Governments influence the economy in two ways: monetary and fiscal policy. Monetary policy consists of adjusting the money supply (the amount of money in circulation) and setting the prime rate (the interest rate that banks pay to each other on loans). Fiscal policy uses government taxation, spending and borrowing to influence the economy.
A central bank creates monetary policy by controlling the money supply and the interest rate (specifically known as the “prime rate” or in economic terms, the “price of money”). These policies aim to stabilize an economy by encouraging borrowing and investment, and controlling unemployment and inflation.
By controlling the money supply, the central bank determines how much money is in the economy at a given time. When the supply increases, the value of a unit of currency decreases, and people spend more. When the supply of money decreases, a unit of currency gains value, keeping inflation down. Central banks change the money supply by buying or selling bonds or by printing money.
A central bank determines the lowest possible interest rate in an economy, called the "prime rate." The central bank charges this rate on loans to commercial banks, and commercial banks charge each other a similar rate on loans. Banks charge customers a higher interest rate, but it goes up and down with the prime rate. Low interest rates encourage borrowing and investing (which are fundamental to a growing economy), whereas high interest rates encourage prudence and limit risk-taking (which control inflation).
Fiscal policy concerns government borrowing, spending and taxation, and influences the economy through aggregate demand (how much people spend). There are three types of fiscal policy: neutral, expansionary and contractionary. Governments pursue neutral fiscal policy when they balance their budgets, so that spending equals revenue. When governments build surpluses (spending equals less than revenue), they pursue a contractionary policy, whereas deficits (spending is more than revenue, implying government borrowing) signal an expansionary policy.
Aggregate demand is the total amount of spending in an economy. Governments can affect aggregate demand through fiscal policy in two ways: taxation and spending. When a government decides how much to tax, it influences the economic activity of the population. In general, tax cuts and tax incentives increase aggregate demand at the expense of government revenue, whereas increases in taxes have the opposite effect. Governments can also affect aggregate demand by how they spend, targeting specific industries with subsidies or government contracts in expansionary policy, and restricting federal projects and cutting subsidies in contractionary policy.