Fiscal Policy and Monetary Policy

At least since the Great Depression 60 years ago there has been general agreement that Washington has a major responsibility for fostering economic prosperity and stability, as the essay on general-welfare liberalism, makes clear. The demands placed on the federal government run the gamut from controlling the business cycle (the ups and downs in employment and prices) to encouraging stable growth in the productivity of labor and capital to regulating commercial activities to ensure the public health, safety, and welfare to protecting business and labor from unfair foreign competition. Attaining these goals is clearly a tall order. More important, even though Americans generally agree on the need for public action, they quarrel bitterly about its extent and form.

Economists and politicians all have their favorite approaches. Many favor a combination of taxing and public spending, while others advocate regulating the supply of money. In practice, economic policy involves a mixture of the two, but during the past several decades each method has at one time or another been dominant.

Fiscal Policy

By manipulating government spending and taxes in order to stimulate or slow down growth, Washington affects the aggregate or total demand for goods and services. This method of economic management is called fiscal policy.

To see how fiscal policy works, consider a period of high unemployment and business stagnation. America has suffered through numerous such periods such as in the early 1980s and 1991 to late 1993. The national government attempts to revive industry and create jobs by injecting billions of dollars into the economy (a task some call "pump priming"). It does so by cutting taxes, thereby leaving individuals and businesses with more to spend; by purchasing goods and services (such as building bridges, dredging harbors, and buying airplanes); and by making direct payments to individuals (social security or unemployment insurance, for example). In theory at least, the net effect is to raise aggregate demand, the total goods and services citizens and businesses can afford to buy. A rise in demand causes industries to manufacture more products, hire additional labor, and invest in new buildings and machinery, all of which helps commerce and trade.

Government spending, moreover, has a multiplier effect. The billions of dollars allocated to public projects go into the pockets of carpenters, steelworkers, bricklayers, truck drivers, and thousands of other laborers, who spend the money on food, clothing, housing, medical care, automobiles, and recreation. Workers in these industries, in turn, spend their wages on additional goods and services. Gradually the government's dollars trickle through the economy. The multiplier effect holds for all types of budget transactions, whether in the form of tax cuts, direct payments, or actual purchases. Consequently, federal pump priming increases national income by much more than the nominal or face amount of the outlays.

In times of prosperity, on the other hand, demand may exceed supply. The excess causes prices to increase and, unless stopped, leads to inflation, a condition in which the value of money decreases as prices rise. When this happens, the government reverses gears by cutting spending, raising taxes, or both. The result is less money in the hands of consumers and business, and less money means lower aggregate demand, which causes prices to level off.

Fiscal policy thus strives to smooth out the business cycle by manipulating the federal budget to maintain just enough demand to keep people working but not so much as to fuel inflation. In essence fiscal policy is a juggling act: By adjusting spending and taxation, the government can in principle maintain high levels of employment and stable prices.

In the past, Democrats, especially members from the liberal wing of the party, have advocated fiscal action to combat unemployment and sustain economic productivity and were willing to risk inflation and incur budget deficits to achieve these ends.

Associated with the British economist John Maynard Keynes, fiscal policy is often called Keynesian theory. Although Franklin Roosevelt effectively adopted Keynesian theory in the 1930s and it has been widely accepted ever since, it has nonetheless always created deep misgivings and endless controversy. Many economists doubt that the national government can fine-tune the economy by raising or lowering taxes and expenditures. Besides being too ponderous and time-consuming, these methods involve enormous uncertainties.

But before dismissing the impact of fiscal policy, consider unemployment. Unemployment as a percent of the labor force has gone up and down since the Republic's founding. But prior to World War II, when policy makers preferred to let the market correct swings in the buisness cycle, the variation in jobless was much greater than in the postwar period. In recent years the rate of unemloyment has hover around 6 percent; at times, as in the early 1982 it reached nearly 11 percent. But the waves have been much smoother than they were in the 1900 to 1940 period, an era of bust and boom.

Despite fiscal policy's apparent success, an even more potent economic policy is monetary policy.

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Monetary Policy

Monetary policy attempts to control the amount of money in circulation or the cost and availability of credit. The objective is straightforward even if difficult to put into practice. If money is readily available because, say, interest rates are low, people can afford to borrow and spend. But unless production keeps pace, there will not be enough goods and services to meet the demand this borrowinn and spending creates. In the face of the excessive demand, producers and suppliers have incentives to raise their prices. As time goes by, prices spiral upward, leading to uncontrolled inflation during which dollars lose their value. The key to keeping inflation in check is to maintain stable interest rates and not let the money supply grow too rapidly.

Monetary policy fall within the province of the Federal Reserve System, the nation's central bank.

Like fiscal policy, monetarism has a downside. Should the government constrict the flow of cash into the economy too severely, consumers and businesses cannot afford to borrow, spending and investments decline, products sit on store shelves, factories close, and new homes, automobiles, and appliances go unsold. As the economy cools off, more and more workers are laid off and the downward plunge picks up momentum. As we saw at the outset, the Fed's decision to curb the supply of money in 1979 led the United States into its worst recession in 50 years. Nevertheless, just as Democrats traditionally favor stimulative policies, conservative Republicans tend to boost monetary policy as the best way to control inflation, which they argue is a greater evil than unemployment.

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Fiscal and monetary policies often work at cross-purposes. Generally speaking, monetarists are mainly concerned with keeping the lid on inflation and will tolerate relatively high unemployment to achieve that goal. Fiscal policy, on the other hand, appeals to politicians who want to keep the economy vigorous and growing even at the cost of moderately higher prices.

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