Table of Сontents
- Monetary Policy Basics & Example
- Fiscal Policy Basics & Examples
- Key Differences Between Fiscal & Monetary Policies
- Monetary & Fiscal Policy Impact On Investors
- Bottom Line
The Federal Reserve Bank of the United States implements monetary policy to manage inflation, control interest rates, and promote the effective operation of the banking system. The US government implements fiscal policy through taxing and expenditure with the goals of balancing the business cycle, boosting employment, and fostering long-term economic growth. Together, monetary and fiscal policies control the nation’s economic activity over time.
Monetary Policy Basics & Example
Under various economic situations, the Federal Reserve implements two different types of monetary policy:
- Expansionary Policy: This is the time when the central bank employs its resources to boost the economy. In order to spur economic growth, the main objective is to raise the money supply and eliminate credit restrictions. Interest rate and/or reserve requirement reductions are two instances of expansive policy.
- Contractionary Policy: When the economy is too hot, the central bank will utilize its instruments to slow the rate of monetary expansion. As an illustration, consider raising interest rates and/or reserve requirements to lower the amount of money in circulation.
The Fed primarily employs 3 instruments to carry out monetary policy:
- Open market operations: This entails purchasing and disposing of assets such as government securities. In an “open market,” where prices are the only criterion for competition, securities dealers transact business with the Fed.
- Discount rate: The interest rate on short-term loans made to banks is under Fed supervision.
- Reserve requirements: The number of reserves that banks must hold, either in their safes or on deposit with the Federal Reserve Bank, is likewise determined by the Fed.
Open market operations are the most often employed of these three instruments.
Who Controls Monetary Policy?
The Federal Reserve oversees the United States monetary policy as the country’s central bank. The Federal Open Market Committee (FOMC), the Fed’s policy-making body, meets eight times a year (or more, if required) to review the outlook for the US economy and to think through potential monetary policy alternatives.
The Goal of Monetary Policy
To promote steady long-term development in the economy and manage inflation, the monetary policy aims to strike a balance between the money supply, interest rates, and the amount of credit that is readily accessible.
Limitations & Challenges
The economy is a very intricate machine with many moving elements that constantly interact with one another. The actions of the economy’s many various constituent groups can be affected, but they can never be entirely controlled or accurately anticipated. Furthermore, no two economic circumstances are identical in every way.
As a result, assessing all the moving elements and deducing trends from them is an imperfect science that may lead to disagreement even inside the Fed. As a result, the efficiency of monetary policy can vary and a number of tradeoffs must be taken into account. As a result, the Fed must constantly strike a balance. These are some of the particular restrictions and difficulties:
- The Fed can only exert control over certain variables and has direct power over short-term interest rates as well as the monetary base (cash held by the general public and bank reserves). It can indirectly affect long-term interest rates by making asset acquisitions.
- The Fed can only push its policies so far. For instance, it may be compelled to make rates negative or even zero, but it still wouldn’t be able to boost 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
The Fed made the somewhat dramatic decision to cut short-term rates to zero and maintain them there for a long enough period of time to allow the economy to recover in reaction to the financial crisis of 2008 and the threat it posed to our financial system.
Fiscal Policy Basics & Examples
The Federal Government is required by its mandate to use its taxing and spending authority to carry out a fiscal policy that impacts the economy by maximizing employment and ensuring sustainable economic growth.
The theories of British economist John Maynard Keynes, who postulated that economic recessions were caused by shortages in private sector demand and that governments could stabilize the business cycle by adjusting spending and tax policies to make up for those shortages, have had a significant impact on fiscal policy.
Additionally, fiscal policies can be either expansionary or restrictive depending on the relevant economic circumstances.
Expansionary: By lowering personal taxes, which should encourage more spending, the government can help the economy bounce back and/or expand. Reduced corporation taxes should encourage more investment and economic development. An increase in government expenditure can result in the creation of new employment or even direct stimulus payments to persons who have been adversely impacted by pandemics or natural catastrophes.
Contractionary: Similar to this, when the government wishes to slow down uncontrollably high development, it can raise taxes or cut expenditures.
The government establishes its fiscal policy using two key tools:
Taxes. The government may affect investment, employment, and even overseas commerce by changing the tax law for people and enterprises.
Government spending. Various economic sectors, including infrastructure, defense, public works, government employment, subsidies, public health, and research and welfare programs, might get increased (or decreased) funding.
Who Controls Fiscal Policy?
The executive and legislative branches of the federal government work in tandem to regulate budgetary policy. The Council of Economic Advisors and the Secretary of the Treasury are two advisory bodies that the executive branch frequently consults.
The Goal of Fiscal Policy
The goals of fiscal policy are to minimize unemployment, respond to external factors like natural catastrophes, moderate the impacts of the business cycle, and keep the national budget deficit under control.
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 issued checks to all people in 2021 as a measure to help those in need and maintain the economy in response to the enormous loss of revenue brought on by the COVID-19 epidemic.
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
Although the two approaches focus on distinct facets of expansion, both monetary policy and fiscal policy may be employed for expansionary aims. By reducing interest rates and reserve requirements, monetary policy can reduce credit costs and increase credit availability. By lowering taxes or increasing government expenditure, such as by issuing stimulus checks, fiscal policy would address growth.
Monetary & Fiscal Policy Impact On Investors
Monetary and fiscal policies frequently have short-term effects on a variety of asset classes, the financial markets, and investors in order to balance the long-term supply and demand dynamics of a rising economy. The table below provides an overview of the impact on important asset classes.
|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 avoiding 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.|
Monetary and fiscal policies both offer beneficial and effective tools that may assist influence and managing the country’s economic activity within specific bounds, notwithstanding the impossibility of sustaining perfect economic circumstances at all times. By regulating the money supply, interest rates, and inflation, the Federal Reserve’s monetary policy affects the amount of economic activity. The legislative and executive parts of the government carry out a fiscal policy through acts to support employment and affect consumer demand. Together, monetary and fiscal policies work in harmony to control supply and demand dynamics that maintain the economy’s long-term, healthy, and sustainable growth rates.