DIFFERENCE BETWEEN MONETARY POLICY AND FISCAL POLICY

DIFFERENCE BETWEEN MONETARY POLICY AND FISCAL POLICY

Monetary policy: is a term used to refer to the actions of central banks to achieve macroeconomic policy objectives such as price stability, full employment, and stable economic growth. In the United States, the Congress established maximum employment and price stability as the macroeconomic objectives for the Federal Reserve; they are sometimes referred to as the Federal Reserve’s dual mandate. Apart from these overarching objectives, the Congress determined that operational conduct of monetary policy should be free from political influence. As a result, the Federal Reserve is an independent agency of the federal government.

Fiscal policy: is a broad term used to refer to the tax and spending policies of the federal government. Fiscal policy decisions are determined by the Congress and the Administration. The Federal Reserve plays no role in determining fiscal policy.

Monetary Policy: The Federal Reserve uses a variety of policy tools to foster its statutory objectives of maximum employment and price stability. One of its main policy tools is the target for the federal funds rate (the rate that banks charge each other for short-term loans), a key short-term interest rate. The Federal Reserve’s control over the federal funds rate gives it the ability to influence the general level of short-term market interest rates. By adjusting the level of short-term interest rates in response to changes in the economic outlook, the Federal Reserve can influence longer-term interest rates and key asset prices. These changes in financial conditions then affect the spending decisions of households and businesses.

Monetary Policy: Federal Reserve has employed since the financial crisis is “forward guidance” about the path of the federal funds rate. Since December 2008, the Federal Reserve’s target for the federal funds rate has been between 0 and 1/4 percent effectively, as low as it can go. Through forward guidance, the Federal Open Market Committee provides an indication to households, businesses, and investors about the stance of monetary policy expected to prevail in the future, given the current economic outlook. By providing information about how long the Committee expects to keep the target for the federal funds rate exceptionally low, the forward guidance can put downward pressure on longer-term interest rates and thereby lower the cost of credit for households and businesses, and also help improve broader financial conditions.

The monetary policymaking body within the Federal Reserve System is the Federal Open Market Committee (FOMC). The FOMC currently has eight scheduled meetings per year, during which it reviews economic and financial developments and determines the appropriate stance of monetary policy.

Fiscal Policy: In reviewing the economic outlook, the FOMC considers how the current and projected paths for fiscal policy might affect key macroeconomic variables such as gross domestic product growth, employment, and inflation. In this way, fiscal policy has an indirect effect on the conduct of monetary policy through its influence on the aggregate economy and the economic outlook. For example, if federal tax and spending programs are projected to boost economic growth, the Federal Reserve would assess how those programs would affect its key macroeconomic objectives maximum employment and price stability and make appropriate adjustments to its monetary policy tools.

Function

Decisions regarding both monetary and fiscal policy types take into consideration the current and expected future actions of the other.

The Federal Reserve Bank board of directors determines the discount rate it charges institutional banks for loans. Decreasing the discount rate increases the demand for loans. More money available in the market is expected to increase economic activity. Discount rates are widely quoted and tracked because other institutions use them as a base for other rates. For example, commercial banks may issue a line of credit to a business that is equal to the discount rate plus a specific percentage amount. This helps the commercial bank cover the cost of money and still make a profit.

The Federal Reserve Bank also controls reserve requirements: the minimum amount that must be held on reserve at banks. The Federal Reserve Bank pays interest on funds held in reserve. Increasing reserve requirements decreases the amount of money available in the market. Decreasing the money supply makes money worth more.

How Government Policy Impacts Your Investments

The ideal investment strategy involves a hands-off approach in which decisions are based on an investor’s time horizon and risk tolerance. Having said that, it pays to be aware of trends in both fiscal and monetary policy given the increasing influence of both factors in financial-market performance. More than ever, the prices of both stocks and bondsare being driven by investors’ interpretation of government and central-bank policy rather than traditional, fundamental factors. It therefore pays to keep an eye on the headlines in order to have a full understanding of why your investments are performing as they are. For a look at the issues affecting the bond market, see my special section.

 Presence of monetary union

When an economy is a part of a monetary union, its monetary authority is no longer able to conduct its monetary policies independently in response to the needs of the economy. Under such a situation the interaction between fiscal and monetary policies undergoes certain changes. Generally, the monetary union follows policies to keep the overall inflation at such levels so as to keep the overall gap between the actual aggregate consumption and desired consumption close to zero.

Fiscal Policies are then used to minimize the country specific welfare losses arising out of such policies. Also, fiscal policies are used to stabilize the terms of tradeand maintain them at their natural levels. Given the common monetary policies and the price levels for all the nations under the union, the fiscal authority of the home country is led to follow contractionary policies in case of deterioration in terms of trade.

Professor Eric Leeper has defined terminology as follows:

• Passive fiscal policy is one in which the authority raises or reduces taxes to balance the budget inter-temporally.
• Active fiscal policy is one in which the tax and spending levels are determined independent of inter-temporal budget consideration.
• Active monetary policy is one that pursues its inflation target independent of fiscal policies.
• Passive monetary policy is one that sets interest rates to accommodate fiscal policies.

REFERENCES

Anton M. et al. (1990) “The Interaction of Fiscal and Monetary Policies: Some           Evidences using Structural Econometric Models” UK, Wall Street.

Buti M. and Roeger W. (1975)”Stabilising Output and Inflation in EMU: Policy           Conflicts and Cooperation under the Stability Pact”

Leeper, Eric M. (1991). “Equilibria under ‘active’ and ‘passive’ monetary and           fiscal policies”. Journal of Monetary Economics, 27, 129–47

Jose M. & Gonzalez P. (2010). “Monetary and fiscal policy interactions during the             financial crisis”Speech, Member of the Executive Board of the ECB.             Madrid, 26 February

 Gregory N. Mankiw(1987) “Macroeconomics” Worth Publishers, Harvard           University, 7th Edition.