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How Fiscal Policy and Monetary Policy Affect the Economy

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  • 0:05 The Business Cycle
  • 0:41 Fiscal Policy
  • 3:01 Monetary Policy
  • 4:55 Lesson Summary
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Lesson Transcript
Instructor: Shawn Grimsley
Governments often intervene in their economies in an attempt to maintain economic stability. In this lesson, you'll learn about fiscal and monetary policies, including what effect they can have on a national economy. A short quiz follows.

The Business Cycle

Meet Barry. Barry is a businessman who has been around the block a few times. He's seen the economic booms and busts of the business cycle, which is a pattern of expansions and contractions in an economy. Barry has seen every part of the business cycle. He's seen the economy grow and expand to a peak, and he's seen the economy contract from its peak into a recession.

He's also seen the economy bounce off the trough - the bottom - and into an expansion and a new peak. You can think of the business cycle as a roller coaster. And, Barry has watched the government try to smooth out the bumps in the business cycle through fiscal and monetary policy.

Fiscal Policy

Fiscal policy is a government's decisions regarding spending and taxing. If a government wants to stimulate growth in the economy, it will increase spending for goods and services. This will increase demand for goods and services. Since demand goes up, production must go up. If production goes up, companies may need to hire more people. People that were once unemployed may now have jobs and money to spend on goods and services.

This will further increase the demand and require more production and, hopefully, the cycle of growth will continue. Barry may even get more business as people have more money to spend on products at his store. Consequently, government spending tends to speed up economic growth.

If the government thinks the economy is overheating - or growing too fast - the government may decrease spending. A decrease in government spending will decrease overall demand in the economy.

Businesses will slow production, which means profits will decline, resulting in less hiring and business investments. A cut in government spending may hurt Barry's business, because there will be less money in people's pockets to spend at his store, possibly from being laid off. If Barry provides goods or services to the government, he may take a double-hit.

The other side of fiscal policy is taxes. Decreasing taxes tends to stimulate economic growth. If taxes go down, Barry will have more money in his pocket. He'll either spend it or save it. If he spends it, he increases demand and businesses have to produce more. This means they may have to hire more people. These people will then have more money to save or spend - maybe at Barry's store. On the other hand, if Barry saves the money, he'll put it in his bank. The bank will loan the money he deposited, and borrowers will spend it.

Some economists are concerned that government spending and reduction in taxes will create a crowding out effect. If the government doesn't have enough revenue to support spending, it will have to borrow money. According to some economists, government borrowing tends to increase interest rates. And, increased interest rates discourage individuals and businesses, like Barry, from borrowing money for spending and investment. According to these economists, government spending may crowd out private investment.

If the government wants to slow down an overheating economy, it may decide to raise taxes. This means people have less money to spend. Fewer people will be hired because there is less demand. Unemployed people don't have extra money to spend at Barry's store. Barry may not make as much money, which means he'll have less money to invest in his business and less money to spend for his personal consumption. The economy will slow down.

Monetary Policy

Monetary policy is the decisions a government makes regarding the money supply and interest rates. Monetary policy in the United States is determined and implemented by the Federal Reserve (also called the Fed), which serves as the central bank for the United States. The primary policy tool used is increasing or decreasing the supply of money in an economy. The Fed will increase the supply of money by buying government securities, such as Treasury bonds.

When the Fed sells these securities, it pumps money into the economy by trading dollars for securities. It will decrease the money supply by selling government securities, which means it's sucking up dollars and replacing them with the securities. This process is called open market operations. It's the Fed's primary policy tool because it can affect spending and interest rates, as we will see later.

If the economy is heading into a recession, a central bank will increase the money supply, which is expansionary policy. Increasing the money supply tends to reduce interest rates since there's more money to loan and the banks have to compete for business from people like Barry. Since money is easier to get, people will spend more and businesses will invest more. This creates more demand for goods and services. More demand means more production, which will require more employees.

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