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Monetary and fiscal policy

Basic mechanics of monetary and fiscal policy. Created by Sal Khan.

Video transcript

Two words you'll hear thrown a lot in macroeconomic circles are monetary policy and fiscal policy. And they're normally talked about in the context of ways to shift aggregate demand in one direction or another and often times to kind of stimulate aggregate demand, to shift it to the right. And what I want to do in this video is focus on what these two different tools who are, who are the actors, and how do they go about actually shifting the aggregate demand curve. So monetary policy-- this is literally deciding how much money to print. So it's literally printing money-- either deciding to print more of it or deciding to print less. It tends to be done in the United States-- especially in most large countries-- it's done by the central bank, which is sometimes directly part of the government. Sometimes it's quasi-independent. In the US, it's a quasi-- The US central bank, which is the Federal Reserve, is quasi-independent. And in future videos we'll talk more about the governance structure of the Federal Reserve. Most of the major appointees are made by the US government. All of its excess profits goes back to the US Treasury, so in that way it's part of the US government. But it's set up to be-- also has some influence from private industry. The member banks have a stake in what's going on. It often coordinates amongst member banks. So you have your Federal Reserve as a central bank in the United States. It's quasi-independent, but it's been given the right to print money. And I'll just draw it here as physical dollars, but most of the money that is going to print actually is electronic money. And the way this affects the aggregate demand curve, the Federal Reserve doesn't just print money and go out and start buying things with that money. Well, it does buy things, but it doesn't go out and buy goods and services. What it does with this is it essentially lends it out, so it's essentially buying debt. And if buying debt seems like a weird thing to say, buying debt it is the same thing as lending money. If I buy a treasury bond, so if I'm buying debt, I'm buying a treasury bond means I'm implicitly lending that money. If I buy the bond directly from the government, that means I'm lending that money to the US government. If I directly buy a bond from a US corporation, I'm essentially lending that money to the corporation. They're going to give me interest payments in the form of coupons, and then they're going to pay back that money at some future date. So this is essentially lending money. And what this does is it's increasing the supply of money that's out there to be lent. And so if we think of the market for money-- so let's see, now we're thinking microeconomic terms for the market for money. If this is the price of money, which is really just the interest rate as a percentage, and this right over here is the supply of money. And I'll just draw-- so this might be our supply curve. That's supply. And this is the demand curve. And let's say right over here, this is short-term money. And we won't focus on the different durations and all of that. But let's say we're sitting right over here at a clearing interest rate of 5%. So it makes sense. So this is right here. This is our demand curve. So all of the people who will get more than 5% benefit out of the money-- maybe they have an investment where they could get 10% on the money or 8% or 5.1%-- they're all willing to borrow that money and then invest it in whatever they want to do. Or this might even be consumption, people who are saying, hey, 5%. That's worth it for me to go out and buy that thing that makes me whatever happy. But from an investment point of view it makes even more sense. If I'm going to get an 8% return on my money-- that's my benefit-- it makes sense for me to borrow it at 5%. It makes sense all the way up to 5.0001%. I'd actually borrow it. And so in the Federal Reserve, or any central bank, prints money and it buys debt. It goes out into debt markets and it usually buys the safest kind of debt, but that affects all of the debt markets. It goes out and buys debt market. They're essentially shifting the supply curve of money to the right. They shift the supply curve to the right. And so at any given interest rate you could say that there is more money. And so the supply curve might look something like that. And this is interesting because assuming the demand has not shifted, what you now have is a different clearing price, a different equilibrium price, for the money. Maybe this is now at 3%. And you also have more money being lent and borrowed. So if this was the old quantity of money that was lent and borrowed-- I'm just going to make up a number here. Let's say that this is $100 billion in some time period. And now we're at $120 billion. So now by essentially printing money, buying debt, increasing the supply of money two things happen. Interest rates went down. And so now you have all of these characters out here who before, they weren't going to borrow money at 5% because their benefit on that money was between 5% and 3%. Maybe it's 4% or 3.5%. It didn't make sense for them to borrow at 5% and invest it and only get a 4% return or a 3% return. But now that interest rates have gone down, now it does make sense for them to borrow the money, all the way down to someone who has some type of project or investment that has a 3% return. They also say, hey, I'm neutral. Now I could borrow at 3%, and then I could invest it. But definitely the person with 3.1% or 3.2%, if they have investments that give them that much, they would definitely want to borrow. And we could assume that all this incremental borrowing-- so this little example that I did right over here-- all this incremental $20 billion of borrowing is going to be spent. People will borrow money not to just sit but stuff it into their mattresses. They'll borrow that money to go invest it in some way, to spend it. And so what this will do, all of this will shift aggregate demand to the right. Right here, we're talking in microeconomic terms, but then if we think about aggregate supply and demand-- so this is aggregate. Let me write aggregate right over here. This is price. This is real GDP. This is our aggregate demand. And then our short run aggregate supply might look something like this. And so if we're shifting aggregate demand to the right where there's going to be more demand for goods and services, these people are going to borrow this money and spend it. You're going to essentially stimulate the economy. So this shifts to the right. You have a situation where real GDP will go from this state to this state right over here. So it was expansionary. And obviously, if the Federal Reserve decides to print less money or if they even decide to essentially soak up the money that's in the market by selling some of the debt that they own, so that they're sucking dollars out of it, then the opposite effect would happen. Now fiscal policy is essentially the government directly going out there and demanding goods and services from the economy. You have the government. It has two sources of revenue that it can spend. It has money from taxes. It has tax revenue. And then it can go out and borrow money. And so it also has access to debt markets. And when the government borrows money, they're essentially issuing treasury bills, if you're talking about the US Treasury Bills and Treasury Bonds. If you were to buy those from the US government, you're essentially lending money to the government to finance their debt. And so they can take these two sources of money, and then if they decide to spend more-- and let's say that they're going to hold taxes fixed. So they're not going to take out any demand from the economy. They might ratchet up debt and then ratchet up spending. And then this government is directly going out there and demanding more goods and services. So that could also shift the aggregate demand curve to the right. So these are two different levers, two different tools, that have been used in governments all around the world to shift aggregate demand one way or another or an attempt to shift aggregate demand one way or the other. Monetary policy is more indirect. Printing money, using that to increase the supply of money that's out there to be lent, that lowers interest rates. And then because it lowers interest rates, there's more willingness to borrow and invest that money. Fiscal policy, you're directly going out there and just buying more goods and services by usually ratcheting up your debt. Or fiscal policy could go the other way. If you're trying to restrain the economy, you could lower your debt, lower your spending, or you could do some other combination. s