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Monetary policy/Fiscal policy

Monetary policy/Fiscal policy

Author: Kate Eskra

This lesson covers monetary policy and fiscal policy.

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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 my examples are in green. So in this tutorial, we will be talking about how both monetary and fiscal policy work to stabilize or stimulate the economy. I'll talk about what the Federal Reserve System does to manage the money supply and the credit in our country, and then I'll talk about what the government does to influence business cycles. And finally, we'll be comparing expansionary and contractionary policies.

OK, so let's start with monetary policy. Monetary policy is policy typically set by a central banking authority. Ours is the Federal Reserve. So I'll usually talk about them just as the Fed. And in this type of policy, we're looking at the money supply and people's access to money, or the interest rate is really what's going to be varied, to try to stabilize economic activity.

So the Federal Reserve, like I said, is the central banking authority for the United States. And they have direct oversight over this monetary policy. So who is the Fed, because most people know you pretty much about the government, but not as many Americans know what the Federal Reserve System really is and what its functions are. So let's talk about it for a little bit.

There are 12 Federal Reserve districts in our country, and the purpose of that is for each of them to monitor and then report on banking conditions throughout the country. So the main functions of the Fed, there are a lot as you can see. First of all, they sell government securities, which are bills, bonds, and notes. They issue currency, clear checks, supervise our lending practices, they act as a lender of last resort for banks, and the one that we're actually going to be focusing on the most is this last one-- the idea that they're the ones who regulate the money supply and try to stabilize our economy. So let's focus on that function of the Fed.

The Fed has three main tools kind of in their bag of tricks, and they're the required reserve ratio, or RRR, changing interest rates, and buying or selling of securities. So first of all, this one, the required reserve ratio, is worth mentioning. But I just want you to keep in mind that they very rarely, if ever, have changed the RRR. It's been found to be way too sensitive, but it is in their bag of tricks. They are technically allowed to change the required reserve ratio.

And really all this is is the portion of funds that banks have to keep on hand at any given time. Obviously, banks are in business to make money. So they lend out most of the money that we deposit in banks. And that's what's known as a fractional reserve system. The RRR right now is set at 10% and has been for a very long time, so they have to keep on hand 10% of all deposits in the back. Technically, if the Fed wanted to increase credit and increase banks' ability to loan out money, they could reduce this percentage. They could lower it to 9% or 8% and allow them to loan out more money. If they wanted to decrease credit, or their ability to loan out money to the public, they could raise the amount of money that they had to keep on hand.

OK, so interest rates are the second to tool of monetary policy, and the Fed controls what's known as the discount rate. And the discount rate is the rate that actually banks pay to borrow from them. And so if the Fed wants to make it easier for banks to make loans, they can lower the discount rate. So if they drive the discount rate down very low, that means that it's going to be easier for banks to get their hands on money, thereby making it easier for us to get credit. Then in turn, banks can lower the rates that they charge us. So this discount rate really leads what controls what other interest rates are in our country.

So the last tool that I want to talk about for a little bit is the buying and selling of securities. And the Fed buys and sells bills, bonds, and notes. The only difference between them is the length of time on them on the open market. And these are known as treasuries. If the Fed wanted to get more money circulating in our economy and kind of speed things up, what they would do is they have a policy of buying securities. Think about it this is way. This is what I always tell my students.

If someone buys something from you, you walk away from that transaction with money, right? So if they buy securities on the open market, that puts more money circulating in the economy. On the contrary, if someone sells something to you, money is taken out of your pockets. You leave with the item, but you have given up money. So if the Fed wants less money circulating, they sell securities. So that's just a very simplified way of looking at this.

OK, so now let's look at fiscal policy. Fiscal policy is set by a central government authority. And really government spending is the biggest thing adjusted to try to stabilize economic activity. But the two tools of fiscal policy are both government spending and taxation.

So with government spending, we are all very aware that our government spends money in our economy in many different areas, from-- I listed just some examples here-- national defense, education and health care, welfare programs and infrastructure. We could make an endless list really. The idea is if the government wants to try to stimulate the economy and get it moving again, if they notice that things tend to be slowing down, they can just try to spend more money.

If they, for example, spend more money in education and health care, that's going to give people somewhere along the way more money. It could create jobs, and it could absolutely give people more money to spend and just pick up the economy again when it is starting to slow down. If, however, sometimes we have, like, an overheated economy, and there's a lot of inflation and they want to try to curb people's spending, they can actually cut spending levels. So they can reduce some of these areas of spending.

Taxation is the other area that the government can control. We are also very aware that all federal, state, and local governments collect taxes from us in order to fund their programs. So again, thinking about it a similar way, if they want to stimulate the economy, they want people out there spending money. So what would they do? They could cut our taxes. The opposite of that would be if they want us spending less money, they could raise taxes to take money out of our pockets, and then we're spending less money in the economy.

OK, so expansionary policy is when either the Fed or the government decides to try to expand the economy. It's usually during a recession or when it looks like we're heading into a recession. As we're slowing down, the government or the Fed tries to enact some policy to pick it back up again. OK? And so we've already gone over all these tools, but I just wanted to compare it in a chart for you here.

Monetary policy would work in different ways than fiscal policy. The goal with both of them is to get the economy going, but they work in different ways. Monetary policy works really through interest rates, through credit, and through getting banks to make loans, whereas fiscal policy works a little bit more directly in just getting us the money to spend right now.

One thing to keep in mind is if one is going to take longer than the other for people to react, it's going to be monetary policy. You're not necessarily going to go out and buy a house tomorrow just because they lowered interest rates, whereas if they cut your taxes, you see that impact immediately in your next paycheck. And so you either then go spend the money or you don't. So that's just something to keep in mind-- the difference between monetary and fiscal policy.

Contractionary policy is the opposite, when either the Fed or the government tries to slow down some economic growth. And so again, this might be during a period of inflation. With monetary policy, they're going to try to keep money in the banks and the less in our hands, so they're going to be raising interest rates versus fiscal policy, which is just trying to take a little bit of money away from us and cool down our spending.

Then finally, we have neutral policy. Neutral policies are either monetary or fiscal policies that are really just meant to maintain the economy at its present level. So this is really non-intervening policy. When we're not in a recession or growing too rapidly, we're said to be in equilibrium. And so policies tend to be neutral. In these cases, spending is generally going to equal revenue from taxes, not be greater than or less than. And the Fed, through monetary policy, is just really going to try to keep the money supply pretty consistent.

So in this tutorial, we looked at how both monetary and fiscal policy work to stabilize or stimulate the economy. We talked about what the Fed does to manage the money supply and credit. And we talked about what the government does to influence business cycles. Finally, we compared and contrasted expansionary and contractionary policies and ended looking at some neutral ideas. 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).

Federal Reserve

The central banking authority for the United States with direct oversight authority for monetary policy.

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.

Neutral Policy

Either monetary or fiscal policy that is enacted with the intent to maintain the economy at its present growth trajectory—non-intervening policy.