Let's begin by discussing monetary policy, which is policy typically set by a central banking authority, which in our case is the Federal Reserve, or simply the Fed. In this type of policy, money supply access and the resulting cost or access to money by consumers, meaning the interest rate, is varied to assist in stabilizing economic activity.
As mentioned, the Federal Reserve is the central banking authority for the United States. They have direct oversight authority for this monetary policy.
So, who is the Fed? Most people have a fair amount of knowledge about the government, but not as many Americans know much about the Federal Reserve System and its functions.
There are 12 Federal Reserve districts in our country, and the purpose for each of them is to monitor and report on banking conditions throughout the country.
So the quite a few main functions of the Fed, including:
We are going to focus primarily on that last bullet point.
The Fed has three main tools in their arsenal.
The RRR is the portion of funds that banks have to keep on hand at any given time, and they can lend out the rest. Obviously, banks are in business to make money, so they lend out most of the money that we deposit in banks, which is known as a fractional reserve system.
Currently, the RRR is set at 10%, where it has been for a very long time, so banks are required to keep 10% of all deposits on hand.
Now, technically, if the Fed wanted to increase credit and banks' ability to loan out money, they could reduce this percentage by lowering it, to 9% or 8%, for instance, which would allow banks to loan out more money.
Conversely, if they wanted to decrease credit or the banks' ability to loan out money to the public, they could raise the amount of money that banks were required to keep on hand.
So, if the Fed wants to make it easier for banks to make loans, they can lower the discount rate. In other words, if they drive the discount rate down very low, that means that it is going to be easier for banks to get their hands on money, thereby making it easier for us to get credit. In turn, banks can lower the rates that they charge us.
This discount rate is the driving force that controls what other interest rates are in our country.
Now, if the Fed wants to get more money circulating in our economy--to speed things up, in a manner--they would adopt a policy of buying securities.
Conversely, if the Fed wants less money circulating, they sell securities.
Fiscal policy is set by a central government authority whereby government spending is the main thing adjusted to try to stabilize economic activity.
Fiscal policy has two main tools.
These are just a few examples. The idea is that if the government wants to stimulate the economy and get it moving again during a slowdown, it can spend more money in order to create jobs or give people money to spend.
EXAMPLEIf, for example, the government spends more money in education and healthcare, it could create jobs, which would eventually give people more money to spend, and in turn, pick up the economy when it is starting to slow down.
On the other hand, if the government needs to slow down an over-heated economy--meaning there is a lot of inflation and they want to curb people's spending--they can actually cut spending levels, by reducing some of these areas of spending.
Again, thinking about it a similar way, if they want to stimulate the economy, they want people to be spending money. So, what can they do? They can cut taxes to give people more money to spend.
The opposite of that would be if they want us spending less money, in which case, they can raise taxes to slow down people's spending in the economy, essentially taking money out of our pockets.
Expansionary policy is when either the Fed or the government decides to try to expand the economy, typically during a recession or what looks like an impending recession.
As we are slowing down, the government or the Fed enacts either monetary or fiscal policy to stimulate economic growth, as measured by the GDP growth rate.
Here is a chart outlining the tools used by both types of policy to expand the economy.
Increase the money supply/Entice banks to make loans
Encourage job creation and more spending in the economy
1. Lower the RRR
2. Lower interest rates
3. Buy securities
1. Increase government spending
2. Cut taxes
One important difference to note is that monetary policy will take longer than fiscal policy to impact consumer behavior.
EXAMPLEFor example, you are not necessarily going to go out and buy a house tomorrow just because the Fed lowered interest rates, whereas if the government cuts your taxes, you feel that impact immediately in your next paycheck--and then you either go spend that money, or you don't.
Contractionary policy is the opposite, when either the Fed or the government tries to slow down economic growth. Again, this might occur during a period of inflation.
Decrease the money supply/Entice people to keep money in banks
Encourage less spending in the economy
1. Raise the RRR
2. Raise interest rates
3. Sell securities
1. Decrease government spending
2. Raise taxes
Finally, we have neutral policy, which is either monetary or fiscal policy that is meant to maintain the economy at its present level. Neutral policy is a non-intervening policy.
When we are not in a recession or growing too rapidly, we're said to be in equilibrium. Therefore, policies tend to be neutral.
In these cases, spending is generally going to equal revenue from taxes, not greater than or less than. Also, the Fed, through monetary policy, keeps the money supply consistent.
Source: Adapted from Sophia instructor Kate Eskra.