Monetary Policy & Fiscal Policy
Monetary policy and fiscal policy refer to the two most widely recognized tools used to influence a nation’s economic activity. Monetary policy is primarily concerned with the management of interest rates and the total supply of money in circulation and is generally carried out by central banks, such as the U.S. Federal Reserve. Fiscal policy is a collective term for the taxing and spending actions of governments. In the United States, the national fiscal policy is determined by the executive and legislative branches of the government.
Both monetary and fiscal policy are tools to government can access to support and stimulate the economy.
Monetary policy addresses interest rates and the supply of money in circulation, and it is generally managed by a central bank.
Fiscal policy addresses taxation and government spending, and it is generally determined by legislation.
Monetary policy and fiscal policy together have great influence over a nation’s economy, its businesses, and its consumers.
Central banks typically have used monetary policy to either stimulate an economy or to check its growth.
By encouraging individuals and businesses to borrow and spend, the monetary policy aims to spur economic activity.
Conversely, by restricting spending and encouraging savings, monetary policy can act as a brake on inflation and other issues associated with an overheated economy.
The Federal Reserve, also known as the “Fed,” has frequently used three different policy tools to influence the economy: open market operations, changing reserve requirements for banks and setting the discount rate. Open market operations are carried out on a daily basis when the Fed buys and sells U.S. government bonds to either inject money into the economy or pull money out of circulation. By setting the reserve ratio, or the percentage of deposits that banks are required to keep in reserve, the Fed directly influences the amount of money created when banks make loans. The Fed can also target changes in the discount rate (the interest rate it charges on loans it makes to financial institutions), which is intended to impact short-term interest rates across the entire economy.
Monetary policy is more of a blunt tool in terms of expanding and contracting the money supply to influence inflation and growth and it has less impact on the real economy. For example, the Fed was aggressive during the Great Depression. Its actions prevented deflation and economic collapse but did not generate significant economic growth to reverse the lost output and jobs.
Expansionary monetary policy can have limited effects on growth by increasing asset prices and lowering the costs of borrowing, making companies more profitable.
Generally speaking, the aim of most government tax policies is to target the total level of spending, the total composition of spending, or both in an economy. The two most widely used means of affecting tax policy are changes in government spending policies or in government tax policies.
If a government believes there is not enough business activity in an economy, it can increase the amount of money it spends, often referred to as stimulus spending. If there are not enough tax receipts to pay for spending increases, governments borrow money by issuing debt securities such as government bonds and, in the process, accumulate debt. This is referred to as deficit spending.
In comparing the two, fiscal policy generally has a greater impact on consumers than monetary policy, as it can lead to increased employment and income.
By increasing taxes, governments pull money out of the economy and slow business activity. Typically, fiscal policy is used when the government seeks to stimulate the economy. It might lower taxes or offer tax rebates in an effort to encourage economic growth. Influencing economic outcomes via fiscal policy is one of the core tenets of Keynesian economics.
When a government spends money or changes tax policy, it must choose where to spend or what to tax. In doing so, government tax policy can target specific communities, industries, investments, or commodities to either favor or discourage production — sometimes, their actions are based on considerations that are not entirely economic. For this reason, fiscal policy is often hotly debated among economists and political observers.
Essentially, it is targeting aggregate demand. Companies also benefit as they see increased revenues. However, if the economy is near full capacity, expansionary fiscal policy risks sparking inflation. This inflation eats away at the margins of certain corporations in competitive industries that may not be able to easily pass on costs to customers; it also eats away at the funds of people on a fixed income.
But how do governments fight inflation?
Inflation occurs when an economy grows due to increased spending. When this happens, prices rise and the economy’s currency is worth less than before; The currency basically does not buy as much as before.
When a currency is worth less, its exchange rate takes effect when compared to other currencies. There are many methods used to control the economy; Some work well, while others may have detrimental effects. For example, controlling inflation through price and price controls can cause recession and job losses.
Contracted Monetary Policy A popular method of controlling the economy is through a contractionary monetary policy. The purpose of a contractionary policy is to reduce a money supply in an economy, lower bond prices and lower interest rates.
This helps to reduce spending because when there is less money to spend, those with money want to save and save rather than spend. It also means that there is less credit available, or it can also reduce costs.
Reducing spending is important during an economy as it helps to halt economic growth and, in turn, the rate of inflation. Controls can use price and price controls to combat inflation, but this can cause recession and loss of inflation. Governments can also employ a contractionary monetary policy to combat inflation, use a money supply in an economic economy, and reduce bond prices and raise interest rates.
There are three main tools for executing a contractionary policy. The first is to raise interest rates by the central bank, in the case of the US, or Federal Reserve.
The Fed funds rate is the rate from which type of bank banks borrow money from the government, but to make money they need to lend it at higher rates.
Thus, when the Federal Reserve raises its interest rates, banks have no choice and do not raise their rates either. When banks raise their rates, fewer people want to lend money because it costs more to use when that money is added to higher interest rates. Then costs fall, prices fall and they fall.
How can the government control inflation?
Mandatory The second tool is to increase reserve requirements on the amount of money banks are legally required to keep on hand to apply for withdrawals. The more banks banks need to hold, the less they need to lend to consumers. If they have fewer loans, less consumption, less spending, reduced spending, or reduced costs.
Reducing or Supplying MoneyThe third method is to directly or directly reduce the money supply by adopting policies that encourage the reduction of money supply.
Two examples of this debt collection charge due to the government and the increase in interest paid on bonds, for whom more investors understand them.
This latter policy increases currency exchange rates due to higher demand and, in turn, increases as imports and decreases as exports.
Both are policies to reduce the amount of money in circulation, because money will go from the pockets of banks, companies and investors, and into the pockets of government, where it can control or happen to it.