Here's how the disconnect between monetary and fiscal policy influences the economy
It is no secret that we have been fighting inflation that reached a 40-year high and the Federal Reserve Bank has embarked on a historic interest rate increase to combat inflation. Not only have they increased interest rates but they have also reduced the size of the Fed’s balance sheet by letting securities mature and therefore tightening monetary policy (quantitative tightening).
On the other hand, fiscal policy has been very much in an expansionary mode. The Congressional Budget Office’s preliminary figures for fiscal year 2023 showed the deficit came in at $2 trillion, nearly $1.1 trillion larger than last year excluding the impact of the administration’s student debt cancellation that the Supreme Court struck down in June. Only the deficits in 2020 of $3.1 trillion and 2021 of $2.8 trillion were higher as the government was trying to stimulate the economy from the affects of the pandemic.
Essentially, the Fed is putting the brakes on the economy and fiscal policy set by the government is pushing on the accelerator. In retrospect, that stimulus has caused our GDP to grow by a robust 4.9% in the third quarter of this year and has kept the unemployment rate at 3.9% while the Fed is trying to slow things down.
Let’s look at monetary and fiscal policy and how they work to influence the nation’s economy.
Fiscal Policy. Fiscal policy refers to the use of government spending and tax policies to influence economic conditions, especially macroeconomic conditions. These include aggregate demand for goods and services, employment, inflation, and economic growth. How does fiscal policy work? U.S. fiscal policy is largely based on the ideas of John Maynard Keynes. He argued that governments could stabilize the business cycle and regulate economic output rather than let markets correct themselves on their own. For instance, when private sector spending decreases, the government can spend more and/or tax less in order to directly increase aggregate demand. Conversely, when the private sector is overly optimistic and spends too much, too fast on consumption and new investment projects, the government can spend less and/or tax more in order to decrease aggregate demand. This means that to help stabilize the economy, the government should run large budget deficits during economic downturns and run budget surpluses when the economy is growing. These are know as expansionary, or contractionary, fiscal policies, respectively. The executive and legislative branches of government are in charge of fiscal policy carried out by the secretary of the treasury.
Monetary Policy. Monetary policy is a set of tools used by a nation’s central bank to control the overall money supply and promote economic growth and employ strategies such as revising interest rates and changing bank reserve requirements. In the U.S., the Federal Reserve Bank implements monetary policy through a dual mandate to achieve maximum employment while keeping inflation in check. How does monetary policy work? Monetary policies are either expansionary or contractionary, depending on the level of growth or stagnation in the economy. A contractionary policy increases interest rates and decreases the money supply to slow growth and to decrease inflation. Conversely, in times of a slowdown or a recession, an expansionary policy grows economic activity. By lowering interest rates and increasing the money supply, saving becomes less attractive and consumer spending and borrowing increase.
As you can surmise from the foregoing, fiscal policy and monetary policy are not in sync. We have fiscal policy that is highly politicized as the legislature and executive branches of government want to stay in power and are trying to stimulate the economy to improve their chances of staying in office with expansionary policy. We have the Fed that is focused on fighting inflation and so far, has been somewhat successful in doing so with their contractionary policy. However, continued high deficits (not to mention our ever increasing national debt) will put upward pressure on inflation and could have the affect of causing the Fed to raise rates even higher. It appears for now that Fed is done with raising rates, but that could change if inflation persists.
This article originally appeared on Springfield News-Leader: Here's how monetary and fiscal policy influence the U.S. economy
