Monetary Vs. Fiscal Policy
Monetary Policy is implemented by the Federal Reserve Bank of the U.S. to control inflation, regulate interest rates, and support the efficient functioning of the banking system. Fiscal Policy is implemented through taxation and spending by the US government aimed at stabilizing the business cycle, fueling employment, and supporting long-term economic growth. Monetary and Fiscal Policies work in tandem to regulate the country’s economic activity over time.
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Monetary Policy Basics & Example
In the United States, the Federal Reserve employs two different kinds of Monetary Policy under different economic conditions:
- Expansionary Policy: This is when the central bank uses its tools to stimulate the economy. The general goal is to increase money supply and ease credit in hopes of boosting economic growth. Examples of expansionary policy are the reduction of interest rates and/or reserve requirements.
- Contractionary Policy: This is when the central bank uses its tools to curb the rate of monetary expansion and cool down an overheated economy. An example would be to increase interest rates and/or reduce the money supply through increased reserve requirements or quantitative tightening (selling of securities held by the government).
The Fed mainly uses 3 tools to implement monetary policy:
- Open market operations: This involves the buying and selling of government securities or other assets. Securities dealers do business with the Fed in an "open market" whereby they compete on the basis of price.
- Discount rate: The Fed controls the interest rate on short-term loans issued to banks.
- Reserve requirements: The Fed also dictates how much in reserves banks must maintain, either in their vaults or on deposit with the Federal Reserve Bank.
Who Controls Monetary Policy in the United States?
As the nation's central bank, the Federal Reserve controls monetary policy for the U.S. The Fed's policy-making body, the Federal Open Market Committee (FOMC), gathers 8 times a year (or more, if necessary) to discuss the outlook for the U.S. economy and consider various monetary policy options that could be implemented.
The Goal of Monetary Policy
Monetary policy is aimed at balancing money supply, interest rates, and available credit in order to foster stable long-term growth in the economy and control inflation.
Limitations & Challenges
The economy is a highly complex mechanism with numerous moving parts that affect one another on a continual basis. Moreover, the economy is driven by the behaviors of many different constituent groups, which can be influenced but never completely controlled or precisely predicted. In addition, no two economic scenarios are exactly alike.
As such, measuring all the moving parts and drawing conclusions about their trends is an inexact science, which can foster disagreement even within the Fed itself. As a result, monetary policy can vary in its effectiveness and must also consider a variety of tradeoffs. This renders the Fed's job a continuous balancing act. Among the specific limits and challenges are these:
- The Fed can only exert control over certain variables. It can directly control the monetary base (currency held by the public and bank reserves) and short-term interest rates. Through asset purchases of sales, it can indirectly influence longer-term interest rates.
- The Fed can only push its policies so far. It could be forced, for example, to reduce rates to zero or even let them go negative, yet still not be able to stimulate the economy.
- Economists often disagree on which monetary policy should be employed for the best results.
- Most policies involve tradeoffs. Purchasing assets to reduce long-term rates, for example, could result in unintended asset bubbles.
- Monetary policy can potentially conflict with fiscal policy or political goals. If implementing an expansionary monetary policy, for example, the government would be challenged to raise taxes for any reason since that would reduce the money supply and interfere with the effectiveness of an expansionary monetary policy.
Monetary Policy Example
In response to the financial crisis of 2008 and the associated threat to our financial system, the Fed took the rather dramatic step of reducing short-term rates to zero and keeping them there for sufficient time to allow the economy to recover.
Fiscal Policy Basics & Examples
Part of the charter of the U.S. Federal Government is to exercise its power of taxation and spending to implement a Fiscal Policy that influences the economy by maximizing employment and maintaining steady economic growth.
Fiscal policy is strongly influenced by the ideas of British economist John Maynard Keynes, who suggested that economic recessions were caused by deficiencies in demand from the private sector and that governments could stabilize the business cycle by adjusting spending and tax policies to make up for those deficiencies.
Fiscal Policies can also be either expansionary or contractionary, as required for different economic conditions.
Expansionary: The government can aid the economy to recover and/or grow by decreasing personal taxation which should lead to an increase in consumption. A decrease in corporate taxes should lead to increased investment and growth. An increase in government spending can create new jobs or can even take the form of direct stimulus payments to those negatively affected by natural disasters or pandemics.
Contractionary: Similarly, when the government wants to cool off excessively rapid growth, it can increase taxes or decrease government spending programs.
The government uses 2 main tools to establish its Fiscal Policy:
- Taxes. By modifying the tax code for individuals and businesses, the government can influence investment, affect employment, and even influence foreign trade.
- Government spending. Spending can be directed (or reduced) towards various sectors of the economy such as infrastructure, defense, public works, government employment, subsidies, public health, or research and welfare programs.
Who Controls Fiscal Policy?
The federal government controls fiscal policy through the coordinated efforts of the executive and legislative branches. The executive branch relies heavily upon the Secretary of the Treasury and the Council of Economic Advisors for advice.
The Goal of Fiscal Policy
Fiscal Policy is intended to mediate the effects of the business cycle, maximize employment, react to external influences such as natural disasters, and control the country's budget deficit.
Limitations & Challenges
Fiscal policy can certainly have challenges and not reach expectations as desired.
- Raising and lowering taxes cannot be done at will or very often for practical purposes
- When trying to expand the economy, the country's deficit can increase if government spending exceeds tax revenue.
- When trying to contract the economy by raising taxes, tax evasion can often increase and political backlash can occur.
- There can often be a time delay between the approval of government fiscal policies and the time it takes to put those policies into operation.
Fiscal Policy Example
The government responded to the massive loss of income resulting from the COVID-19 pandemic by issuing checks in 2021 to all citizens as a way to assist those in need as well as keep the economy going.
Key Differences Between Fiscal & Monetary Policies
Monetary policy is implemented by the Federal Reserve Bank, which operates independently from the federal government. The Fed focuses on adjusting the nation's supply of money and credit, changing interest rates, and modifying bank reserve requirements.
Fiscal policy focuses more on the demand side of the economy and is shaped by the executive and legislative branches of the U.S. government. The federal government relies on taxes and government spending as its primary tools.
Expansionary Monetary Policy vs. Expansionary Fiscal Policy
Monetary Policy and Fiscal Policy can both be used for expansionary purposes, though the two policies address different aspects of expansion. Monetary Policy address expansion by lowering interest rates and reserve requirements, making credit cheaper and more available. Fiscal Policy would address expansion through lower taxes or increased government spending, such as the issuance of stimulus checks.
Monetary & Fiscal Policy Impact On Investors
To balance the long-term supply and demand forces of a growing economy, Monetary and Fiscal Policies will often result in short-term consequences to various asset classes and to the financial markets, thus affecting investors. The impact on major asset classes is summarized in the table below.
Bonds | Equities | Cash | |
Expansionary Policies | Lower interest rates typically have a positive impact on existing bonds. In addition, asset purchases by the Fed will have a positive impact on those assets targeted - usually government bonds. | Expansionary Policies are generally positive for equities markets, though there can be a delayed impact as investors wait to see whether earnings are in fact rising as a result. | Low interest rates discourage investors from avoid holding too much cash and cash equivalent investments. |
Contractionary Policies | Higher interest rates typically have a negative impact on existing bond prices, particularly those with long-term durations. | The reaction of equity markets to inflation or to modest interest rate hikes is mixed. However, when either of these influences is particularly strong, it can have negative short-term consequences for equities. | Rising interest rates can result in higher deposit rates. |
Bottom Line
While maintaining perfect economic conditions at all times is an unattainable ideal, Monetary and Fiscal Policies both provide valuable and effective tools that can help influence and regulate the country's economic activity within certain limits. Monetary Policy, implemented by the Federal Reserve, influences the level of economic activity by controlling the money supply, interest rates, and inflation. Fiscal Policy is executed through actions by the legislative and executive branches of government to promote employment and influence consumer demand. Together Monetary and Fiscal Policies align to manage the supply and demand forces that keep the economy growing at healthy and sustainable rates over time.
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