When it comes to influencing macroeconomic outcomes, governments have typically relied on one of two primary courses of action: monetary policy or fiscal policy. Show
Monetary policy involves the management of the money supply and interest rates by central banks. To stimulate a faltering economy, the central bank will cut interest rates, making it less expensive to borrow while increasing the money supply. If the economy is growing too rapidly, the central bank can implement a tight monetary policy by raising interest rates and removing money from circulation. Fiscal policy, on the other hand, determines the way in which the central government earns money through taxation and how it spends money. To stimulate the economy, a government will cut tax rates while increasing its own spending; while to cool down an overheating economy, it will raise taxes and cut back on spending. There is much debate as to whether monetary policy or fiscal policy is the better economic tool, and each policy has pros and cons to consider. Key Takeaways
An Overview of Monetary PolicyMonetary policy refers to the actions taken by a country's central bank to achieve its macroeconomic policy objectives. Some central banks are tasked with targeting a particular level of inflation. In the United States, the Federal Reserve Bank (the Fed) has been established with a mandate to achieve maximum employment and price stability. This is sometimes referred to as the Fed's "dual mandate." Most countries separate the monetary authority from any outside political influence that could undermine its mandate or cloud its objectivity. As a result, many central banks, including the Federal Reserve, are operated as independent agencies. When a country's economy is growing at such a fast pace that inflation increases to worrisome levels, the central bank will enact restrictive monetary policy to tighten the money supply, effectively reducing the amount of money in circulation and lowering the rate at which new money enters the system. Raising the prevailing risk-free interest rate will make money more expensive and increase borrowing costs, reducing the demand for cash and loans. During and after the Great Recession, the Federal Reserve made use of quantitative easing as a means to spur the economy. The Fed can also increase the level of reserves commercial and retail banks must keep on hand, limiting their ability to generate new loans. Selling government bonds from its balance sheet to the public in the open market also reduces the money in circulation. Economists of the Monetarist school adhere to the virtues of monetary policy. When a nation's economy slides into a recession, these same policy tools can be operated in reverse, constituting a loose or expansionary monetary policy. In this case, interest rates are lowered, reserve limits loosened, and bonds are purchased in exchange for newly created money. If these traditional measures fall short, central banks can undertake unconventional monetary policies such as quantitative easing (QE). Monetary Policy Pros and ConsPros
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An Overview of Fiscal PolicyFiscal policy refers to the tax and spending policies of a nation's government. A tight, or restrictive fiscal policy includes raising taxes and cutting back on federal spending. A loose or expansionary fiscal policy is just the opposite and is used to encourage economic growth. Many fiscal policy tools are based on Keynesian economics and hope to boost aggregate demand. Fiscal Policy Pros and ConsPros
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What Is the Difference Between Fiscal Policy and Monetary Policy?Fiscal policy is policy enacted by the legislative branch of government. It deals with tax policy and government spending. Monetary policy is enacted by a government's central bank. It deals with changes in the money supply of a nation by adjusting interest rates, reserve requirements, and open market operations. Both policies are used to ensure that the economy runs smoothly; the policies seek to avoid recessions and depressions as well as to prevent the economy from overheating. What Are the Main Tools of Monetary Policy?The main tools of monetary policy are changes in interest rates; changes in reserve requirements (how much reserves banks need to keep), and open market operations, which is the buying and selling of U.S. Treasuries and other securities. What Are Examples of Fiscal Policy?Fiscal policy involves two main tools: taxes and government spending. To spur the economy and prevent a recession, a government will reduce taxes in order to increase consumer spending. The fewer taxes paid, the more disposable income citizens have, and that income can be used to spend on the economy. A government will also increase its own spending, such as on public infrastructure, to prevent a recession. The Bottom LineMonetary and fiscal policy tools are used in concert to help keep economic growth stable with low inflation, low unemployment, and stable prices. Unfortunately, there is no silver bullet or generic strategy that can be implemented as both sets of policy tools carry with them their own pros and cons. Used effectively, however, the net benefit is positive to society, especially in stimulating demand following a crisis. When inflation is the Fed aims to slow the economy?The Federal Reserve seeks to control inflation by influencing interest rates. When inflation is too high, the Federal Reserve typically raises interest rates to slow the economy and bring inflation down.
Which statement describes how the Fed respond to high inflation?The action taken by the Fed in order to fight inflation is the contractionary monetary policy. It includes reducing the money supply in the country thus slowing the economy down and diminishing inflation. One of the tools used to achieve this goal is the increase in interest rates.
What would be a way for the Federal Reserve to slow down the economy when it is growing too quickly or is inflationary?One way through which the Federal Reserve can slow down the economy when it's growing too quickly is through open market operations. In the open market, the Federal Reserve can sell more government bonds, resulting in reduced money supply within the economy, thus driving up the interest rates.
What can the Federal Reserve do to slow demand pull inflation?Tools the Federal Reserve Uses To Control Inflation
The Fed has several tools it traditionally uses to tame inflation. It usually uses open market operations (OMO), the federal funds rate, and the discount rate in tandem. It rarely changes the reserve requirement.
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