Governments often influence the economy through fiscal and monetary policy. A central bank, such as the Federal Reserve in the United States, typically sets monetary policy. National governments, like the U.S. Congress, may decide fiscal policy. Learn the key components of fiscal vs monetary policy here.
In the United States, the Federal Reserve sets and manages monetary policy and uses it to influence the economy. Monetary policy generally encourages growth or slows inflation by managing money supply and demand. In other countries, central banks, regulatory authorities and the International Monetary Fund steer the monetary policy of other countries. Monetary policy affects many aspects of a country’s economy, from interest rates to the stock market. However, its effects can last for generations.
The Federal Reserve decides whether to expand or contract the economy based on factors such as the gross domestic product (GDP), inflation, and the unemployment rate. Stimulating the economy is designed to raise the GDP. Meanwhile, more restrictive monetary policy is designed to slow the economy to offset inflation, either in the present or the future.
The Federal Reserve has a variety of tools to affect monetary policy. For example, the Fed wants to increase inflation, it will put more money in circulation. If the Fed wants to decrease inflation, it will take money out of circulation.
Fed Monetary Policy Tools
The Federal Reserve has a number of tools at its disposal for influencing monetary policy. Below are just a few examples
The discount rate
Interest on reserves
The Fed can use this to either encourage or discourage banks to lend money. This is interest paid to banks by the Federal Reserves on the money the banks have with them. When the Fed lowers the interest rate, banks are incentivized to lend out more money. As a result, they can make more money by lending it out than by keeping it with the Fed. When the Fed raises the interest rate, banks are encouraged to increase their reserves. They can make more money that way.
This is how much banks and financial institutions are obligated to hold in reserve, relative to customer deposits. This is determined by the Fed. If the reserve requirement increases, it decreases the money supply in the economy and potentially inflation as well. If the reserve requirement decreases, it increases the money supply in the economy.
Open market operations (OMO)
This is when the Fed buys or sells government securities to expand or contract the market. Buying Treasuries will expand the market, by putting new money into the hands of individuals and corporations. Selling treasuries will contract the market by putting money into government funds or reserves.
Quantitative easing is another tool that the Fed used during the 2008 financial crisis. It and other central banks reduced interest rates to nearly 0% and made very large open market purchases. This was intended to try to get consumers to take out more loans and buy more expensive items like household appliances, cars, and houses. The goal was to grow the economy and get it out of the recession.
Fiscal policy involves the taxes the government collects and how much money it spends. In the United States, Congress controls fiscal policy. The goal of most government fiscal policy is to target the total level of spending, the total composition of spending, or both. The two most common ways of affecting fiscal policy are changes in government spending policies or tax policies. Tax cuts and spending increases are expected to stimulate economic growth in the short run, while tax increases and spending cuts are generally expected to slow future economic expansion and inflation.
If the government wants more business activity in the economy, it will increase the amount of money it spends in order to stimulate the economy. This is often referred to as stimulus spending. If not enough in taxes has been collected in order to pay for the spending increase, the government can borrow money by issuing debt securities like government bonds. That is deficit spending, and it is a way that a government can accumulate debt. The government might also cut taxes in order to increase spending. If people have more money, they will generally spend more money, which will increase business activity. Expansionary fiscal policy can risk sparking inflation, which means the value of your income initially decreases until your company gives you a raise, or permanently decreases your income if you are on a fixed income.
Fiscal Policy Motivation
If a government wants to lower business activity in the economy, it can raise taxes. This pulls money out of the economy and as a result slows business activity. However, this only applies to lower income earners. The amount the wealthy pay in taxes doesn’t typically encourage economic growth. High income earners spend much less for every tax dollar saved than low income earners. In addition, governments typically use fiscal policy to stimulate the economy, not to slow down the economy.
However, fiscal policy is not always based on economic considerations. Fiscal policy may help or hurt specific industries, communities, investments, and commodities. Since elected officials make those decisions, they may cater to constituents or donors. In addition, where a politician falls on the political spectrum can impact their perspective on fiscal policy. If you lean to the left on the fiscal policy spectrum, you are generally more likely to push for higher government spending and higher taxes. If you lean to the right on the fiscal policy spectrum, you are generally more likely to prefer lower government spending and lower taxes.
Fiscal vs Monetary Policy
Monetary policy often impacts the economy broadly. Meanwhile, fiscal policy often has less efficient influence on economic trends. However, both monetary and fiscal policy can stimulate or decrease economic growth, by implementing policies that either tend to increase or decrease spending in the economy.
Both fiscal policy and monetary policy can affect consumers. Fiscal policy can lead to increased employment and income, through policies like government expanding or tax cuts for lower-income earners. Monetary policy can affect your stock portfolio and interest rates if you are considering getting a mortgage. When interests rates are low, real estate sales tend to go up because buyers can afford to get a larger mortgage. When interest rates go down, cash and other commodities can become better investments.
The Bottom Line
If there are big shifts in monetary policy, you’re probably going to want to consult with a financial advisor to see how these shifts will affect your portfolio. Then, see if you should change any of your investments. Changes in fiscal policy can be obvious, as they typically appear in your year-end tax bill. When there are changes in tax policy, you may want to consult a tax attorney or another advisor who can help you with your tax planning.
- Changes in monetary or fiscal policy may affect your finances. You might want to consult a financial advisor to find out if and how these changes could impact you, positively or negatively. Finding the right financial advisor who fits your needs doesn’t have to be hard. SmartAsset’s free tool matches you with financial advisors in your area in 5 minutes.
- Worried about inflation affecting your retirement plans? You can check out our inflation calculator here.
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