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Monetary and Fiscal Policy

Monetary and Fiscal Policy

Author: Kate Eskra
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This lesson covers the Monetary and Fiscal Policy

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Tutorial

MONETARY AND FISCAL POLICY

Source: Images of Economy Below and Beyond Full Employment created by Kate Eskra, Images of Phillips Curves created by Kate Eskra

Video Transcription

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Hi. Welcome to Macroeconomics. This is Kate. This tutorial is on monetary and fiscal policy. As always, my key terms are in red and examples are in green.

In this tutorial, we'll talk about how monetary and fiscal policy work to stabilize and stimulate the economy through aggregate demand. We'll compare expansionary and contractionary policies. And we'll look at the relationship between real GDP growth and the price level, as shown on the Phillips Curve.

So here are two graphs that show two different situations when our economy's not actually in equilibrium. At equilibrium, our long-run aggregate supply curve would intersect right here, where our short-run aggregate supply and aggregate demand intersect.

But we know that at times it's possible for our economy to be producing below full employment. That's shown here. And in that case, we are currently producing where we have unemployed resources. Our unemployment rate is high.

It's also possible on this side for our economy to be producing beyond full employment in the short term. In this case, inflation can become a major concern. So over here, unemployment is the concern. And over here, inflation is the concern.

So what can be done about it? Well, often there's going to be intervention, either in the form of the government or the Federal Reserve. And when the government intervenes, that's called fiscal policy. Fiscal policy is policy typically set by a central government where government spending is adjusted to stabilize economic activity. The government has two tools basically, government spending and taxation.

Monetary policy is different, though. It's typically set by a central banking authority where the money supply access, and then the resulting cost or access to money, which is the interest rate, is varied to assist in stabilizing economic activity. There's three tools of monetary policy, the required reserve ratio, interest rates, and buying and selling of Treasury securities.

So let's talk about expansionary policy first. Expansionary policy is either monetary or fiscal policy that's enacted to stimulate economic growth as measured by the GDP growth rate. And why do we want to enact expansionary policy? Well, we do this when unemployment is the concern, when we're producing below full employment.

So with monetary policy, this works by increasing the money supply. We're enticing banks to make loans. We're enticing people to take money out of the banks. They can do that through lowering the reserve requirement, lowering or targeting lower interest rates in the economy, and buying Treasury securities, getting money into people's hands.

Fiscal policy encourages job creation and more spending in the economy. And that can be accomplished through increasing government spending or cutting taxes.

So you can see this is our graph when we're in a recession. We need people demanding goods and services to get us to the long-run aggregate supply or to our full employment. Fiscal policy, as we talked about, kind of directly tries to create demand by spending money to create programs and jobs. Monetary policy works by increasing the money supply, encouraging people to spend money and take out loans.

Either way, the end result is an increase in aggregate demand. And that's what you can see there. It takes us to full employment, reducing our unemployment rate, and utilizing all of our resources.

Either of these policies will have a multiplied effect. Here's your definition of the multiplier effect. It's the sum total impact of a policy action on the economy.

The money multiplier is equal to the ratio of the reserve requirement, so it's 1 divided by the reserve requirement, so that a given reserve requirement will result in a net multiple of the original increase, where we have to multiply times the change in loanable funds. Sounds a little bit complicated, but it's really not. The big idea is just that every dollar either the government or Federal Reserve injects into our economy is going to have a multiplied effect on aggregate demand. So if a bank can even make one more loan as the result of a policy, that creates more and more and more loans possible. And the end result would be you would find the multiplier by dividing 1 divided by the reserve requirement ratio.

With fiscal policy, if even one more person receives a paycheck as a result of a new government program, that person goes out and spends money in businesses now that they have more money. And that impacts other people, which then they go out and spend more money, and so on and so forth. So you can see, I just used one example. But this is on a much bigger level in the overall economy. So it has a multiplied effect whenever there's a policy.

So what happens if we stimulate aggregate demand too much? If the impact on aggregate demand is too much, that can actually push equilibrium temporarily past our long-run aggregate supply curve. When that happens, now you can see prices go up. And when prices go up, that includes input prices.

So when suppliers or producers are experiencing increased prices, that can shift SRAS, or Short-Run Aggregate Supply, to the left. And that brings our economy back to equilibrium, but now at higher prices. So the end result would be an increase in prices or inflation. So we don't want overstimulate aggregate demand, because we cannot get past our long-run aggregate supply curve and achieve long-run economic growth through just stimulating aggregate demand. That's important to understand.

OK. Let's look at the opposite. Let's look at when inflation is now the concern and our government or Fed needs to slow down the economy. So this is either monetary or fiscal policy when it's contractionary that's enacted to slow economic growth,

In this case, in monetary policy they're looking to decrease the money supply and actually entice people to keep money in the banks. They could raise the reserve requirement. They could raise interest rates, or sell Treasury securities. With fiscal policy, they're trying to encourage less spending actually in the economy. And that can be accomplished through decreased government spending or raising taxes.

So when the economy is overheated, we're temporarily past our long-run aggregate supply. And inflation really becomes the concern. So we actually need people demanding fewer goods and services.

Fiscal policy decreases demand by cutting spending. Monetary policy works by decreasing the money supply, again encouraging people to save money and take out fewer loans. Either way, the end result is a decrease in aggregate demand. And you can see that there.

So as you've seen on these graphs, theoretically there's this direct relationship between real GDP growth and the price level. As aggregate demand is stimulated or as it increases, the economy grows and unemployment falls. But it does push prices up.

As aggregate demand decreases, the economy contracts. And what we're trying to do through decreasing aggregate demand is push prices down. But we're going to have a trade-off. And unemployment will rise slightly, or more sometimes.

And that's what our Phillips Curve illustrates for us. It's a graphical depiction of this inverse relationship between inflation and unemployment. So intuitively, higher employment or lower unemployment is consistent with a strong economy and demand. So as demand increases beyond short-run supply capabilities or resource constraints, inflation begins to increase.

So here's a Phillips Curve. And you can see the axes are here's the annual inflation rate. Here's the unemployment rate. And there's a trade-off between the two, because there's an inverse relationship between them.

So when unemployment is low, we can tend to have high inflation because of really high demand. When unemployment rises, we have lower inflation.

So in this example that I drew here, if unemployment is really high over here at 10%, the government or Fed could enact expansionary policy. You can see that at a 10% unemployment rate, our inflation is really, really low. That's not the concern. So if they enact some kind of expansionary policy, it will lower unemployment. But we'll see a slight increase in prices or inflation.

In this example, though, if inflation is what's really, really high up here, 10% inflation is extremely high, the government or Fed could enact contractionary policy. We're actually way below our full employment rate. We're at 2% unemployment the way I drew it here. So we could have lower inflation. But we would have a slightly higher unemployment rate as demand in our economy starts to fall.

Very low levels of unemployment, like less than 5%, are generally unsustainable and can create bubbles, like think about the housing bubble in the early 2000s. So when we're anywhere at like a 2% unemployment rate, which we generally are not, that can create these bubbles. And so they would want to cool down the economy in that case. So contractionary policies can prevent this from happening.

Critics of this model sometimes point to the 1970s, though, when we couldn't find a point on this Phillips Curve, because our economy experienced very high rates of inflation but at the same time as having high unemployment. And that's known as stagflation. So there were times in the 1970s when inflation was well over 10% and the unemployment rate was also high, over 8%. So that would need a new curve like way out here.

So stagflation is the situation where unemployment is high and inflation is high, contrary to that Phillips Curve I showed you. And stagflation occurs when policy actions fail to boost economic growth and the economy instead becomes stuck in this seeming impossible position. It's not a great situation.

So in this tutorial, we looked at how both monetary and fiscal policy work. We talked about expansionary policies first, trying to increase aggregate demand, and contractionary policies, decreasing it. And then finally I showed you the Phillips Curve.

Thanks so much for listening. Have a great day.

Terms to Know
Contractionary Policy

Either monetary or fiscal policy that is enacted to slow economic growth (as measured by the GDP growth rate).

Expansionary Policy

Either monetary or fiscal policy that is enacted to stimulate economic growth (as measured by the GDP growth rate).

Fiscal Policy

Policy typically set by a central government authority whereby government spending is adjusted to stabilize economic activity.

Monetary Policy

Policy typically set by a central banking authority, whereby money supply access and the resulting cost or access to money (interest rate) is varied to assist in stabilizing economic activity.

Multiplier Effect

The sum total impact of a policy action on the economy; the money multiplier is equal to the ratio of the reserve requirement, 1/rr, such that a given reserve requirement will result in a net multiple of the original increase equal to “x the change in loanable funds.”

Phillips Curve

The graphical depiction of the inverse relationship between inflation and unemployment; intuitively, higher employment (lower unemployment) is consistent with a strong economy and demand; as demand increases beyond short-run supply capabilities or resource constraints, inflation begins to increase.

Stagflation

The situation where unemployment is high and inflation is high, contrary to the Phillips curve; stagflation occurs when policy actions fail to boost economic growth and the economy instead becomes stuck in a seemingly impassable position.