Quick Answer
The Federal Reserve runs monetary policy: open market operations, administered rates, the discount window, and reserve requirements, aimed at money supply and interest rates. Congress and the President run fiscal policy: government spending and taxation, aimed at aggregate demand. Expansionary versions of each stimulate a contracting economy; contractionary versions slow an overheating one.
The exam leans hard on keeping these two levers straight, since both aim at the same goal (a stable, growing economy) through completely different actors and tools. The sections below break down each lever's tools, then the crowding-out and multiplier effects that connect fiscal policy back to interest rates.
Who Controls Which Policy?
| Aspect | Monetary Policy | Fiscal Policy |
|---|---|---|
| Controlled by | Federal Reserve Board (the Fed) | Congress and the President |
| Tools | Open market operations (OMOs), administered rates (including the discount rate), the discount window, reserve requirements | 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 policy is Congress and the President setting taxes and spending; monetary policy is the Fed managing money supply and rates. These are constantly confused on the exam.
How Does the Fed Implement Monetary Policy?
- Monetary policy is controlled by the Federal Reserve Board (the Fed)
- The Fed's dual mandate: maximum employment and stable prices (target roughly 2% inflation)
- The Fed influences the economy by controlling the money supply and interest rates
Federal Reserve tools:
| Tool | Description | Expansionary Action | Contractionary Action |
|---|---|---|---|
| Open market operations (OMOs) | Fed buying/selling government securities | Buy securities (injects cash) | Sell securities (drains cash) |
| Administered rates | Rates the Fed sets directly, including the discount rate and interest on reserve balances | Lower rates | Raise rates |
| Discount window | Direct Federal Reserve lending to eligible institutions | Make credit cheaper or more available | Make credit more expensive or less available |
| Reserve requirements | Percentage of deposits banks must hold in reserve | Lower requirements (banks lend more) | Raise requirements (banks lend less) |
Key distinctions:
- Open market operations are the Fed's most frequently used tool
- The Fed directly sets its administered rates, including the discount rate. The discount rate is not the only rate the Fed controls directly
- The federal funds rate is the overnight rate banks charge each other for lending reserves. The Federal Open Market Committee sets a target range for it and steers the actual market rate into that range primarily through administered rates, but market transactions between banks determine the actual rate
Exam Tip: Gotchas
- Do not treat the discount rate as the only rate the Fed sets directly. The Fed also directly administers other rates, such as interest on reserve balances, and uses those administered rates as its primary way of steering the federal funds rate toward its target range.
- The initial margin requirement on securities purchases (currently 50%, set under Regulation T) is set by the Fed but is a securities-credit rule, not one of the Fed's monetary policy implementation tools above. Do not list it alongside open market operations, administered rates, the discount window, and reserve requirements as a fifth monetary policy tool.
Expansionary (loose) monetary policy:
- Goal: stimulate economic growth during contraction/recession
- Actions: buy securities, lower administered rates (including the 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 administered rates (including the discount rate), raise reserve requirements
- Effect: decreases money supply, raises interest rates, discourages borrowing and spending
How Does Fiscal Policy Work?
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)
What Is the Crowding Out Effect?
- Occurs 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
What Is the 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 budget deficit means expansionary fiscal policy. A surplus means contractionary fiscal policy.
What Should You Check on Exam Day?
- Know which actor controls which policy: the Fed for monetary, Congress and the President for fiscal
- Know all four monetary tools (OMOs, administered rates including the discount rate, the discount window, reserve requirements) and that OMOs are used most often
- Do not call the initial margin requirement a monetary policy tool; it is a Fed-set securities-credit rule
- Match expansionary and contractionary actions to their effect on money supply, rates, spending, and taxes
- Connect a budget deficit to expansionary fiscal policy and a surplus to contractionary fiscal policy
- Be able to explain crowding out (deficit financing raises rates, squeezing private borrowers) and the multiplier effect (each dollar of spending generates more than a dollar of activity)