Monetary Policy - controlled by the politically neutral Federal Reserve ( or US Central bank) and Fiscal Policy- controlled by the elected government are both used to manage the economy. The two work independently but the outcome of their actions are interconnected and both need to be working in tandem.
Monetary Policy is Controlled by the Federal Reserve, whose present Chairman is Ben Bernanke. The goal is "maximum employment, stable prices, and moderate long-term interest rates." Based on the state of the economy, the Fed takes measures to incentivize a required behavior that will lead to a target state of unemployment/GDP/inflation.
Case 1: Let us begin by focusing on the sequence of steps within the pink box below, which are typically taken when unemployment is very high ( >6%) :
The Fed reserve tries to reduce Interest rates, which encourages borrowing ( to spend), both by businesses and by consumers.
GDP ( Gross Domestic Product ) which is an indicator of a country's economic condition is the sum of the following:
- Consumer Spending
- Business Spending
- Government Spending
- Total Exports less total Imports
So increase in spending by Consumers/Businesses/Government leads to an increase in GDP and a general improvement in the economy which in turn leads to improvement in the employment situation.
Higher employment means higher earnings and thereby even more consumer spending. If this happens, we can say that the economy has been stimulated !
Some More: Higher earnings will also lead to higher tax revenue for the government, even if tax rate is not increased. The government can then chose to pay down debt or increase government spending. Remember government spending can also contribute to increase in GDP. We will talk more about it when we get to Fiscal Policy.
Fiscal Policy
Quantitative Easing
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