Fundamentals of Business

Economic effects of fiscal policy

Fiscal policy is used by governments to influence the level of aggregate demand in the economy, in an effort to achieve economic objectives of price stability stability, full employment and economic growth.

Monetary Policy

Economic strategy chosen by a government in deciding expansion or contraction in the country's money money-supply supply. Applied usually through the central bank, a monetary policy employs three major tools:
(1) buying or selling national debt,
(2) changing credit restrictions,
and
(3) changing the interest rates by changing reserve requirements.
Monetary policy plays the dominant role in control of the aggregate demand and, by extension, of inflation in an economy. Also called monetary regime.
Monetary policy is generally referred to as either being an expansionary policy, or a contractionary policy, where an expansionary policy increases the total supply of money in the economy, and a contractionary policy decreases the total money supply.

Expansionary policy is traditionally used to combat unemployment in a recession by lowering interest rates, while contractionary policy has the goal of raising interest rates to combat inflation (or cool an otherwise overheated economy).
Monetary policy should be contrasted with fiscal policy, which refers to government borrowing, spending and taxation.

Monetary policy rests on the relationship between the rates of interest in an economy, that is the price at which money can be borrowed, and the total supply of money. Monetary policy uses a variety of tools to control one or both of these, to influence outcomes like economic growth, inflation, exchange rates with other currencies and unemployment. Where currency is under a monopoly of issuance, or where there is a regulated system of issuing currency through banks which are tied to a central bank, the monetary authority has the ability to alter the money supply and thus influence the interest rate (in order to achieve policy goals).

A policy is referred to as contractionary if it reduces the size of the money supply or raises the interest rate. An expansionary policy increases the size of the money supply, or decreases the interest rate. Further monetary policies are described as accommodative if the interest rate set by the central monetary authority is intended to spur economic growth, neutral if it is intended to neither spur growth nor combat inflation, or tight if intended to reduce inflation.

There are several monetary policy tools available to achieve these ends. Within almost all modern nations, special institutions (such as the Bank of England, the European Central Bank or the Federal Reserve System in the United States) exist which have the task of executing the monetary policy independently of the executive. In general, these institutions are called central banks and often have other responsibilities such as supervising the smooth operation of the financial system.

It must now take into account such diverse factors as:
I) short term interest rates;
II) long term interest rates;
III) velocity of money through the economy;