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In 1992, when presidential campaign advisor James Carville famously told Bill Clinton's staff, "It's the economy, stupid!" he was stressing the importance of what matters most to a majority of voters.
The two most widely recognized tools to influence the economy, and keep constituents happy, are monetary policy, controlled by the Federal Reserve, and fiscal policy, which falls under the auspices of Congress and the president. Both play important roles in maintaining a stable and balanced U.S. economy.
Monetary policy, which can broadly be described as either expansionary or contractionary, is set by central banks. In the case of the U.S., the Federal Reserve is the central bank.
Monetary policy is designed to influence economic conditions by increasing (or decreasing) the size of the money supply and pushing interest rates lower or higher.
By increasing the money supply, the Fed's action can lower interest rates, make borrowing easier, boost gross domestic product, reduce unemployment, and provide a lift to the stock market. When inflation or hyperinflation threaten to overheat the economy, the Fed tightens (decreases) the money supply to avoid inflation or even hyperinflation.
Expansionary monetary policy is a macroeconomic tool that a central bank — like the Federal Reserve in the U.S. — uses to stimulate economic growth. A bank usually implements it during a contractionary phase of the business cycle — when the gross domestic product (GDP) in a nation starts to decline.
A decline in GDP can have a variety of undesirable effects, including:
All these effects, if unchecked, can eventually lead to a recession or depression.
The overall goal of any expansionary policy is to encourage spending and borrowing. The theory is that when there's more money available to individuals and businesses at lower costs, it will result in the increased purchase of goods and services, stimulating growth.
Contractionary monetary policy is a macroeconomic tool that a central bank uses to reduce inflation.
The goal is to slow the pace of the economy by reducing the money supply, or the amount of cash and readily cashable funds circulating throughout the nation. It is the opposite of expansionary monetary policy.
Governments and central banks gauge when an economy is overheating by looking at the rate of inflation. It's natural for a rise in demand to spark some increase in the prices for goods and services. The U.S., for example, generally considers the average annual inflation rate of 2% to 3% as normal.
But if inflation is rising above its target growth rate, it acts as a warning — and becomes the key catalyst for implementing a contractionary monetary policy.
The Federal Reserve, the U.S. central bank, has several monetary policy levers it can use to influence the economy. The Federal Open Market Committee (FOMC) is a committee made up of 12 individual voting members. This committee sets the target range for the federal funds rate, the interest rate banks must pay when borrowing money from each other (or lending to one another).
If the fed funds rate increases, it places upward pressure on broader interest rates, and if this rate goes lower, it puts downward pressure on these broader rates.
In addition to setting the target range for the fed funds rate, the FOMC can help keep the effective rate for this rate within the aforementioned range by buying or selling securities. By purchasing securities, the committee can help place downward pressure on interest rates, and by selling them, it can achieve the opposite.
A separate body, the Federal Reserve Board, which consists of seven members nominated by the president and ratified by the senate, is responsible for setting reserve requirements and the discount rate.
By lowering reserve requirements, the board can give individual banks the ability to lend more money, placing upward pressure on the money supply. Alternatively, by making these requirements stricter, the board reduces banks' ability to lend, placing contractionary pressure on the money supply.
An example of contractionary monetary policy materialized during the 1970s. From 1972 to 1973, inflation jumped from 3.4% to 8.7%.
There were many reasons for this dramatic price rise, such as wage control and untying the U.S. dollar from the gold standard. To combat it, the Fed increased the fed funds rate from 6% in January to 11% in August. This reduced inflation to around 5.7%.
However, in August, the OPEC energy crisis hit, which caused oil prices to skyrocket.
Inflation reached 12.3% in 1974 and the fed funds rate hit a high of 13%.
Even though prices were rising, economic growth was still low, which led to a paradoxical period of stagflation. The country plunged into a recession and the Fed reduced rates to try and improve the situation. However, prices remained stubbornly high.
Eventually, the Federal Reserve increased interest rates to 20% in 1980, when the inflation rate was posting 14%. This move finally reversed the price trend. Inflation eventually dropped to 3.8% in 1982.
A great example of expansionary monetary policy materialized in the aftermath of the Great Financial Crisis, when the Fed engaged in a phase of unprecedented monetary stimulus called quantitative easing, where it purchased trillions of dollars worth of assets in an effort to stimulate the economy.
As a result, the federal funds rate was close to zero between 2009 and 2015. While some market observers warned that these aggressive purchases of assets might cause inflation, the inflation that some worried about failed to materialize.
Another situation that provides examples of both expansionary and contractionary monetary policy is the global coronavirus pandemic that was first declared in 2020.
During the coronavirus pandemic, the Fed's ability to control a wildly swinging economy through monetary policies was severely tested. First, it reduced short-term interest rates to zero. When that proved insufficient, the FOMC began buying $120 billion worth of bonds and mortgage-backed securities every month.
These measures were designed to keep interest rates low and increase the money supply to help shore up the economy, which had contracted by as much as 19.2%. The moves by the Fed helped limit the duration of the recession to just the two-month period between February and April 2020.
The next step in monetary policy was to begin pulling back the unprecedented stimulus to get inflation in check. The Fed did so by starting a process known as tapering, in which it gradually slows the pace at which it buys securities.
The FOMC took further action, hiking the benchmark federal funds rate repeatedly between 2022 and 2023, increasing it by over 500 points to its highest level in over 20 years.
Like monetary policy, fiscal policy is either expansionary or contractionary, depending on whether the goal is to boost the economy or tamp down inflation. When the federal government sets fiscal policy it uses different tools than the FOMC does to achieve the same economic stability. This allows fiscal policy to have a much more targeted effect on the economy.
Fiscal policy is determined by Congress and the president, who work together to enact legislation.
When the government wants to expand the economy, instead of increasing the money supply, it spends more, taxes less, and effectively increases aggregate (total) demand within the economy. When it wants to pull back, it implements a policy to cut spending, raise taxes, or do both.
Importantly, the government can target spending, something increasing the money supply doesn't do. It can target the poor, individual industries, geographic areas, and more. Since government is inherently political, there is always a danger money will go to the loudest, most influential voices, or, even worse, be spent on the wrong things.
Using taxes to control the money supply allows for the same targeting as spending, but is also subject to the same political influences. As with spending programs, there are also dangers of misused incentives.
The time lag between implementation and results is shorter with targeted fiscal policy, but the legislative process creates its own delay on the implementation side, according to Professor Robert R. Johnson of the Heider College of Business at Creighton University.
"The economy may benefit from increased fiscal spending or lower tax rates currently, but by the time lawmakers are able to pass appropriate legislation, the economy may have turned and may not need fiscal stimulus," Johnson says. "The Federal Reserve can pivot much more easily with respect to monetary policy than Congress can with fiscal policy."
The government can cut taxes if it wants to stimulate economic growth. For example, the U.S. went into recession in 2000, and in 2001, lawmakers enacted the Economic Growth and Tax Relief Reconciliation Act of 2001 in an effort to stimulate growth.
This legislation cut federal income tax rates, increased the amount that could be contributed to 401(k) plans and individual retirement accounts (IRAs), reduced the federal estate tax, and cut federal capital gains taxes.
In 2003, government officials enacted the Jobs and Growth Tax Relief Reconciliation Act of 2003, further reducing capital gains and dividend taxes.
It is worth noting that the federal government also increased expenditure during the 2000s, to a point where these gains outpaced inflation by 62%, according to a Heritage Foundation report.
While this created substantial budget deficits and caused the national debt to grow, it put money directly into the economy, which helped stimulate expansion.
Other examples of fiscal policy are the CARES Act and the American Rescue Plan Act. The CARES Act, signed into law in 2020, provided more than $2 trillion in stimulus, directed at small businesses and individuals in the form of forgivable loans and direct relief checks, tax law changes to allow penalty-free withdrawals from retirement accounts, and other measures.
The $1.9 trillion American Rescue Plan Act of 2021 provided more stimulus, including money to mount a national vaccination program and safely reopen schools, additional direct relief checks, an extension to unemployment benefits and stipends, emergency rent aid, increased child tax credits, and additional community funding.
Monetary and fiscal policy are controlled by different sets of government officials. People who work for the Fed are responsible for monetary policy, while lawmakers are in charge of fiscal policy.
Although monetary and fiscal policy are both designed to achieve economic stability, the officials responsible for them approach that goal in different ways. The primary difference between fiscal and monetary policy is found in the meaning of the names of the two policies. Monetary refers to the supply of money, or the amount there is to spend. Fiscal implies the budget, or how the money will be spent.
Monetary policy and fiscal policy both have their time constraints. For example, the FOMC can increase (or decrease) the federal funds rate target range during its policy meetings, which happen eight times per year. It can engage in open-market operations (buying and selling of assets) to help ensure the Fed funds rate is within this range, but it usually makes these transactions gradually.
The relatively small FOMC can implement monetary policy quickly compared to the ability of Congress and the president to pass complex legislation. The downside, according Johnson, is the lag between implementation and results.
"The Federal Reserve has a dual mandate of price stability and maximum sustainable employment," says Johnson. "It is difficult, if not impossible, to determine how long it takes for Fed actions to work their way through to the final goals."
Finally, when the Fed cuts interest rates, the demand for dollars to invest in U.S. markets is reduced. The resulting weaker currency makes goods produced in the U.S. cheaper and easier to export. On the other hand, without the watchful eye of the FOMC, inflation and even hyperinflation can result from an overheated economy. As with all things monetary, balance is key.
Note: The time lag between implementation of government policy and results is called a response lag. Other types including recognition lag, decision lag, and implementation lag define delays that can create inefficiencies related to Fed and government economic policies.
Monetary and fiscal policy are both capable of having a significant impact on the economy. The Fed can either stimulate (or help dampen) economic activity through monetary policy. By increasing the fed funds rate, it can place upward pressure on a broad range of interest rates and make it more expensive for consumers and businesses to borrow money. This can help cool down robust business activity in order to help contain inflation.
Fiscal policy can also have a significant impact on the economy. An increase in government expenditure, for example, is one of the fastest ways to stimulate activity, as it puts money directly into the hands of government employees and contractors, who can in turn use it for consumption, which is a major component of GDP and has a significant influence on the job market.
Cutting taxes for businesses can reduce their expenses, making it easier for them to hire employees and purchase new equipment.
Monetary and fiscal policy are most effective when used together. When expansionary policies are needed, the former can be used to boost the money supply and cut interest rates, making it easier for individuals and companies to borrow money. At the same time, fiscal policy can put money right into their pockets either by cutting taxes or bolstering government expenditure.
When the government is looking to bring inflation under control, monetary policy can help shrink the money supply and increase interest rates, making it more costly for individuals and businesses to borrow money, while fiscal policy can reduce the after-tax income of individuals and businesses in order to reduce spending.
Certain nations (for example, the U.S.) have a long history of generating budget deficits. Even if the Fed ratchets up the fed funds rate in order to push interest rates higher, and starts selling assets in order to reduce the money supply, lawmakers may very well continue to spend more than they bring in with tax revenue, a situation that is inherently inflationary.
Expansionary monetary and fiscal policy can place upward pressure on prices by increasing the money supply and providing both individuals and businesses with higher after-tax income.
In contrast, contractionary monetary and fiscal policy can help dampen increases in the price level by reducing the size of the money supply and reducing the after-tax income of consumers and corporations.
Expansionary monetary and fiscal policy can help create jobs by bolstering consumption and giving businesses more money after taxes, therefore making it easier for them to take on additional workers. Contractionary monetary and fiscal policy can do the opposite.
Expansionary monetary policy can easily help reduce interest rates by lowering the federal funds rate. In contrast, contractionary monetary policy can help increase interest rates by increasing this benchmark rate.
What is the main difference between monetary policy and fiscal policy? Chevron icon It indicates an expandable section or menu, or sometimes previous / next navigation options.
Monetary policy is designed to influence the economy through the money supply and interest rates, while fiscal policy involves taxation and government expenditure.
Which is more effective: monetary policy or fiscal policy? Chevron icon It indicates an expandable section or menu, or sometimes previous / next navigation options.
It depends on the time frame you are using. In the short term, monetary policy is more effective, whereas fiscal policy is better at creating long-term, structural changes in the economy.
How do monetary and fiscal policies impact inflation? Chevron icon It indicates an expandable section or menu, or sometimes previous / next navigation options.
Monetary policies impact changes in the price level (inflation) directly by influencing the size of the money supply and interest rates. Fiscal policy affects inflation indirectly through government expenditure and taxation.
A freelance writer and editor since the 1990s, Jim Probasco has written hundreds of articles on personal finance and business-related content, authored books and teaching materials in the fields of music education and senior lifestyle, served as head writer for a series of Public Broadcasting Service (PBS) specials and created radio short-form comedy. As managing editor for The Activity Director's Companion, Jim wrote and edited numerous articles used by activity professionals with seniors in a variety of lifestyle settings and served as guest presenter and lecturer at the Kentucky Department of Aging and Independent Living Conference as well as Resident Activity Professional Conferences in the Midwest.Jim has served on the boards of several nonprofit organizations in the Dayton, Ohio area, including the Kettering Arts Commission, Dayton Philharmonic Education Advisory Committee, and the University of Dayton Arts Series. He is past president of an educational foundation that serves teachers and students in the Kettering (Ohio) City School District.Jim received his bachelor's from Ohio University in Fine Arts/Music Education and his master's from Wright State University in Music Education.
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