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Lesson in Course: Market movements (advanced, 7min )
How does the government deal with an economic crisis?
The central bank of the United States, or the Federal Reserve, is one of two economic policymakers. It decides monetary policy, which changes the money supply in the economy. When the Fed creates money, the Federal Government steps in and distributes it throughout the economy to consumers with its fiscal policy.
Both policymakers are essential to the health of the economy. So let's take a quick dive into how monetary and fiscal policies work together.
When the economy is in a depression, both the Fed and the Federal Government need to work together to benefit us, the people.
When interest rates are at 0%, the Fed can't create credit by changing interest rates. Instead, the central bank relies on printing money.
The Fed uses quantitative easing as a tool to create money in this situation.
When the Fed uses quantitative easing to buy US Treasury bonds, the central bank has lent money to the central government. Borrowing adds debt (owed by the government in this case) and credit to the economy, increasing the money supply. The Federal Government then distributes the money to people through stimulus programs, tax cuts, investments, and spending on other goods and services.
More government spending and stimulus encourages consumers to start spending and purchasing again. As transactions pick up, the economy begins to recover and grow again. Eventually, the economy will enter a new expansion phase, and the central government can raise taxes to repay the debt owed to the central bank. The Fed might sell the US Treasury Bonds back to the federal government.
However, a budget has to be approved by bipartisan policymakers before government spending and stimulus can be distributed.
Policymakers need to balance the amount of money printed and the stimulus required to jumpstart the economy to prevent too much spending. The worst-case scenario is when the government overspends and cannot pay back the debt in time. We have a similar experience when we borrow too much individually, having multiple mortgages, car loans, and maxed-out credit cards. While the US government has not defaulted (missed a payment) yet, some states and other countries have.
Balancing the fiscal budget requires cooperation between the executive and legislative branches. The President starts the process by presenting a budget plan to Congress. The House of Representatives and the US Senate have to review and approve the budget before any money is spent.
In general, Republicans are more fiscally conservative. They prefer to borrow less money and limit the amount of credit created.
On the other hand, Democrats tend to support more social programs and strong safety nets that require more government spending.
It takes a bipartisan effort to agree on a budget, and there have been cases where budgets did not meet approval. In January 2018 and January 2019, the government shut down because an agreement could not be made on the budget. However, in response to COVID-19, both parties put aside their differences to pass a $2 trillion stimulus package called the CARES Act.
As an investor, understanding the balance between fiscal and monetary policies will help give you clues about what might happen in the stock market. In most cases, monetary policies occur first to make funds available for fiscal policies. For instance, the Fed started cutting interest rates and using quantitative easing in response to the possible fallout of COVID-19 in early March 2020, before the CARES Act passed later that month.
The S&P 500 responded by starting to recover as investors anticipated the economic benefit of the stimulus package for recovery. (Sunday, March 22, 2020, was the first procedural vote on the bill).