Monetary and Fiscal Policies
The government employs two main policy tools to manage the economy: monetary policy (controlling money supply and interest rates) and fiscal policy (taxation and spending). Understanding how each works is essential for predicting market movements.
Monetary vs Fiscal Policy
| Aspect | Monetary Policy | Fiscal Policy |
|---|---|---|
| Controlled by | Federal Reserve Board (the Fed) | Congress and the President |
| Tools | Discount rate, open market operations (OMOs), reserve requirements, Regulation T | Government spending, taxation |
| Expansionary | Lower rates, buy securities, lower reserves | Increase spending, cut taxes |
| Contractionary | Raise rates, sell securities, raise reserves | Decrease spending, raise taxes |
| Goal | Manage money supply and interest rates | Influence aggregate demand |
Exam Tip: Gotchas
- The Federal Reserve has nothing to do with fiscal policy. Fiscal = Congress/President (taxes, spending). Monetary = Fed (money supply, rates). These are constantly confused on the exam.
Monetary Policy (Federal Reserve)
- Monetary policy is controlled by the Federal Reserve Board (the Fed)
- The Fed's dual mandate: maximum employment and stable prices (target ~2% inflation)
- The Fed influences the economy by controlling the money supply and interest rates
Federal Reserve Tools (DORM)
| Tool | Description | Expansionary Action | Contractionary Action |
|---|---|---|---|
| Discount rate | Rate the Fed charges banks for direct borrowing | Lower the rate | Raise the rate |
| Open market operations (OMOs) | Fed buying/selling government securities | Buy securities (injects cash) | Sell securities (drains cash) |
| Reserve requirements | Percentage of deposits banks must hold in reserve | Lower requirements (banks lend more) | Raise requirements (banks lend less) |
| Margin (Regulation T) | Margin requirement for securities purchases (currently 50%) | Lower Reg T (more borrowing) | Raise Reg T (less borrowing) |
Key distinctions:
- Open market operations are the most frequently used tool of the Fed
- The discount rate is the only rate the Fed directly controls
- The federal funds rate is the overnight rate banks charge each other for lending reserves; the Fed targets this rate but does not set it directly
Expansionary (loose) monetary policy:
- Goal: stimulate economic growth during contraction/recession
- Actions: buy securities, lower discount rate, lower reserve requirements
- Effect: increases money supply, lowers interest rates, encourages borrowing and spending
Contractionary (tight) monetary policy:
- Goal: slow economic growth and combat inflation during expansion/peak
- Actions: sell securities, raise discount rate, raise reserve requirements
- Effect: decreases money supply, raises interest rates, discourages borrowing and spending
Fiscal Policy (Congress and the President)
Fiscal policy refers to the government's use of spending and taxation to influence the economy. It is controlled by Congress and the President.
Expansionary fiscal policy:
- Increase government spending and/or decrease taxes
- Stimulates economic activity during contraction
- Results in budget deficits (spending exceeds revenue)
Contractionary fiscal policy:
- Decrease government spending and/or increase taxes
- Slows economic activity during expansion/peak
- Results in budget surpluses (revenue exceeds spending)
Crowding Out Effect
- When government borrowing to finance deficits competes with private borrowers for available funds
- Increased demand for loanable funds drives up interest rates
- Higher rates make it harder for businesses and consumers to borrow - crowding out private investment
Multiplier Effect
- Government spending creates a ripple effect as money circulates through the economy
- Each dollar spent generates more than one dollar of economic activity
- Multiplier is generally larger during recessions than during expansions
Exam Tip: Gotchas
- A deficit = expansionary fiscal policy. A surplus = contractionary fiscal policy.