While consumers affect the economy by spending according to their own situation and financial pressures, Federal policy decisions also influence the economy. Fiscal policy, enacted by Congress, uses taxation and legislation to boost employment, stabilize prices, and stimulate economic growth. In contrast, monetary policy, which is controlled by the Federal Reserve Bank (the Fed), manipulates short-term interest rates in an effort to spur growth or control inflation.
If the Fed perceives that prevailing forces will increase inflation, it may attempt to slow the economy by raising short-term interest rates (the assumption being that increases in the cost of borrowing are likely to dampen personal and business spending). On the other hand, if the Fed perceives the economy has slowed too much, it may attempt to stimulate growth by lowering short-term interest rates (i.e., lowering the cost of borrowing in an attempt to stimulate spending).
In maintaining this balancing act, the Fed walks a fine line. If it doesn’t tighten the reins soon enough (by raising interest rates), it runs the risk of inflation getting out of control. If it fails to loosen soon enough (by lowering interest rates), it can plunge the economy into recession.
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