Kevin has edited encyclopedias, taught history, and has an MA in Islamic law/finance. He has since founded his own financial advice firm, Newton Analytical.
Ever wish the economy would just stay still long enough for you to make some sense of it? As nice as that sounds, a stagnant economy is not a good thing. This lesson will explain why that is and examine the cyclical phases of the US economy.
The Unstable Market
It's a fact of life…the economy is unstable. The price of gas can go up, and it can go down. The price of guacamole at your favorite burrito place may go up, or they may run a special on it where it is free for the week. You may get a promotion with a raise, or you may get fired and lose all your income.
Now, all those details are hard enough to manage in one person's life, but once you've multiplied them by the 330 million people living in the United States, you've got a massive economy that is constantly moving in many directions and never staying the same. But as you'll see in this lesson, an ever-changing economy that moves in cycles, like the US economy, isn't always a bad thing.
Periods of Growth
To be honest, we don't want the economy to stay the same. That would be a disaster, as that would mean that there is never any opportunity for new and better inventions or new and better jobs for people. Think about it…would you really want to wait around for someone to retire or, worse yet, die before you could make more money? Would you want to design a new app knowing that the amount of money that is spent on apps across the economy is already spread pretty thin, so it may not make enough to justify your efforts? Probably not. Therefore, a growing economy is a good thing.
To be healthy, an economy must always be growing. Granted, we don't want it to grow too fast, or else it loses track of itself and inflation results. Inflation is an increase in prices and a decrease in the value of money. However, most people feel that if inflation can be kept in check, then a little bit of it is not such a bad thing. After all, if the total worth of all the materials, services, and jobs produced in an economy grows 5% every year, but inflation only goes up by 2%, then that is a net gain, and that is ideal.
Periods of Decline
Sometimes economies shrink. If you lose your job or get a pay cut, chances are you don't have the same amount of money to spend on things as you did before. The same thing happens to an economy. If enough jobs are lost or enough people stop buying goods and services, then there isn't the same amount of money to go around as before. When this decrease in economic growth begins, it is referred to as a slowdown. Needless to say, this is a problem. In fact, people often have one major, overarching request of their elected leaders: keep the economy growing. When an economy shrinks for two quarters, or six months, in a row, it is called a recession. As you probably saw in 2008-2009, recessions are not ideal economic conditions for anyone.
Managing Inflation & Recession
Staying out of recession is a priority for pretty much everyone involved in the economy. The government has a few tools at its disposal to avoid recession. Politicians disagree on how often the tools should be used, but just about every politician has suggested their use at some point. Congress can enact what is called fiscal policy to help the economy along. Fiscal policy involves changing government taxes and spending. This can encompass billions of dollars and is best thought of as the government jumping in front of the bullet of recession. To prevent recession, Congress can give people tax cuts or increase government spending, which acts as a shot in the arm of energy to a slow economy. However, if an economy is growing too fast, Congress can also slow it down through fiscal policy by either raising taxes or cutting spending. As you can probably imagine, it's a bit of a balancing act.
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I was careful to say Congress during that last bit as opposed to government, because there is another independent agency of the government that can act to prevent inflation or recessions. This part is the Federal Reserve, which is the banker to banks across the country. It is allowed to conduct monetary policy by changing the way it does business with the banks. While that may not sound that impressive, think about your relationship with your local banker. If the bank offers an insanely low interest rate on borrowing money, then chances are you may decide to buy a new car. Likewise, if it said that you have to keep a certain minimum in your checking account, then that may slow your spending. The Federal Reserve does the same thing with bankers. If they raise or lower the discount rate, the rate at which they loan banks money, then banks act just like you would at the offer of a lower, or higher, interest rate on that new car. Finally, if they raise or lower the reserve rate, the amount of money the banks have to keep in their vaults at all times, then it has the same effect as a minimum on your checking account.
In this lesson, we looked at why the economy is unstable and why that is not necessarily a bad thing. We saw how growing markets were good, as it meant that the economy was constantly creating new jobs and opportunities. These periods are known as expansions, but we must be wary of money losing its value, also known as inflation. We also saw how shrinking economies meant that people lost the ability to spend as much as before during slowdowns, and how two quarters of shrinking economic growth is a recession. When the economy begins to leave the recession, this is known as a recovery. Finally, we saw how through fiscal policy and monetary policy that government was able to slow down inflation and help get the economy out of recessions.
Through fiscal policy, Congress can raise spending or lower taxes to speed up the economy or cut spending or raise taxes to slow down economic growth. Monetary policy allows the Federal Reserve to speed economic growth by making it easier for banks to create money, whether by cutting the discount rate at which banks are loaned money or the reserve rate which determines how much money a bank must keep in its vaults. As you might expect, by raising either the reserve rate or the discount rate, economic growth is slowed.
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