Our government and the Federal Reserve use two powerful tools to steer our economy in the right direction: fiscal and monetary policy. If used properly, they can produce similar results in stimulating our economy and slowing it down as it heats up. The ongoing debate is which one is more effective in the long-term and short-term.
Fiscal policy means that our government uses its spending and taxing power to influence the economy. The combination and interaction of government expenditures and revenue collection is a delicate balance, which requires a good timing and a little luck. The direct and indirect effects of fiscal policy will affect personal expenditures, capital expenditures, exchange rates, deficit levels, and even interest rates that are usually related to monetary policy.
Fiscal Policy and the Keynesian School
Fiscal policy is usually associated with Keynesianism, whose name comes from the British economist John Maynard Keynes. His main work “General Theory of Employment, Interest, and Currency” has influenced new theories about economic operations and is still being studied. He developed most of his theories during the Great Depression, and over time, Keynesian theories have been used and misused because they are popular and are often specifically used to alleviate economic recessions.
In short, Keynesian economic theory is based on the belief that the positive actions of our government are the only way to guide the economy. This means that the government should use its power to increase aggregate demand by increasing spending and creating a loose monetary environment, which should stimulate the economy by creating jobs and ultimately promoting prosperity. The Keynesian theory movement showed that monetary policy itself has its limitations in resolving financial crises, thus triggering a debate between Keynesianism and monetarism.
Despite the successful use of fiscal policy during and after the Great Depression, Keynesian theory was questioned in the 1970s after a long period of popularity. Monetarists and suppliers such as Milton Friedman claim that the government’s ongoing actions have not helped the country avoid sub-average gross domestic product (GDP) expansion, recession, and interest rate fluctuations. Endless loop.
Overview of fiscal and monetary policy
Some side effects
Just like monetary policy, fiscal policy can be used to influence the expansion and contraction of GDP as a measure of economic growth. When the government exercises power through tax cuts and increased spending, they are implementing expansionary fiscal policies. Although on the surface it seems that expansionary efforts can only have a positive impact by stimulating the economy, the domino effect has a much wider scope. When the rate of government expenditure exceeds the rate of tax revenue, the government can finance expenditure by issuing interest-bearing bonds, thereby accumulating excessive debt, which leads to an increase in national debt.
When the government increases the amount of debt it issues during the expansionary fiscal policy, the issuance of bonds on the open market will eventually compete with the private sector that may also need to issue bonds at the same time. This effect, called the crowding-out effect, can indirectly raise interest rates due to increased competition for borrowed funds. Even if the stimulus measures generated by the increase in government spending have some initial positive effects in the short term, the drag caused by the increase in interest expenditures of borrowers, including the government, may alleviate part of this economic expansion.
Another indirect effect of fiscal policy is that foreign investors may push up the dollar when they try to invest in U.S. bonds that are currently trading on the open market with higher yields. Although the strengthening of the domestic currency is positive on the surface, depending on the magnitude of the interest rate change, it can actually make the export cost of U.S. goods higher, while the import cost of foreign-made goods is lower. Since most consumers tend to use price as the determinant of their purchasing behavior, the shift to buying more foreign goods and the slowdown in demand for domestic products may lead to temporary trade imbalances. These are all possible situations that must be considered and anticipated. It is impossible to predict which outcome will occur and how many will occur, because there are many other moving targets, including market influence, natural disasters, wars, and any other major events that can drive the market.
There is also a natural lag or time delay in fiscal policy measures, from determining the need for them to actually passing Congress and finally passing the president. From a forecasting perspective, in a perfect world where economists predict the future with 100% accuracy, fiscal measures can be proposed as needed. Unfortunately, given the inherent unpredictability and dynamics of the economy, most economists have encountered challenges in accurately predicting short-term economic changes.
Monetary Policy and Money Supply
Monetary policy can also be used to ignite or slow down the economy. It is controlled by the Federal Reserve. The ultimate goal is to create a loose monetary environment. Early Keynesians did not believe that monetary policy had any long-term effects on the economy because:
- Since banks can choose whether to lend excess reserves at lower interest rates, they may simply choose not to lend; and
- Keynesians believe that consumer demand for goods and services may have nothing to do with the cost of capital to obtain these goods.
In different periods of the economic cycle, this may or may not be, but monetary policy has been proven to have a certain impact and influence on the economy and the stock and fixed income markets.
The Federal Reserve has three powerful tools in its arsenal and is very active with all of them. The most commonly used tool is their open market operations, which affect the money supply by buying and selling U.S. government securities. The Federal Reserve can increase the money supply by buying securities and reduce the money supply by selling securities.
The Fed can also change the bank’s reserve requirements to directly increase or decrease the money supply. The statutory reserve ratio affects the money supply by adjusting how much reserves banks must hold. If the Fed wants to increase the money supply, it can reduce the amount of reserves required, and if it wants to reduce the money supply, it can increase the amount of reserves required by banks.
The third way the Fed changes the money supply is to change the discount rate, which is a tool that continues to receive media attention, forecasts, and speculation. The world often waits for the Fed’s statement, as if any change will have a direct impact on the global economy.
The discount rate is often misunderstood because it is not the official interest rate consumers pay for loans or receive from savings accounts. This is the interest rate at which banks seek to increase reserves when they borrow directly from the Federal Reserve. However, the Fed’s decision to change this interest rate does flow through the banking system and ultimately determines the borrowing fees that consumers pay and the benefits they receive from deposits. In theory, maintaining a low discount rate should encourage banks to hold fewer excess reserves and ultimately increase the demand for currency. This begs the question: which is more effective, fiscal policy or monetary policy?
Which policy is more effective?
This topic has been debated for decades, and the answer is both. For example, for Keynesians, if fiscal policy is implemented for a long period of time (such as 25 years), the economy will experience multiple economic cycles. At the end of these cycles, hard assets such as infrastructure and other long-term assets will still exist and are likely to be the result of some type of fiscal intervention. In the same 25 years, the Fed may have used their monetary policy tools to intervene hundreds of times, and may only succeed in achieving their goals at some point.
Using only one method may not be the best idea. Fiscal policy has a lag in penetrating the economy. Monetary policy has shown its effectiveness in slowing down the economy’s warming rate faster than expected, but it has not produced the same effect as monetary easing has rapidly promoted economic expansion. Therefore, it has The success is slim.
Although each side of the policy scope has its own differences, the United States has sought solutions in the middle, combining various aspects of the two policies to solve economic problems. In guiding the economy, the Federal Reserve may receive more recognition because their efforts are widely known, and their decisions can greatly boost the global stock and bond markets, but the use of fiscal policy still exists. Although there is always a lag in its effects, fiscal policy seems to have a greater impact over a long period of time, and monetary policy has proven to have some short-term success.