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Have no fear. As with other principles described in this book, the economic schools are presented on a “what you need to know” basis.
55. FISCAL POLICY
In the natural course of business and commerce, the economy may expand, contract, or linger in the doldrums, creating pleasure or pain for individuals, corporations, and society as a whole (see #8 Business Cycle). As a measured effort to provide some stability and reduce pain among certain individuals or sectors of the economy, governments try to influence the economy, and smooth out the down cycles in particular.
There are two primary ways the federal or any national government can influence the economy: fiscal policy and monetary policy. Fiscal policy is the use of government spending and tax policy (see #47 Tax Policy and Income Taxation) to put money into or take money out of the economy. Monetary policy (see #56), on the other hand, influences the economy through changes in the money supply and interest rates (see #17 Money Supply and #21 Interest Rates).
What You Should Know
By congressional design or approval, governments can change the level and direction of spending quickly. As a first step in the recovery plan for what turned out to be the Great Recession, Congress passed the American Recovery and Reinvestment Act of 2009, providing more than $700 billion in new, “shovel-ready” spending programs across the country. This is the largest and one of the most quickly passed fiscal stimulus packages in history.
Fiscal stimulus programs like this are designed to provide jobs and thus stimulate aggregate economic demand by giving earners the ability to spend more money. Some stimulus packages are also designed to help certain parts of the economy (as opposed to the whole), or to strengthen or encourage specific sectors. The 2009 stimulus package, for instance, contained spending for alternative energy technologies. Some fiscal stimulus programs can help reduce the effects of poverty or accomplish other social or distribution-of-income objectives.
Stimulus may also be accomplished by reducing taxes, as was done several times since the begi
Fiscal policy can also be used dampen or attenuate an economy. This can occur either by reducing spending (difficult to do politically in the short run) or by raising taxes.
Economists are somewhat split on the effectiveness of fiscal policies. As recently demonstrated, tax reductions and especially tax rebates during tough times can simply be used for saving and thus don’t stimulate the economy (see #35 Paradox of Thrift). Government spending increases and decreases can be very political. They may not be allocated to the greatest need but rather subject to intense lobbying, resulting in waste and a significant loss of time before the benefits are realized (even the rapidly passed 2009 law wasn’t expected to have real effect for as much as a year). For these reasons, many believe that monetary policy is more effective, but it has boundaries too. Notably, Congress controls fiscal policy while the Federal Reserve (see #30 Federal Reserve) controls monetary policy. Most likely, a combination of the two works best, as has been deployed over the course of time (see #57 Keynesian School and #58 Chicago School).
Why You Should Care
Government is in place to use your tax dollars to make your country a better place to live; fiscal policy is one of the biggest tools it has to do this. How the government spends money is important, as are the size and nature of the budget deficits that may result (see #42 Federal Deficits and Debt). Fiscal policies, especially those involving tax changes, are likely to affect you.
56. MONETARY POLICY
While fiscal policy moderates economic growth and stability directly through government spending and taxation, monetary policy does it a bit more indirectly by controlling the supply of money and its cost through interest rates.
What You Should Know
When there is more money in the system, in theory and usually in practice, there is more economic activity. People have more money to make purchases or to pay off debts to enable more purchases later. The Fed can put more money into the system directly or by reducing interest rates through open market operations (see #32 Fed Open Market Operations).
Adding money to the system usually has a fairly rapid effect, for it stimulates lending and also sets expectations of easier money down the road; business decision-makers have more dollars to chase both now and in the future. But putting more money in the economy to chase the same amount of goods and services, especially when the supply of certain key goods is constrained, as happened in the 2008 oil market, can be highly inflationary—those additional dollars make all dollars worth less.
Monetary policy also influences exchange rates (see #92 Currency Policy and Exchange Rates), which in turn can stimulate or attenuate an economy. Lower interest rates make the dollar relatively less attractive because foreign investors will receive less interest on their holdings. This drives down the value of the dollar against world currencies, which also stimulates U.S. demand as prices for American goods become relatively more attractive to overseas buyers.
Over time, monetary policy has received greater emphasis as a tool to regulate the economy. One big reason is that it works quickly and largely without congressional approval. Policymakers feel they’ve learned how to moderate the business cycle quickly and efficiently with it, and have learned how to adjust all the knobs and dials (not just interest rates) to achieve desired outcomes. The quantitative easing bond-buying programs of the past few years are an excellent example.
Critics feel the overuse of monetary stimulus has left the door open for serious inflation problems in the future as money supply increases have hit all-time records. Many now advocate slow and steady monetary growth—not harsh expansion and contraction cycles tied to big increases and decreases in the Fed funds rate—as the proper way to achieve economic prosperity and stability.
Why You Should Care
Monetary policy will affect your daily life. Most of the effect is indirect, via a healthy and more stable economy. If you’re in the market for a mortgage or a short-term loan, monetary policy will have some effect on the interest rates you’ll pay. Since monetary policy takes aim mostly at short-term interest rates, however, the effect on longer-term mortgage rates is not direct. Monetary policy will also affect the amount of interest you receive on savings. Finally, we all should be aware of the potential long-term effects of monetary growth on inflation (see #18 Inflation and #59 Austrian School).
57. KEYNESIAN SCHOOL
The Keynesian school, often referred to by other names like Keynesian economics or even the somewhat haughty “neoclassical synthesis,” is a school of analysis and thought about the greater economic environment and the role that government should play in that environment. Essentially, the Keynesian school believes strongly in the theory and practice of capitalism but holds that government intervention, in several forms, is necessary to smooth the bumps and keep capitalist societies on a healthy, steady, and prosperous course.
What You Should Know
Keynesian economic theories went public during the Great Depression, and were the basis for British economist John Maynard Keynes’s 1936 book The General Theory of Employment, Interest and Money. At that time, economists and policymakers were intent on finding causes and cures for the depression under way, which many attributed to a complete failure of the capitalist model. Keynes set out to prove that capitalism was okay, it just needed some government intervention occasionally, and that intervention should never be mistaken for government control—that is, a pla