Breaking Down Monetary vs. Fiscal Policy

An all-to-often overlooked way that people can affect their financial wellbeing is through their vote. One of the cornerstone concepts to grasp about the Great American Experiment is the distinction between fiscal and monetary policy and the fundamental role that each has in shaping our economy. Having a handle on the big picture, jargon, and responsibility of each will assuredly make you not only a better citizen but a better custodian of your personal wealth, which operates by the careful mechanisms of monetary and financial policy.

Monetary Policy

Our monetary policy is the job of the Federal Reserve. In fact, Congress has mandated that the power to direct our monetary policy be free from political influences, for obvious reasons. Therefore, beyond the congressionally decreed goals of “maximum employment and price stability as the macroeconomic objectives for the Federal Reserve,” the Federal Open Market Committee (FOMC) employs their policy tools independently to achieve those ends (federalreserve.gov). A taste of the tools that the FOMC has at their disposal is the reserve requirement, the discount rate, and open market operations:

  • Reserve requirement: defined by the Federal Reserve as “the amount of funds that a depository institution must hold in reserve against specified deposit liabilities.” In lay people’s terms, this is just measure to regulate the amount of cash a bank can lend out to control the amount of cash available in the economy.
  • Discount rate: defined by Investopedia as “the interest rate charged to commercial banks and other depository institutions for loans received from the Federal Reserve Bank’s discount window.”
  • Open market operations: defined by the Federal Reserve as “the purchase and sale of securities in the open market by a central bank…to adjust the supply of reserve balances so as to keep the federal funds rate around the target federal funds rate established by the Federal Open Market Committee (FOMC).” The federal funds rate is the technical base rate behind the interest rates, or cost of borrowing money, in our economy.

The goal of price stability is achieved through controlling interest rates by means of these various tools and traditionally they pursue a target of a slight inflation rate of 3%. As you may be aware, the Fed generally pinpoints maximum employment at the “natural unemployment rate” of about 5%, to allow for frictional and structural unemployment, both of which are healthy in the cycle of job searching.

Fiscal Policy

Our fiscal policy exists in the realm of Congress, and refers to the manner in which they implement specific legislation in order to influence the U.S. economy. Their legislative powers fall into two huge categories: revenue collection (taxes) and spending. With every action taken, whether it is the purchase of goods and services, collection of taxes, or transfer payments, Congress attempts to reallocate resources within the economy to their highest valued use to society as a whole. This is crucial because while our free market economy is generally good at efficiently allocating resources to their highest valued uses, we naturally have other concerns such as equality and positive or negative externalities that are not taken into account by the market price of a good or service.

Fiscal policy is characterized as tight (or contractionary) when the revenues exceed the spending and the budget is in surplus, and loose (or expansionary) when the spending exceeds the revenues causing a budget deficit. In layman’s terms, tight fiscal policy is when the government will increase taxes and/or reduce spending, causing the budget deficit to shrink with the extra revenue. A loose fiscal policy will be designed to cut taxes and/or increase spending and usually causes the budget deficit to grow. The Concise Encyclopedia of Economics further clarifies that, “the focus is not on the level of the deficit, but on the change in the deficit.” Overall, fiscal policy is crucial for successful stabilization of the economy, as it has the power to affect aggregate demand, or raising the demand for goods and services since the government becomes a buyer in the markets.

Their Relationship

Clearly, both are extensively interrelated and rely upon each other to provide the framework for our economy, where the American Dream continues to true in each generation. The Federal Reserve’s webpage reminds that, “the FOMC considers how the current and projected paths for fiscal policy might affect key macroeconomic variables such as gross domestic product growth, employment, and inflation. In this way, fiscal policy has an indirect effect on the conduct of monetary policy through its influence on the aggregate economy and the economic outlook.” Jointly, Congress and the fiscal policies which it imparts are directly influenced by the interest rates and such that the Fed controls.

Conclusion

Since the average citizen has a low incentive to become sufficiently educated on such topics, this quick reference ought to be useful in making it easier for our vote to more faithfully represent our actual desires. It is important to understand both fiscal and monetary policy since each has not only direct but unintended consequences on the financial wellbeing of ourselves and those we love. Though our political voice can only affect our representatives whose legislation makes up fiscal policy, understanding monetary and fiscal policy, which are essentially the rules that we play by in our economy, will only bring greater clarity and order to our financial decisions.

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