Monetary policy vs. Fiscal policy: comparison, examples

  • Monetary policy seeks to control the economy by manipulating the money supply and interest rates.
  • Fiscal policy is designed to achieve the same goal using targeted taxes and spending.
  • The Achilles heel of the two types of policies are the lags between implementation and results.
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In 1992, when presidential campaign adviser James Carville told Bill Clinton’s staff, “It’s the economy, idiot! He stressed the importance of what matters most to a majority of voters.

The two most widely recognized tools for influencing the economy and satisfying voters are monetary policy, created by the Federal Reserve, and fiscal policy, which is the responsibility of Congress and the President. Both play an important role in maintaining a stable and balanced US economy.

Monetary policy vs fiscal policy: at a glance

While monetary and fiscal policies are both designed to achieve economic stability, those responsible for them approach this goal on different fronts. The main difference between fiscal policy and monetary policy is in the meaning of the names of the two policies. Monetary refers to the supply of money, or how much there is to spend. Tax involves the budget, or how the money will be spent.

  • Monetary policy involves the manipulation of interest rates and the money supply and is the responsibility of the Federal Open Market Committee (FOMC).
  • Fiscal policy, determining how the existing money supply will be spent, is the responsibility of the United States Congress and the President, who use fiscal policy and spending legislation to achieve economic stability.

What is monetary policy?

Monetary policy, which can be broadly described as expansionary or restrictive, is defined by the Fed, a non-governmental body created by Congress in 1913.

To set monetary policy, the FOMC, which usually meets eight times a year, controls the money supply by buying (or selling) securities in the open market, changing the reserve requirements of federal banks, and raising or lowering. the interest rate that the Fed charges banks that borrow, called the discount rate.

By increasing the money supply, the Fed’s action can lower interest rates, make borrowing easier, increase gross domestic product, reduce unemployment, and revive the stock market. When inflation or hyperinflation threatens to overheat the economy, the Fed tightens (shrinks) the money supply to avoid inflation or even hyperinflation.

The government’s fiscal policy, which relies on public spending and fiscal policies, attempts to grow or contract the economy to achieve the same goals as the Fed’s monetary policy, simply through different means.

In the case of monetary policy, targeted interest rates, for example, can put downward pressure on inflation or provide a much needed boost over a period of time.


recession

. It helps that the Fed is by design neutral, unencumbered by the political machinations of Congress. Neutral or not, however, the impact of monetary policy is broad. It affects the whole economy and targeted implementation is almost impossible.

The relatively small FOMC can implement monetary policy quickly relative to Congress’ ability to pass complex legislation. The downside, according to Professor Robert R. Johnson of Creighton University’s Heider College of Business, is the lag between implementation and results.

“For example, the


Federal Reserve

has a dual mandate of price stability and maximum sustainable employment, “Johnson said.” It is difficult, if not impossible, to determine how long it takes for the Fed’s actions to reach the end goals. “

Finally, when the Fed lowers interest rates, the demand for dollars to invest in the US markets is reduced. The resulting weaker currency makes goods produced in the United States cheaper and easier to export. On the other hand, without the watchful eye of the FOMC, inflation and even hyperinflation can result from an overheating economy. As with anything monetary, balance is key.

Example of monetary policy

During the coronavirus pandemic, the Fed’s ability to control a booming economy through monetary policies was put to the test. First, he brought short-term interest rates to zero. When that proved insufficient, the FOMC began buying $ 120 billion worth of bonds and mortgage-backed securities each month.

These measures were aimed at keeping interest rates low and increasing the money supply to help support the economy, which had contracted to 19.2%. The Fed’s actions limited the duration of the recession to just two months between February and April 2020.

The next step in monetary policy was to start withdrawing the unprecedented stimulus to bring inflation under control. The Fed did this by initiating a process known as tapering, in which it gradually slows the rate at which it purchases securities.

What is tax policy?

Like monetary policy, fiscal policy is either expansionary or restrictive, depending on whether the objective is to stimulate the economy or to contain inflation. When the federal government sets fiscal policy, it uses different tools than the FOMC to achieve the same economic stability. This allows fiscal policy to have a much more targeted effect on the economy.

When the government wants to grow the economy, instead of increasing the money supply, it spends more, taxes less, and effectively increases aggregate demand in the economy. When it wants to retire, it implements a policy of reducing spending, increasing taxes, or both.

Importantly, the government can target spending, which the money supply does not increase. It can target the poor, individual industries, geographic areas, etc. Since government is inherently political, there is always a risk that the money will go to the loudest and most influential voices, or worse yet, be spent on the wrong things.

Using taxes to control the money supply allows 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 timeframe between implementation and results is shorter with targeted fiscal policy, but the legislative process creates its own delay on the implementation side, according to Johnson.

“The economy may benefit from increased tax expenditures or lower tax rates now, but by the time lawmakers are able to pass appropriate legislation, the economy may have turned and may not need a fiscal stimulus, ”Johnson said. “The Federal Reserve can pivot much more easily with respect to monetary policy than Congress can with fiscal policy.”

Fiscal policy can be used to effectively reduce unemployment and poverty, a big plus, but also easily lead to budget deficits. In fact, deficit spending contributions resulting from fiscal policy are the primary reason the United States’ annual deficit for 2021 was $ 2.77 trillion. However, this deficit and the deficit of $ 3.13 trillion in 2020 are mainly the result of government spending to counter the impact of the pandemic.

Example of tax policy

Monetary and fiscal policy helped bring relief during the pandemic. On the fiscal policy side, the CARES Act and the American Rescue Plan Act are prime examples.

The CARES law, enacted in 2020, provided more than $ 2 trillion in stimulus measures, aimed 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 set up a national immunization program and reopen schools safely , additional direct relief checks, an extension of unemployment benefits and allowances, emergency rent assistance, an increase in child tax credits and community funding.

The financial report

Monetary policy and fiscal policy are powerful mechanisms for influencing and stabilizing the economy. The main problem in both cases is the lag, either between idea and implementation, or between implementation and results.

These time lags represent an Achilles heel when it comes to government or Fed responses to economic disasters. Recognition is the best way to combat the negative effects of these delays. Monetary and fiscal policy makers need to plan for the unexpected, as data is scarce in both areas.

In addition, the two types of decision-makers should work together to take advantage of all the tools at their disposal to avoid cases where the actions of one agency outweigh those of the other.


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