The government sets fiscal and monetary policy in response to the state of the economy. As you will see, policy changes can either stimulate a flagging economy or bolster one that is already doing well. Read on to find out how how these changes can directly impact your business.

Monetary Policy vs. Fiscal Policy

Fiscal and monetary policy have similar end goals. The government could use either to:

  •  Reduce unemployment.
  •  Reduce inflation.
  •  Encourage positive economic growth.

In fact, the main goal of both monetary policy and fiscal policy is to minimize the cyclical fluctuations that occur in the economic cycle. Downturns are unavoidable, but good policy can blunt their impact when they do happen. Governments use monetary policy in particular to smooth things out, and this often results in measures to lower inflation. Inflation occurs when prices rise, but the value of money decreases. During recessions, governments tend to use fiscal policy to spur recovery.

Here is how governments use both monetary and fiscal policies in more detail:

  •  Monetary policy influences demand and supply of money primarily through   the manipulation of interest rates.
  • Fiscal policy determines how governments spend money and set tax rates.

Implications for Business

Monetary and fiscal policies affect businesses both directly and indirectly. Therefore, it’s crucial that you monitor changes in government policies and understand how those changes will impact your business. Let’s take a look at the different types of fiscal and monetary policy so you can get a handle on them.

Contracting Fiscal Policy

When congress wants to increase government income, they move toward contracting fiscal policies. Typically, they do this when the economy is in an upswing and in danger of forming an economic bubble. This type of policy smooths the peak of the upswing and can potentially prolong it.

The takeaway for you is that contracting fiscal policy increases government revenue, which increases investment in public works, but this means that consumers will have less disposable income. This is, of course, because the government increases revenue by raising taxes.

Additionally, contracting fiscal policy may indicate that the government will look to cut spending. When this happens, government jobs are cut. This can increase consumer distress and is an indicator you should watch out for. However, newly unemployed and very motivated works will seek employment elsewhere, so it may be a good time to expand your team if you need to.

Finally, be aware that contracting fiscal policy will likely mean that the government will buy less from private corporations. Contracts may dry up.

In general, the opposite of all of this would hold, if the government employed expansionary monetary policy instead. Now let’s look at monetary policy.

Expansionary Monetary Policy

On the other hand, if the government wants to boost the economy, they may move into expansionary monetary policy mode. This policy bolsters the economy primarily through lower interest rates. At any time, the Federal Reserve can opt to decrease interest rates, but typically, this is only done when the economy slows. The Federal Reserve can also have an impact by purchasing U.S. bonds from the Treasury.

Lower interest rates increase the money supply. As this happens, the government receives income without having to raise taxes. What this means for you is that consumer distress should lessen, which means that consumers may spend more as they gain confidence in the economy. Furthermore, as interest rates decrease, loans become more attractive to both businesses and consumers because they are cheaper. In the long run, expansionary monetary policy would result in inflation, but in the short term, consumers spend more of their disposable income.

Contracting Monetary Policy

Just as with a contracting fiscal policy, a contracting monetary policy is used during times of plenty, and the aim is slightly different. When the government uses this type of policy, it is trying to prevent economic bubbles. An economic bubble is characterized as rapid economic growth that's followed by a sudden loss of value. The first thing that happens is that the Federal Reserve raises interest rates. This enables the government to control the rate of money that banks lend. Then, the government sells U.S. bonds to raise revenue. This, in turn, allows the government to reduce inflation.

What this means for you is that consumers will borrow less money, and they may be hesitant to make large purchases.

Summing Up

As a business owner, you know that it’s all about supply and demand. Supply and demand, in broad terms, determines how often and by how much you raise and lower your prices. Fiscal policy affects the amount of money consumers have to spend. When consumers have lots of discretionary income, they spend more and make larger purchases. When taxes increase, consumers spend less.

Monetary policy, on the other hand, has a direct impact on the money supply. Interest rates determine how costly loans are to obtain. When loans are easy to get, consumers spend more. Naturally, demand increases when consumers have more discretionary income.

The Lag Effect

It’s important to note that there is a lag between policy change and noticeable effects. If the economy is in a slump and the government switches is expansionary posture, don’t expect this stimulus to bring customers to your door overnight.

Yet, when the government switches from one policy type to another, you can be sure that changes in the economy will eventually follow. Being aware of these changes can help you make long-term predictions about the economy, which, in turn, can help you set prices.