Monetary and Fiscal Policies

Economic policy makers use monetary and fiscal policies to influence the economy. 

Monetary policies are enacted by the Federal Reserve Board and its Federal Open Market Committee. Monetary policies involve setting targets for short-term interest rates to either fight inflation or stimulate a sagging economy.

The Federal Reserve Board (The Fed) requires that its member banks keep a certain percentage of their customer deposits in reserve. This is called the reserve requirement. If the Fed raises the reserve requirement, banks have less money to lend out to people trying to buy homes and start businesses. So, if the economy is overheating, the Federal Reserve Board could raise the reserve requirement to cool things down, and if the economy is sluggish, they could lower the requirement to make more money available to fuel the economy.

However, of the three main tools of monetary policy changing the reserve requirement is the most drastic measure and, therefore, the tool used least often by the Federal Reserve.

In a nutshell that means that if banks can lend out maybe $10 for every $1 they have on reserve, when the Federal Reserve Board changes the amount required to be deposited in reserve by just a little bit, the effects are multiplied throughout the financial system. The multiplier effect is calculated by taking total bank deposits divided by the reserve requirement.

The Fed's Federal Open Market Committee (FOMC) can also use open market operations and either buy or sell US. Treasury securities on the secondary market. If they want to cool things down by raising interest rates, they sell Treasuries on the open market to depress their price and, thereby, increase their yield. If they want to fuel a sluggish economy by lowering interest rates, they buy Treasury securities, thereby driving up their price, which is the same thing as pushing down their yield.

Yields and rates are the same thing. It is the price of debt securities that moves in an inverse relationship to rates/yields. We will look at interest rates and bond prices in more detail up ahead.

When people say the FOMC is raising short-term interest rates by 25 basis points, they're talking about the discount rate, which is the rate the Federal Reserve Board charges banks that borrow directly from the FRB. If banks have to pay more to borrow, they will in turn charge their customers more to borrow from them. So, if the Fed wants to raise interest rates, they just raise the discount rate and let the banking system take it from there.

The Federal Reserve Board does not set tax policy they enact monetary policy. And, typically, they only influence short-term interest rates, although if circumstances require it, they can also influence longer-term rates reflected by Treasury Notes and Treasury Bonds.

The Securities Exchange Act of 1934 covers many aspects of the securities industry. This legislation gave the Federal Reserve Board the power to establish margin requirements under Regulation T and Regulation U. These regulations stipulate how much credit can be extended by broker-dealers and banks in connection with customer margin accounts. So, as with the other tools above, the Federal Reserve Board can make credit more available or less available through margin requirements, depending on the direction of their current monetary policy.

You can think of the Federal Reserve Board/FOMC as a sort of pit crew trying to perform tune-ups on an economy that never pulls over for a pit stop. If the economy starts going too fast, they let some air out of the tires by raising the reserve requirement, raising the discount rate, and selling Treasury securities. If the economy starts to slow down, they pump some air into the tires by lowering the reserve requirement, lowering the discount rate, and buying Treasuries.

Inflation is most likely to occur during the phase of the business cycle called the "peak," a time associated with the phrase "irrational exuberance" during which too many investors and entrepreneurs are convinced that things will keep improving forever.

To fight inflation the Fed slows things down by raising interest rates. Deflation is found during the contraction. To fight deflation the Fed pumps air back into the economy by lowering interest rates.

If the Federal Reserve is fighting inflation, this could be referred to as "tight credit" or a "tight money policy." If the "Fed" is pumping inflation back into the economy, the exam could call this "loose credit" or a "loose-money policy".

Fiscal policy is what the President and Congress do: tax and spend. Keynesian economists recommend that fiscal policy be used to increase aggregate (overall) demand for goods and services.

To stimulate the economy, just cut taxes and increase government spending. Reduced taxes leave more money for Americans to spend and invest, fueling the economy. If the government is spending more on interstate high-way construction, this means a lot more workers are going to be hired for construction crews. Or maybe the federal government orders military transport vehicles from a unit of GM. If so, GM will order a lot more parts from suppliers and hire more workers, who would make and spend more money to push the economy along.

On the other hand, if we need to cool things down, followers of Keynesian economics suggest that the federal government increase taxes and cut spending. Higher taxes leave less money for Americans to spend and invest, and decreased spending puts less government money into companies, who, in turn, spend less money on supplies, equipment, and salaries.