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How does monetary policy differ from fiscal policy

how does monetary policy differ from fiscal policy

Fiscal Vs. Monetary Policy – and What It Means For You

Posted February 19, 2012 by thomas

This is an election year (in case that you hadn’t noticed). Which means the rhetoric is flying on both sides. And both sides have historically twisted the facts about monetary policy – and who benefits from what kinds of policies – in their favor.

To vote intelligently, though, you need to be able to see through the campaigning and make your own assessment based  on the actual economics – and not the veneer the campaigns put on it.

The twin engines of economic policy-making

The government has two basic avenues for economic policy: Fiscal policy and monetary policy. Let’s talk first about how they differ:

Fiscal policy is the policy the government makes through its spending decisions, but also through changes in the tax code. Congress – with the Constitutional “power of the purse,” directs fiscal policy, though the executive branch – under the President – also has  substantial ability to tinker with fiscal policy at the margins, through regulatory changes.

If the government spends more money than it takes in, and it doesn’t maintain significant sovereign reserves (the U.S. does not have a huge sovereign reserve fund, in practice), then the government must borrow the difference. That is, it must issue bonds.

In a nutshell: Deficit spending, all things being equal, is pro-jobs and pro-growth. It tends, also, to be pro-inflation – which means that foreign investment tends to fall and money has an incentive to leave the country – so deficit spending is only pro-growth to a point.  If world investors believe the U.S. cannot control its spending, they become worried that the U.S. will either default on its bonds, eventually – or inflate the currency so much that Treasury holders will lose money. Then the U.S. has to spend more money in interest payments to attract investors.

We’re seeing the beginning of this phenomenon with S&P’s downgrade of U.S. debt from AAA to AA last summer. However, that doesn’t hurt too badly yet – European sovereign debt looks even worse! American bonds are still buoyed by money fleeing the euro. Continued expansion of Asian economies, together with their huge savings rate of 30 percent plus (Americans, in contrast, save around 4 percent of their incomes, if that) also helps support U.S. bond prices – and keep yields low.

If Asia slows down, or if Asian consumers begin spending their money instead of banking it (all those savings have to go somewhere!), and if Europe gets its act together and starts  attracting “safe money” investors again, demand for U.S. debt may well fall – and interest rates will rise, which is really saying the same thing.

Monetary policy, on the other hand, seeks to control the overall money supply.

Here’s the dirty secret – which isn’t a secret: Congress does not directly control monetary policy – nor does the president, nor any other elected official. Instead, since 1913, monetary policy has been under the purview of the Federal Reserve – currently under the chairmanship of Ben Bernanke, in concert with a less well-known board of governors.

Originally, the Federal Reserve was founded in 1913 to take the edge off of the severe booms and busts that plagued Americans following the Civil War and through the turn of the century. These radical inflationary and deflationary cycles were wreaking havoc on workers, laborers, farmers and bankers alike. The Federal Reserve came about with a mission to act as a counterweight – moderating runaway growth cycles, and helping to stimulate the economy  during down times.

So how does the Fed do it? Mostly by controlling

the money supply:

Buying and Selling Treasuries

Inflation is the result of too much money chasing too few goods.  If the Fed senses inflation, they can take money out of the economy by selling Treasury bonds. Any money they receive is essentially retired from circulation.

Similarly, if the Federal Reserve wants to stimulate the economy, they can increase the money supply – by buying Treasury bonds. The Reserve then credits the sellers’ balance sheets – and allows them to lend money against those reserves – magnifying the infusion of cash, and increasing the money supply.

This, in turn, makes it easier for borrowers to get credit.

The Federal Reserve has lately been increasing the money supply on a massive scale, in response to the fallout from the mortgage crisis. Normally, this is inflationary. But the Federal Reserve did so in order to prevent (they think) a massive deflationary cycle as a result of the collapse of the real estate and mortgage world.

Bank Reserve Requirements

The Federal Reserve can also encourage more or less lending by increasing bank reserve requirements. For example, the Federal Reserve could slow lending down – while shoring up bank stability – by requiring them to have six cents on hand for every dollar loaned out instead of four.

There’s a cost for this, though: If it gets too difficult to borrow, businesses don’t get opened, cars and homes don’t get financed, and workers lose their job.

The second major mechanism the Fed uses to impact monetary policy is setting the rate at the discount window. This is the rate the Fed charges banks to borrow overnight to maintain their reserve requirements – and it affects the Reserve Rate, which is the rate banks charge each other to provide overnight loans.

The lower the reserve rate, the easier it is to borrow – and the more banks are willing to lend, all else being equal. But if they get too willing to lend, then inflation heats up. If inflation rises above interest rates, it doesn’t pay to save.

The result is a massive transfer of wealth from savers to borrowers – which ultimately discourages investment and slows down the economy.

The Federal Reserve, then, is constantly walking a tightrope between trying to encourage reasonable growth and a very modest rate of inflation, without restricting too much and sending the economy into recession.

So Who Benefits? Borrowers vs. Savers

When it comes to monetary and fiscal policy, where you stand depends a lot on where you sit.

If you’re a net borrower – that is, if your balance sheet consistently shows you have borrowed more cash than you have on hand in financial instruments – you benefit from “easy money.” That is, you benefit from low interest rates, and policies that encourage growth even at the expense of accepting inflation.

This isn’t limited to credit card users and irresponsible borrowers. If you borrow a lot to finance your farming operation, or you borrowed to fund college, or real estate, or a small business, you’re in the same boat. Inflation lets you borrow today’s big dollars, and pay back smaller dollars tomorrow. If inflation is higher than your interest rate, you win,

If you’re a net lender, on the other hand, the opposite is true. Low interest rates hurt the returns you get on your savings – and allowing inflation to eat away at your wealth. High interest rates, however, go into your pocket – ideally to reinvest! This is true of anyone who lends, saves or invests more than they borrow.

And neither party is a reliable ally. For either of you.

Category: Bank

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