Monetary and Fiscal Policy
The Monetary and Fiscal Policies, although controlled by two
different organizations, are the ways that our economy is kept under
control. Both policies have their strengths and weaknesses, some
situations favoring use of both policies, but most of the time, only
one is necessary.
The monetary policy is the act of regulating the money supply
by the Federal Reserve Board of Governors, currently headed by Alan
Greenspan. One of the main responsibilities of the Federal Reserve
System is to regulate the money supply so as to keep production,
prices, and employment stable. The "Fed" has three tools to manipulate
the money supply. They are the reserve requirement, open market
operations, and the discount rate.
The most powerful tool available is the reserve requirement.
The reserve requirement is the percentage of money that the bank is
not allowed to loan out. If it is lowered, banks are required to keep
less money, and so more money is put out into circulation
(theoretically). If it is raised, then banks may have to collect on
some loans to meet the new reserve requirement.
The tool known as open market operations influences money and
credit operations by buying and selling of government securities on
the open market. This is used to control overall money supply. If the
Fed believes there is not enough money in circulation, then they will
buy the securities from member banks. If the Fed believes there is too
much money in the economy, they will sell the securities back to the
banks. Because it is easier to make gradual changes in the supply of
money, open market operations are use more regularly than monetary
When member banks want to raise money, they can borrow from
Federal Reserve Banks. Just like other loans, there is an interest
rate, or a discount rate, the third tool of the monetary policy. If
the discount rate is high, then fewer banks will be inclined to
borrow, and if it is low, more banks will (theoretically) borrow from
the reserve banks. The discount rate is not used as frequently as it
was in the past, but it does serve as an indicator to private bankers
of the intentions of the Fed to constrict or enlarge the money
The monetary policy is a good way to influence the money
supply, but it does have its weaknesses. One weakness is that tight
money policy works better that loose money policy. Tight money works
on bringing money in to stop circulation, but for loose policy to
really work, people have to want loans and want to spend money.
Another problem is monetary velocity. The number of times per year a
dollar changes hands for goods and services is completely independent
of the money supply, and can sometimes contradict the efforts of the
Fed. The benefits of the monetary system are that it can be enacted
immediately with quick results. There are no delays from congress.
Second, the Fed uses partisan politics, and so has no ties to any
political party, but acts in the best interests of the U.S. Economy.
The second way to influence the money supply lies in the hands
of the government with the Fiscal Policy. The fiscal policy consists
of two main tools. The changing of tax rates, and changing government
spending. The main point of fiscal policy is to keep the
surplus/deficit swings in the economy to a minimum by reducing
inflation and recession.
A change in tax rates is usually implemented when inflation is
unusually high, and there is a recession with high unemployment. With
high inflation, taxes are increased so people have less to spend, thus
reducing demand and inflation. During a recession with high
unemployment, taxes are lowered to give more people money to spend and
thus increasing demand for goods and services, and the economy begins
A change in government spending has a stronger effect on the
economy than a change in tax rates. When the government decides to
fight a recession it can spend a large amount of money on goods and
services, all of which is released into the economy.
Despite the effectiveness of the Fiscal policy, it does have
drawbacks. The major problems are timing and politics. It is hard to
predict inflation and recession, and it can be a long period of time
before the situation is even recognized. Because a tax cut can take a
year to really take effect, the economy could revive from the
recession and the new unnecessary tax cut could cause inflation.
Politics are another problem. Unlike the monetary policy run
by the partisan Fed, the fiscal policy is initiated by the government,
and so politics play a key role in the policy. When the concerns of
the government are viewed, it becomes obvious that a balanced budget
is not the primary objective, anyway. The fiscal policy can also be
used as a campaign tactic. If tax cuts are initiated and government
spending is increased, then the president is more likely to be
re-elected, but has first to deal with the inflation his tactic
Monetary and fiscal policies are what helps keep the nation's
economy stable. With them it is possible to control demand for
services and goods and the ability to pay for them. It is possible to
manipulate the money in private hands without directly affecting
them. The policies are simply a myriad of tools used to prevent a long
period where there is high unemployment, inflation, and prices, along
with low wages and investment.