Q&A Hero

Question

Explain the difference between fiscal policy and monetary policy. Discuss how each of these approaches can be used to influence the state of the economy.

Fiscal policy refers to changes in the level of government spending and/or taxation that are intended to help keep the economy more stable. For example, during a recession, the government might try stimulate the economy by encouraging additional spending. One way to do this would be to cut taxes on individuals or businesses, thus giving them more income to spend. Another approach would be for the government to increase its own level of spending on social programs, defense programs or in other areas. On the other hand, when the economy is overheated and experiencing inflationary pressures, the government might try to use fiscal policies to reduce the overall demand for goods and services. This could be done by increasing taxes or by cutting government spending on social programs, defense programs or in other areas.
Monetary policy refers to actions by the Federal Reserve System (the Fed) to control the supply of money and interest rates. When the level of economic activity is declining, the Fed normally will reduce interest rates, thus making it more attractive for businesses and households to borrow. This will encourage more spending on goods and services, thus stimulating the economy. When the economy is growing too rapidly (and thus creating inflationary pressures) the Fed often will pursue policies designed to increase interest rates, thus reducing borrowing and reducing the demand for goods and services. This should help curb inflationary pressures.

Mini-Case
Gig Abite is a bright, hard-working engineer who once owned a successful engineering consulting firm in his native country of Frinezia. Gig became discouraged by the high tax rates in Frinezia, so he immigrated to the United States eleven years ago. Soon after moving to the U.S., Gig again started his own business, which he named Giganeers Consulting. The company struggled at first, and almost went under midway through its second year. However, Gig never lost faith, the company survived, and it soon developed a growing reputation for quality work at a reasonable cost. Giganeers began experiencing sustained growth early in its fourth year. In fact, Gig frequently had to hire additional employees over the next few years to keep up with the increasing workload. His company, which started with only Gig and 2 other full time workers, now provides jobs for 43 full-time employees as well as many part time workers.
Despite these past successes, some clouds are on the horizon. The company recently suffered its first drop in business since its very early years. Gig is convinced that the problem is not with his company, but rather is due to a downturn in the U.S. economy. He read a news story last week that reported that the value of the total output of final goods and services in the U.S. declined over the last quarter. The article also stated that many economists believed that this downward trend is likely to continue for several more months. Gig is concerned that he will have to lay off some of his employees if the economy doesn't improve. This is something he does not want to do. He hopes that the government does something soon to put the economy back on track.