Finance is based on economics. Economics is made up of macroeconomics, a look at the economy as a whole, and microeconomics, which looks at the behavior of consumers and firms in an effort to understand their decision-making processes.
For consumers, microeconomic trends are important because firms use economic data to make business choices about how to operate based on factors such as the economy, competition, and consumer choices.
Important Economic Concepts: Fiscal and Monetary Policy
According to the U.S. Federal Reserve Bank, the difference between fiscal and monetary policy is:
Monetary policy is typically implemented by a central bank while fiscal policy decisions are set by the national government. However, both monetary and fiscal policy may be used to influence the performance of the economy in the short run.
The central bank refers to the U.S. Federal Reserve System, which is responsible for regulating the country’s monetary policy, including our money supply, credit, and the value of our currency. Their primary goal is to provide price stability by controlling inflation. The Federal Reserve is an independent agency of the federal government, intended to be free from political influence.
The expectation is that a “stimulative” monetary policy improves the economic rate of growth, while a “restrictive” monetary policy slows the economy to offset inflation. Similarly, “stimulative” fiscal policies are meant to stimulate growth in the short term, while tax increases and spending cut slow economic expansion.
Impact of Fiscal Policy on the Consumer
U.S. fiscal policy refers to the tax and spending policies of the federal government. Generally, tax cuts and increased spending are part of the government’s fiscal policy designed to increase short-run economic growth. Fiscal policy decisions are determined by the Congress and the Administration.
The general belief is that when it is operating below full employment levels, a stimulative fiscal policy is good for the economy.
While fiscal policy, in general, is broad in nature, the impact of changes to fiscal policy are often felt by certain groups of people. For instance, a tax cut for families with children raises disposable income allowing them to spend more.
Fiscal policy is important for managing the economy. It affects the amount of output produced, known as the Gross Domestic Product or GDP.
Here’s how it works. Fiscal expansion raises the demand for goods and services. This increases output and prices. How high the demand will increase depends on the current economy. In a recession, the output is likely to be more, but the price level won’t change. With full employment, it will affect prices more and have a smaller impact on output.
Recently, the World Health Organization (WHO) recommended the use of fiscal policy to ‘influence food prices in ways that encourage healthy eating.” The recommendation was to tax less healthy foods as a way to “create a financial incentive for consumers to avoid them.”
Impact of Monetary Policy on the Consumer
When it comes to the consumer, monetary policy affects employment, the level of prices, and long-term interest rates. It affects the volume of money and credit available.
For consumers, the goal of the Federal Reserve Bank is to achieve maximum employment and price stability. The purpose of raising or lowering interest rates is to impact the demand for goods and services. The difficulty is that it sometimes can take a long time for monetary policy to have any effect on the economy and inflation. This is called a lag.
The lag for the economy can take as long as two years, whereas inflation lags tend to take three years or more. Unfortunately, lags are difficult to predict and people often become impatient.
It is the role of the Federal Reserve Bank to set the discount and prime interest rates. The discount rate is what banks charge when lending to each other. The prime rate is the amount charged to consumers. To tighten the economy, the Federal Reserve Bank increases these interest rates. The purpose of “tightening the economy” is to curb rising inflation.
The balance between fiscal and monetary policy can be unsteady. Understanding how the U.S. economic system works can help you understand its impact on your financial future.