Seat of the European Central Bank in Frankfurt, Germany.
Economy really is one the few areas that impacts everyone, and while that might have its benefits, poorly guided economic policies can impact the lives of millions – this is why it’s crucial to get an understanding of this area, how it can be carried out and its possible implications.
Nowadays, the two main tools used to control economic growth are fiscal and monetary policies. These policies are used by governments and central banks around the world to either promote a faster economic growth or to slow things down when the economy is growing too fast. Economic growth is the increase of economic productivity. – economic productivity can be defined as the output (such as goods and services) an economy can produce given a set of inputs (like labor or capital).
One of the first promoters of such policies was John Maynard Keynes, one of the most influential economists of all time. In the first half of the 20th century, and more adamantly during the Great Depression, Keynes challenged the beliefs of the neoclassical economists like Friedrich Hayek that government spending was harmful to the economy and that, in the case of recessions, markets self-regulate in short to medium term without outside intervention. On the contrary, Keynes claimed that this self-regulation was not a certainty, and if it did happen, it would take too long, causing disproportionate harm and suffering to the population. Consequently, he stated that intervention was needed to speed up the economy’s recovery process, with fiscal and monetary policies being the main tools to promote this recovery.
Fiscal policy is carried out by governments in 2 main ways: adjustment of government spending and tax rates.
Government spending, as the name suggests, encompasses the government expenditure in the society. This can range from investment in building infrastructure, promoting research or improving welfare, healthcare and education. The logic behind adjusting government spending to promote or inhibit the growth of the economy is that the acquisiton of goods and services creates demand for these products, which in turn increases output and reduces unemployment (it is also important to note that there are areas of investment which spurt the economy more than others). For example, government investment in building roads not only creates jobs to accomplish the goal but also increases demand for construction companies and can also facilitate commuting, possibly leading to further benefits downstream like enabling people to apply for new jobs. This is known as expansionary fiscal policy and it is used when the economy is moving too slow (for instance, when unemployment rates are high or the country’s productivity is low). Government spending is usually financed through means like government borrowing, issuing of government bonds or taxation. On the other hand, contractionary fiscal policy is based on reducing government spending as a way to cool off the economy in case it is growing too fast (for instance, in case of high inflation – a scenario which recently happened after the Russian invasion of Ukraine).
When it comes to the adjustment of tax rates, governments can also apply an expansionary or contractionary fiscal policy. By adjusting tax rates, the government can control how much money people are encouraged to spend or invest – lower tax rates means the population is left with more money to spend and invest, increasing demand, which in turn leads to more revenue for companies. In their turn, companies then need to hire and invest more to keep up with demand and stay competitive, thus spurting the economy. Higher tax rates have the opposite effect.
Monetary policy is carried out by central banks like the Federal Reserve in the USA (commonly known as the Fed) or the European Central Bank in Europe. The main purpose of these central banks is to oversee, control and regulate the nation’s banks to make sure their supply of money is correct at each point in time. Moreover, and similarly to governments with fiscal policy, central banks can use monetary policy to speed up or slow down the overall economy through the control of the money supply.
Monetary policy is carried out mainly through the adjustment of interest rates and money supply.
The adjustment of interest rates (the price of borrowing money) encompasses the amount of money banks get (in the case of loans like mortgages) and give (in the case of savings). An expansionary monetary policy is characterized by low-interest rates to expand the economy since it is easier to pay back loans and savings accounts yield less money – thus, there is a lower incentive for people to keep money in the bank and a higher incentive to invest and get loans. A contractionary policy implies the opposite – higher interest rates encourage people to not invest and keep money in their accounts, slowing down the economy – you probably witnessed this second scenario when inflation rose after the outbreak of the war in Ukraine.
In some cases, however, central banks do not have the power to control the interest rates that local banks use. In these cases, to control the growth of the economy, central banks adjust the money supply i.e. the money they loan to local banks – in an expansionary monetary policy, the central banks increase the money supply, and so banks will have more money to loan to the population and interest rates will consequently decrease (since banks have more money to loan, borrowers can choose from where to get their loans, meaning that banks need to compete by lowering interest rates). This way, the opposite takes place in a contractionary monetary policy scenario – central banks limit the money supply, virtually increasing the value of money and so interest rates rise (since money is more scarce, banks try to get the highest interest rates possible). In its essence, the adjustment of money supply operates on the basis of the law of supply and demand – for the same demand (the borrowers), an increase in supply (more money) will lower the price (interest rates), while a decrease in supply will do the opposite.
Fiscal and monetary policies, using tools government spending, tax rates or money supply, can have an impact on multiple macroeconomic factors like the aggregate demand for goods and services, savings and investment rates or even inflation and unemployment rates. Since Keynes, governments and central banks across the world have been increasingly more active in the economy using these policies to control their economies, prevent recessions and achieve a sustainable and steady growth.
So, the next time you’re unsure about how to best manage your money, take a look around! Are governments applying expansionary policies to get you to invest? Or, on the other hand, are interest rates high and banks offering you attractive terms in savings accounts? Gathering this data can help make informed decisions and manage your money to its fullest potential!
YKW // 22 April 2023
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