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Fiscal Policy and Monetary Policy Following the 1989 collapse of the Soviet Union, many people cited the United States’ free market as its key advantage over the state-controlled economy of the USSR. Capitalism seemed to have won the day and many Americans reaped the benefits of an unfettered market. But it is a mistake to believe that our “free market” stands completely detached from the government. The truth is the government uses numerous policies and plans to influence the economy and keep swings in the market from getting out of hand. Government and the Economy The drawback to the fierce competition and effort required by capitalism is that the economy can be subject to boom and bust cycles. When an economy is strong, people tend to spend more and invest in longterm plans. This optimism pushes the economy faster and faster, causing spikes in inflation and interest rates. Eventually, the economy slows and people begin to hold on to more of their money. More often than not, the drop in market participation causes a sudden, brief economic recession. Workers lose jobs, businesses are reevaluated—with some closing—borrowing drops and people consume fewer goods. If the conditions are right, the economic pause can lead to a downward spiral of dropping demand and increased unemployment. During the Great Depression, the government started to take on the responsibility of influencing the economy for the good of citizens. The goal was not to change the process of free trade, but to keep the inevitable swings Northern Oak Wealth Management, Inc. 555 E. Wells St. Suite 1625 Milwaukee, WI 53202 www.northern-oak.com (414) 278-0590 of the market from becoming dangerously severe. The government primarily influences the economy through its use of the federal monetary and fiscal policies. Fiscal Policy U.S. fiscal policy is simply how the government uses taxation and spending (i.e. the U.S. budget) to influence the economy. When the economy is running above or below its optimal level, the government can alter the budget to influence its level of output. If, for instance, the economy is on a powerful upswing and in danger of overheating, the government may choose to raise taxes or decrease spending to remove some money from the market. Or, if the economy is slow, the government might increase its spending as a way to create jobs until consumer demand rises. The U.S. government likes to see fiscal and monetary policy working together to create an economy that behaves reasonably under all conditions. Fiscal policy is often described as either being “loose” or “tight.” Loose fiscal policy means the government is increasing spending or cutting taxes in hopes of spurring the economy. Since the goal is for the government to put more money into the economy than it takes out, loose fiscal policy usually means government deficit spending. This article was written by Advicent Solutions, an entity unrelated to Northern Oak Wealth Management, Inc.. The information contained in this article is not intended to be tax, investment, or legal advice, and it may not be relied on for the purpose of avoiding any tax penalties. Northern Oak Wealth Management, Inc. does not provide tax or legal advice. You are encouraged to consult with your tax advisor or attorney regarding specific tax issues. ©2013 Advicent Solutions. All rights reserved. Not surprisingly, “tight” fiscal policy is the opposite of loose policy. Tight fiscal policies usually result in higher tax rates or the termination of tax loopholes. The government may also choose to slow programs or close public works projects that are no longer needed. A tighter budget reduces deficits and potentially creates budget surpluses that can offset the debt caused when loose policy was needed. Temporary measures to tighten or loosen fiscal policy may be effective, but they are not always timely. New legislation on spending or tax hikes can easily take over a year to move through Congress, and may miss the point when it would do most good. Fortunately, some parts of fiscal policy are automatic. These are programs or rates, which are always in effect, but become more used as the economy moves up or down. For instance, during an economic downturn, more people lose their jobs and require government assistance. As program use increases, the budget loosens as more money is put into the pockets of people who need it. This not only helps preserve citizen wellbeing but also supplies money to the economy and keeps demand from falling too low. On the other end, income tax brackets help tighten fiscal policy when the economy picks up speed. An economic boom means higher wages for employees—and higher wages mean higher nominal taxes. The new tax revenue can help the government get a budget surplus and put money aside for future needs. The general goals of fiscal policy are usually simple: either speed up or slow down the economy. However, the government is able to target specific industries or groups to stimulate some forms of economic behavior over others. Usually, this type of specific fiscal policy takes the form of targeted tax breaks or hikes, such as middle-class tax breaks, green energy tax credits, etc. Potential Problems with Fiscal Policy The problems associated with fiscal policy usually occur with a prolonged policy of overspending. Chronic government deficits can damage the credibility of a government and make repayment of debt difficult. However, many hold the belief that in most situations, it is better to fix economic problems first so that debt can be reduced faster later on. If a government is able to pull a country out of a recession, they can cease stimulus and allow for the automatic tightening of the policy (less people using assistance, higher tax revenues). A secondary problem with fiscal expansion is the possibility that government spending will cause direct or indirect damage to companies trying to expand. The deficits that accompany loose fiscal policy require an increase in government-issued bonds. Some claim that the increased availability of government bonds drives down or “crowds out” the demand for private bonds, making it harder for companies sell the bonds needed to fund growth. Monetary Policy U.S. monetary policy takes a less direct approach to influencing the economy. Whereas fiscal policy controls how the government spends money in the economy, monetary policy attempts to control how easy it is for people and companies to access money they need to expand. The control of monetary policy largely comes down to the Federal Reserve (commonly referred to as “the Fed”). The Fed is a quasi-government system of 12 banks that provide economic stability to the various regions of the country. They act as a backstop for private banks and are willing to loan out money to them if they run short on cash. Its role as the nation’s cash reserve gives the Fed the unique ability to manipulate the average interest rates on loans in the country. When the Fed decides interest rates need to go lower, it drops the rate at which it loans out money to banks or provides them with an excess of cash through bond-buying programs. The banks, eager to put the new cash to use, loan it out to individuals at decreased rates. Alternatively, the Fed can also withdraw money and raise its loan rates, driving up the cost of private borrowing. Like with fiscal policy, monetary policy is referred to as either being “loose” or “tight.” The low rates of loose policy encourage people to take out loans for business expansion or to purchase goods they had been saving up to buy. It is meant to make people more inclined to spend rather than save, which can help jumpstart consumer demand in a declining economy. Tight monetary policy is usually used when the Fed wants to protect the economy from excessive growth. When an economy is allowed to expand too quickly, it can have serious inflation issues and hurt average consumers. If the Fed sees the economy (or inflation) is increasing at a dangerous rate, it can tighten monetary policy, make some loans impractical and limit growth at safe levels. Since fiscal policy can take over a year to implement, monetary policy is usually the first tool the government uses to adjust the economy. However, monetary policy is less direct and less precise than fiscal policy; it tries to change overall market climate rather than increase or decrease the amount of cash in people’s pocket. Potential Problems with Monetary Policy Many economists argue that the biggest risk from monetary policy is inflation-related. Keeping a loose policy during a growing economy will almost certainly lead to high inflation. However, if policy is tightened too much or is not allowed to loosen during a weak economy, the country might experience “deflation,” which can lead to money hoarding and a further economic contraction. Working Together The government likes to see fiscal and monetary policy working together to create an economy that behaves reasonably under all conditions. It must tighten or loosen both policies as needed to combat the unique threats of each economic situation. Each policy may be enough to combat problems on its own, but goals are met much quicker when both policies are in use. Unfortunately, the government is not always able to reach a consensus on the proper course of action for its policies. Monetary policy may be loosened or tightened as long as inflation is kept in check, but fiscal policy cannot be changed until Congress agrees that the changes are in the best interest of the people. Citizens should remember that fiscal and monetary policy are tools the government uses to influence the economy, not control every aspect of it. The U.S. government might like to encourage growth or slow inflation, but it cannot decide what people do and how they respond to economic challenges. The consumers are in charge of the free market system, and they decide how far it goes. Fiscal and monetary policies are meant to protect our economy and make sure we keep the right momentum to continue moving forward.