Fiscal policy and monetary policy are used by governments to steer the economy through performing open market operations and changing both the reserve requirement and the federal funds interest rate in monetary policy. Conversely, fiscal policy involves government spending and taxes. Moreover, the monetary policy assists policy concentrating on the relevant economic shocks while fiscal policy promotes macroeconomic stability through sustenance of aggregate demand and private sector incomes in times of economic downturn and moderating the economic activity when the economy is growing strongly. It is thus the duty of the government to control the economy from severe fluctuations.
Since the 2008 economic recession, the United States economy has been characterized by slow growth, high unemployment, a reduction in the number of people looking for a job, as well as a great uncertainty that has held back investment. Moreover, there have been increased taxes and regulatory burdens, intensified by favoritism toward embedded interests, thereby undercutting the nation’s dynamic entrepreneurial growth significantly (Miles, 2014).
The Consumer Price Index inflation rate for January 2015 has stood at 0.3 percent against a government target of 2 percent with comparison to five years ago in 2010 January when it was 3.5 percent. Moreover, the unemployment rate for January 2015 is 5.7 percent down from 9.8 percent in January 2010. However, there have been job gains in retain, construction, financial activities and manufacturing. The interest rate for January 2015 was 0.25 percent as compared to five years ago in January 2010 when it stood at 3.73 percent (Miles, 2014).
Economists attribute the current state of economy to politics whereby the government’s effort to increase government spending and regulation have been opposed by the Congress. Moreover, the Health Care Law of 2010 has reduced competition in the health insurance markets thereby affecting job creation and full-time employment. The reason unemployment rate improved was that more Americans were at work and more reported being added to the labor force. However, fluctuations in the unemployment rate may occur due to seasonal changes in weather, opening or closure of learning institutions, or major holidays.
Conversely, the inflation rate dropped due to increased short-term uncertainty though with a relatively slighter magnitude. Low inflation rates correspond to low interest rates as the future purchasing power increases and the cost of doing business declines. Further, inflation is depended on the expected inflation and the indicators of excess demand, such as unemployment. The inflation rate also dropped because the general price levels of goods and services decreased over the five year period.
Fiscal policy is used by the government to increase aggregate demand by encouraging spending as well as an easy money environment to stimulate the economy and create employment and the amount of money in circulation. The government may use fiscal policy to stimulate the economy through reducing taxes to encourage the household to spend more. When taxes go down, people are left with more disposable income to spend which in turn offsets the drop in investment and leads to economic growth (Evans & Chamberlain, 2014).
Monetary policy is the action taken by the Fed to influence the abundance and cost of money and credit in the economy to promote price level stability and decrease unemployment. Moreover, expansionary monetary policy ensures an increase in the amount of money in circulation. The Fed may use open market operations whereby it buys the existing U.S. Treasury securities thereby increasing the reserve base and escalating banks’ ability to extend loans and credit to household. With increased access to loans, the households are able to spend more thereby boosting the economy (Erceg & Levin, 2014).
By reducing taxes, the disposable income goes up which consequently increases consumption and thus higher aggregate demand. A rise in aggregate demand leads to an expansion in real GDP thereby firms produce more. When firms produce more, the demand for workers increases thus reducing the unemployment rate. As the amount of income in households’ hands goes up due to reduced taxation, they spend more on goods and services, hence their demand outstrips supply. This leads to the general prices of goods and services going up thereby leading to higher inflation rate. This prompts the government to limit inflationary prices by cutting the supply restrictions to stabilize the economy. Conversely, lower taxes expand the aggregate demand, which therefore leads to an increase in the general prices of goods, and thus increasing the interest rates (Evans & Chamberlain, 2014).
Open market operations lead to more money in the hands of households and businesses, which is then spend in buying goods and services. The companies that sell these goods and services will hire more people to produce those goods and services thereby reducing the unemployment rate. Further, since the Fed sells securities to banks, banks will in turn have more money at their vaults, and to have that money return an interest, it has to be loaned out (Erceg & Levin, 2014). This makes the banks to reduce interest rates so that they can attract borrowers. Increases in interest rates slows the growth rate in the aggregate demand, thereby reducing the inflation rate.