Governments regulate money through fiscal and monetary policies. Monetary policy aims to keep inflation and unemployment low, while encouraging economic growth through loans and credit. However, balancing economic growth and low inflation is a challenge, requiring governments to prioritize one over the other.
Governments have two types of regulation when it comes to managing money, fiscal policy and monetary policy. Fiscal policy determines how governments raise money through taxes and spend that revenue. The role of monetary policy is to manipulate the availability of a nation’s currency to keep inflation and the national unemployment rate low.
Generally, if a country’s economy is growing, there will be a healthy supply of jobs for workers to fill and a low unemployment rate. A low unemployment rate helps maintain a healthy economy, as these employed workers are also consumers with money to spend on the products and services that different companies offer. When consumers are buying, companies are making money and can continue to employ – and hire more – workers who, in turn, also act as consumers.
Inflation refers to what happens when a particular nation’s currency becomes so plentiful that it begins to lose value. This results in rising prices, which means that the purchasing power of each monetary unit decreases. Governments want to keep inflation to a minimum because rising prices hurt consumers’ ability to buy goods and services. In addition to hurting consumers’ living standards, this, in turn, hurts the companies whose goods and services consumers aren’t buying. This then hurts the economy.
Monetary policy’s role in encouraging economic growth generally takes a form that makes it easier for businesses to obtain loans and credit to expand their operations and for entrepreneurs to obtain money to start new businesses. A government’s central bank can do this by reducing reserve requirements, or the percentage of liabilities a bank must legally hold as liquid currency. This allows banks to make more loans and issue more credit than they can with higher reserve requirements. Central banks can also encourage economic growth by increasing the money supply, or the total value of a nation’s currency in circulation.
To keep inflation low within the confines of the monetary policy role, a government can restrict the amount of money that is in circulation in order to preserve the value of each monetary unit. This involves steps opposite to those that stimulate economic growth. This includes increasing reserve requirements for banks and decreasing the country’s money supply.
The challenge inherent in the role of monetary policy is that governments cannot encourage economic growth without risking inflation, and cannot take steps to keep inflation low without risking an economic slowdown and a corresponding rise in the unemployment rate. This requires governments to prioritize economic growth or keeping inflation low at any given time. Central banks typically deal with this dilemma by taking modest steps to keep inflation low during periods of economic growth and risking inflation to focus on encouraging economic growth when economies are in recessions or depressions.
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