1.2. Tools of Government Policy

A government has two basic tools for managing the economy. It can:

• Increase/decrease the amount of money in the system (monetary policy)

• Increase/decrease its revenues and spending (fiscal policy)

Specifically, monetary policy is the practice of controlling the supply of money and the cost of credit through changes in interest rates. The government attempts to stimulate the economy by lowering interest rates and slow the economy by raising interest rates. Fiscal policy attempts to change the economy by modifying tax rates and government spending. Specifically, lower taxes and higher government spending are meant to stimulate the economy by putting more money in consumers’ pockets. In contrast, higher taxes and r