Monetary & Fiscal Policy

The tools the government uses to control aggregate demand
The tools the government uses to control aggregate demand

Many people believe that government can predictably offset economic downturns.  The idea is that government can not only foresee business cycle movements before they occur, but then act to offset the natural tendency of the economy. Many expect the government to step in during recessionary periods. This is fiscal policy. Others look to the Federal Reserve to help manage the economy. This is monetary policy.

Real World Examples

  • Crowding Out

    The idea is that government stimulus spending may not add to the overall level of spending, since individuals may just let federal spending substitute for their own.

    For example, say the government started a new program in which they buy a new car for every college student in America. You probably would not oppose this program – you’d get a brand new car!  But it probably means that you wouldn’t buy a car on your own. The point is, if the government is buying cars for people, these people don’t buy as many cars for themselves. All of this means government spending is sometimes just a substitute for private spending. Economists call this “crowding-out.” Crowding-out occurs when private spending falls in response to increases in government spending.

  • A Modern Bank Run

    For a modern example of a bank run, consider England’s Northern Rock Bank in 2007. Northern Rock is no small bank, as they have over $10 billion in revenue per year. But extensive losses stemming from investments in mortgage markets led them to near collapse. In September of that year, depositors began queuing outside some locations fearing they would lose their deposits. In the U.S. over 300 banks failed between 2008 and 2011 without a bank run occurring.

    The difference is the level of deposit insurance offered in the two nations.  In England, depositors are insured for 100% of their first $4,000 in deposits, and then only 90% of their next $70,000. On the other hand, in 2007, FDIC insurance in the U.S. offered 100% insurance on the first $100,000 of deposits.

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