Managing the Economy with Fiscal and Monetary Policies

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  • 0:01 Intro to Fiscal and…
  • 0:29 Definition of Fiscal Policy
  • 1:07 Effects and Tools of…
  • 2:48 Definition of Monetary Policy
  • 3:37 Effects and Tools of…
  • 5:56 Lesson Summary
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Lesson Transcript
Instructor: Aaron Hill

Aaron has worked in the financial industry for 14 years and has Accounting & Economics degree and masters in Business Administration. He is an accredited wealth manager.

Learn what fiscal and monetary policy are and how they are used to manage the economy. Find out the goals of these policies and some of the tools that each use to help you find a job and influence the amount of money in your pocket.

Fiscal and Monetary Policy

Your ability to get a job, the amount you pay for food at the grocery store, the interest rate on your new car, and the taxes that come out of your paycheck are all directly influenced by fiscal and monetary policy. The financial health of the country you live in and ultimately your own individual financial health are linked to these two important economic areas. Let's explore both fiscal and monetary policy.

Definition of Fiscal Policy

Whether you are studying economics or political science, fiscal policy is best defined as the use of government revenue collection (taxes) and government spending to influence the economic activity in a country. These two fiscal methods - taxes and government spending, which are rooted in the works of the famous economist John Maynard Keynes (1880s-1940s) - work to improve unemployment rates, control inflation, and increase/decrease personal income.

So how do these methods actually work? Let's find out the answer to that now.

Effects and Tools of Fiscal Policy

1. Tax method

Imagine the economy is sluggish, work is hard to find, and the country is in a recession. Here comes fiscal policy to the rescue! The government might step in, and through legislation, lower the personal income tax rates for businesses and individuals. If people are paying less in taxes, they now have more money to spend or invest in business ventures!

The additional spending at Wal-Mart, Target, the grocery store, on vacations, and at the local mall all drive economic growth. The higher demand for products and greater business profits result in companies hiring more workers or increasing pay to stay competitive. This continues to drive more income and spending, and the cycle continues until things are pulled back to ensure inflation doesn't get out of control.

2. Spending method

Let's say the government thought the tax rates were already low enough and didn't want to use that method to increase income and drive economic growth. Another option the government might consider is to increase its own spending. They could do this by building more highways, schools, and national parks. They could increase spending in government sectors, such as national defense. All of this additional spending usually has the goal of creating more jobs, which increases income for many individuals and drives economic growth.

So where does the money come from? In theory, the resulting deficits from spending would be paid for by the booming economy, which now has more citizens paying taxes and generating revenue for the government.

Definition of Monetary Policy

If fiscal policy doesn't seem to be the right answer or needs some help to drive the economy, its counterpart, monetary policy, is standing by and ready to act. Monetary policy is the manipulation of the money supply by a central bank (in the United States, this is the Federal Reserve) through the methods of changing interest rates, bank reserve requirements, and open market operations to manage the economy. Don't worry if you don't know what those mean; we will discuss them shortly. Much like fiscal policy, monetary policy's goals are to maintain full employment (jobs for citizens), keep inflation at acceptable levels, and drive economic growth.

So how does the Federal Reserve actually influence and manage the economy? Let's find out.

Effects and Tools of Monetary Policy

1. Open market operations

This is the most often used method for managing the economy. In short, the Federal Reserve buys and sells U.S. Treasury securities. This influences the amount of money that banks have on hand to loan out to you for that new car you have been wanting, the line of credit you need to start your business, or the purchase of your very first house! If the Fed buys treasury securities, banks have more cash reserves, which they use to make more loans at lower interest rates and increase the money supply. This drives economic growth.

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