxes, while monetary policy pertains to the availability, regulation, and cost of credit.

Fiscal Policy impacts aggregate demand, resource allocation, and distribution of income.  It deals with the budget of economic activity.  There are three possible stances of fiscal policy, which are expansionary, contractionary, and neutral.  The neutral stance of the fiscal policy is when the government spending is equal to the tax revenue or (G=T), so the government spending is fully funded by taxes.  When the stance of the fiscal policy is neutral, there is no affect on economic activity.  The expansionary stance of the fiscal policy is when government spending is more than the tax revenue (or G>T).  Expansionary stance is when there is an increase in government spending; this can be due to either a rise in government spending, or a decrease in tax revenue.  The last stance of the fiscal policy is the contractionary stance, which is when government spending is less than the tax revenue brought in.  This contractionary stance is possible when there is higher taxation revenue, lower government spending, or a combination of the two simultaneously.

The United States government spends money on a variety of different things, and the fiscal policy’s job is to fund these services.  The fiscal policy has three ways of funding the government’s spending, which are taxation, seignorage, and borrowing money from the citizens.  The government can receive extra money from higher taxes, benefit from printing money, and also from the population which does result in a fiscal deficit.  The government can fund its fiscal deficit by issuing bonds such as treasury bills (T-bills) and consolidated stock (consols).  These pay interest, whether it be a fixed time period or indefinitely.

Fiscal policy is used to influence the aggregate demand of the economy, which is the demand for gross domestic product, or the total demand for the final goods and services of the economy.  The government tries to influence aggregate demand so that there is price stability, full employment, and economic growth.  The idea behind stimulating aggregate demand by lowering government spending or raising taxes is that once it is done, the economy will grow from it.

Monetary policy is the process by which the central bank manages the supply of money.  Monetary policy is typically referred to as being in an expansionary or contractionary, just as fiscal policy is.  The expansionary policy increases the size of the money supply or lowers the interest rates.  The contractionary policy decreases the size of the money supply, or makes the interest rates higher.  The expansionary part of the monetary policy is usually used to fight unemployment during a recession by lowering interest rates.  The contractionary part of the monetary policy targets to raise interest rates to combat inflation.  The expansionary and contractionary policies must be meticulously used so that they do not go too far in either direction (expansionary or contractionary) or cause a big problem in the economy.

One of the primary tools of the monetary policy is open market operations.  The open market operation used to manage money in circulation by buying and selling different credit instruments.  The short term goals of open market operations are typically to achieve a certain target interest rate.  The monetary policy is associated with the interest rate and credit.  This did not used to be the case, as the only two parts of the policy were the decisions of coinage and decisions to print paper money to start credit.  The monetary policy has grown so much since its start that there are many different factors of its success, including short term interest rates, long term interest rates, speed of money through the economy, exchange rates, quality of credit, corporate ownership and debt, government and private sector spending and savings, international capital flow, and financial derivatives.  Since there are so many factors that must be accounted for, some people think that the economy should go back to how it used to be, which was called the gold standard.

The gold standard is basically the elimination of the Federal Reserve Bank and the dollar’s fiat currency status along with it.  In a gold standard, the standard economic unit of account is the weight of gold.  Under the gold standard, banks guarantee that the owner of the money can receive their money in gold at any time.  The reason this is a large issue is because at certain points in time, there were a periods of time when some banks could not give the owner their money.  If a person went to the bank with the intention of withdrawing money from their savings account, it was not possible for them to do so because the bank simply did not have the money.  With the gold standard this is not a problem, because the banks are required to have the money physically at all times.

Monetary policy refers to the actions that the Federal Reserve Bank (Fed) takes to influence the financial conditions to achieve its goals.  The Fed’s main job is to raise and lower interest rates, which is just one of many tasks that it must carry out.  For example, if rates on interest are lowered, the borrowing of money then becomes less expensive to the consumer, making them more motivated to spend their money since there is a better deal on a loan.  The reason that the Fed is so important is that it provides a stable currency that can be used throughout the whole country.  Before the Fed was introduced to the U.S., there were over 30,000 currencies throughout the United States.  Before the Fed, currency could be issued by anyone for a certain good.  There were many problems with this, because some currencies were worth more than others, and there was no basis on how to tell which was worth more.

The original purpose for the Fed was to organize and stabilize the monetary system in the United States.  It was made to set up a method that would create liquidity, which is the ability to take out money.  The reason liquidity was coveted is so that the banks could honor every customer’s withdraw.  The Fed also had to set up a method to create elastic currency, which means that they had to control inflation by making sure prices did not climb too fast.  Elastic currency plays a major part in the impedance of inflation and recession.

The fiscal and monetary policies both play an important role in the survival of the economy in the United States.  They both are required to regulate certain aspects of the economy in order to keep from going into a depression.  The Federal Reserve Bank also plays an important role in economy, because it is in control of the monetary policies.  As the economy grows and becomes more complex, there will only be more changes and additions to these policies, as it has come a long way from the gold standard in the early 1900s.

Source by Jonathan Schaefer

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