There are two powerful tools our government and the Federal Reserve use to steer our economy in the right direction: fiscal and monetary policy. When used correctly, they can have similar results in both stimulating our economy and slowing it down when it heats up. The ongoing debate is which one is more effective in the long and short run.
Fiscal policy is when our government uses its spending and taxing powers to have an impact on the economy. The combination and interaction of government expenditures and revenue collection is a delicate balance that requires good timing and a little bit of luck to get it right. The direct and indirect effects of fiscal policy can influence personal spending, capital expenditure, exchange rates, deficit levels and even interest rates, which are usually associated with monetary policy.
Fiscal Policy - the Keynesian School
Fiscal policy is often linked with Keynesianism, which derives its name from British economist John Maynard Keynes. His major work, "The General Theory Of Employment, Interest And Money," influenced new theories about how the economy works, and is still studied today. He developed most of his theories during the Great Depression and Keynesian theories have been used and misused over time, as they are a popular and are specifically applied to mitigate economic downturns.
In a nutshell, Keynesian economic theories are based on the belief that proactive actions from our government are the only way to steer the economy. This implies that the government should use its powers to increase aggregate demand by increasing spending and creating an easy money environment, which should stimulate the economy by creating jobs and ultimately increasing prosperity. The Keynesian theorist movement suggests that monetary policy on its own has its limitations in resolving financial crises, thus creating the Keynesian versus the Monetarists debate.
While fiscal policy has been used successfully during and after the Great Depression, the Keynesian theories were called into question in the 1980s after a long run of popularity. Monetarists, such as Milton Friedman, and supply-siders claimed that the ongoing government actions had not helped the country avoid the endless cycles of below average gross domestic product (GDP) expansion, recessions and gyrating interest rates.
Some Side Effects
Just like monetary policy, fiscal policy can be used to influence both expansion and contraction of GDP as a measure of economic growth. When the government is exercising its powers by lowering taxes and increasing their expenditures, they are practicing expansionary fiscal policy. While on the surface, expansionary efforts may seem to lead to only positive effects by stimulating the economy, there is a domino effect that is much broader reaching. When the government is spending at a pace faster than tax revenues can be collected, the government can accumulate excess debt as it issues interest bearing bonds to finance the spending, thus leading to an increase in the national debt.
When the government increases the amount of debt it issues during expansionary fiscal policy, issuing bonds in the open market will end up competing with the private sector that may also need to issue bonds at the same time. This effect, known as crowding out, can raise rates indirectly because of the increased competition for borrowed funds. Even if the stimulus created by the increased government spending has some initial short-term positive effects, a portion of this economic expansion could be mitigated by the drag caused by higher interest expenses for borrowers, including the government.
Another indirect effect of fiscal policy often overlooked, is the potential for foreign investors to bid up the U.S. currency in their efforts to invest in the now higher yielding U.S. bonds trading in the open market. While a stronger home currency sounds positive on the surface, depending on the magnitude of the change in rates, it can actually make American goods more expensive to export and foreign made goods cheaper to import. Since most consumers tend to use price as a determining factor in their purchasing practices, a shift to buying more foreign goods and a slowing demand for domestic products could lead to a temporary trade imbalance. These are all possible scenarios that have to be considered and anticipated. There is no way to predict which outcome will emerge and by how much, because there are so many other moving targets, market influences, natural disasters, wars and any other large scale event that can move markets.
Fiscal policy measures also suffer from a natural lag, or the delay in time from when they are determined to be needed, and the time their measures pass through congress and ultimately the president. From a forecasting perspective, in a perfect world where economists have a 100% accuracy rating for predicting the future, fiscal measures could be summoned up as needed. Unfortunately, given the inherent unpredictability and dynamics of the economy, most economists run into challenges in accurately predicting short-term economic changes.
Monetary Policy - the Money Supply
Monetary can also be used to ignite or slow the economy but is controlled by the central bank, the Federal Reserve with the ultimate goal of creating an easy money environment. Early Keynesians did not believe that monetary policy had any long-lasting effects on the economy because A) since banks have a choice to lend out the excess reserves they have on hand from lower interest rates, they may just choose not to lend and B) Keynesians also believe that consumer demand for goods and services may not be related to the cost of capital to obtain theses goods. At different times in the economic cycle, this may or may not be true, but monetary policy has proven to have some influence and impact on the economy and equity and fixed income markets.
The Federal Reserve Board carries some powerful tools in its arsenal and is very active with all three. The most commonly used tool is their open market operations, which the Fed is active in on a daily basis. They purchases and sell U.S. government bonds in the open market which can increase or decrease reserves with banks while influencing the supply of money whether they are buying or selling bonds. The Fed can also change the reserve requirements at banks thus directly increasing or decreasing the supply of money. The Fed can also make changes in the discount rate which is the tool that is constantly receiving media attention, forecasts, speculation and the world often awaits the Fed's announcements as if any change would have an immediate impact on the global economy.
The discount rate is often misunderstood, as is not an official rate that consumers will be paying on their loans or receiving on their savings accounts. However, it is the rate that is charged to banks seeking to increase their reserves when they borrow directly from the Fed. The Fed's decisions to change this rate does, however, flow through the banking system and ultimately determines what consumers pay to borrow and what they receive on their deposits. In theory, holding the discount rate low should induce banks to hold fewer excess reserves and ultimately increase the demand for money. This begs the question: which is more effective, fiscal or monetary policy?
The battle has been hotly debated for decades and the answer is both. For example, to a Keynesian promoting fiscal policy over a long period (25 years) of time, the economy will go through multiple economic cycles. At the end of those cycles, the hard assets like infrastructure such as buildings, bridges, roads and other long-life assets, will still be standing and most likely be the result of some type of fiscal intervention. Over that same 25 years, the Fed may have intervened hundreds of times using their tools and maybe only had success in their goals some of the time. On the other hand, using just one method may not be the best idea, because of the lag in fiscal policy as it filters into the economy. Monetary policy has shown its effectiveness in slowing down an economy that is heating up at a faster than desired pace (inflationary fears), but it has not had the same magnitude of change affect when it comes to quickly inducing an economy to expand as money is eased, so its success is muted.
The Bottom Line
Though each side of the policy spectrum has its differences, the United States has sought a solution in the middle ground, combining aspects of both policies in solving economic problems. The Fed may be more recognized, as their efforts are well publicized and their decisions can move global equity and bond markets drastically, but the use of fiscal policy lives on. While there will always be a lag in its effects, fiscal policy seems to have greater effects over long periods of time and monetary policy has proven to have some short term success.