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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
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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.