10: Political Economy - Fiscal and Monetary Policy

When it comes to creating and guiding a healthy economy, governments utilize two tools: fiscal, and monetary policy.

In this learning object, we discuss what a healthy economy is, what these macroeconomic tools -fiscal and monetary policy- are, and who and how is responsible for them.

Here is a definition in a nutshell:

Fiscal Policy = taxing and spending

Monetary Policy = lending and borrowing

Governments use taxation, spending, lending, and borrowing to influence the economy

and move it toward the three main economic goals that define a healthy economy:

1. Price Stability - keeping prices relatively constant is important in healthy economies; they should not rise too quickly, resulting in inflation, or fall too drastically, causing deflation. As nothing in reality remains constant, though, governments aim for gradual price increases, ideally just under 2% annually. This fiscal control allows individuals to make informed decisions on investing, saving, or borrowing, maintains currency stability, and aids economic growth.

2. Economic Growth - the increase of goods and services in an economy at a specified time frame (e.g., annually), is measured in Gross Domestic Product (GDP). Ideal for the United States -an already highly developed economy- is a GDP increase of about 3-4% annually. Successful economies reach continued growth through investment, innovation, a smart use of natural resources, and adequate regulation, to name a few. A healthy economy lifts living standards, incomes, and maintains funding for social programs.

3. Full Employment - in a healthy economy, anyone who wants to work should be able to. The government aims at an ideal unemployment rate of 3-4%. Please note here, that "full employment" does not mean 0% unemployment because there are always people who cannot work, are in between jobs, or are students, etc. This is the third important economic goal because high unemployment can lead to social unrest, and political instability.

Interestingly, the United States does not (at this point in time) adopt the fourth economic policy goal that many other countries measure:

4. Shared Prosperity - Germany, Norway, Finland, Mexico, Columbia, Ethiopia ,and Rwanda are some of the countries that integrate a measure of shared prosperity as a gage of how healthy their economies are. The Gini Index (or Gini Coefficient), measures wealth inequality within a country. Ranging from 0%-100% (perfect equality to perfect inequality), governments measure if their economic growth benefits only the wealthy or a broader segment of society. Among developed economies, Norway tends to score best with a Gini Index of about 22%, South Africa among the worst with 63%, and the United States tends to be in the "mildly unequal" place of about 42%.

In this learning module, our readings, classroom activity, and homework assignments teach you the basics of each of these policy tools, who is responsible for them, and what the processes are to optimize them toward reaching the economic policy goals.

Student Learning Outcomes

1. Define and distinguish between fiscal and monetary policy, including their tools, goals, and institutional frameworks.
2. Analyze the impact of fiscal policy (government spending and taxation) on national output, employment, and inflation.
3. Evaluate the role of the Federal Reserve in conducting monetary policy and its influence on interest rates, credit availability, and price stability.
4. Apply macroeconomic models (e.g., IS-LM, AD-AS) to predict the short-run and long-run effects of policy decisions.
5. Interpret economic indicators (GDP, CPI, unemployment rate) to assess the timing and effectiveness of policy interventions.
6. Critically assess policy trade-offs, such as inflation vs. unemployment or short-term stimulus vs. long-term debt sustainability.
7. Use real-world data to simulate or evaluate policy outcomes in terms of social justice.