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Monetary policy and fiscal policy refer to the two most widely recognized "tools" used to influence a nation's economic activity. Monetary policy is primarily concerned with the management of interest rates and the total supply of money in circulation and is generally carried out by central banks such as the Federal Reserve. Fiscal policy is the collective term for the taxing and spending actions of governments. In the United States, the national fiscal policy is determined by the Executive and Legislative Branches.

Monetary Policy

Central banks have typically used monetary policy to either stimulate an economy into faster growth or slow down growth over fears of issues such as inflation. The theory is that, by incentivizing individuals and businesses to borrow and spend, monetary policy will cause the economy to grow faster than normal. Conversely, by restricting spending and incentivizing savings, the economy will grow less quickly than normal.

The Federal Reserve, also known as the "Fed," has frequently used three different policy tools to influence the economy: opening market operations, changing reserve requirements for banks and setting the "discount rate." Open market operations are carried out on a daily basis where the Fed buys and sells U.S. government bonds to either inject money into the economy or pull money out of circulation. By setting the reserve ratio, or the percentage of deposits that banks are required to hold and not lend back out, the Fed directly influences the amount of money created when banks make loans. The Fed can also target changes in the discount rate, or the interest rate charged by the Fed when making loans to financial institutions, which is intended to impact short-term interest rates across the entire economy.

Fiscal Policy

Fiscal policy tools are numerous and hotly debated among economists and political observers. Generally speaking, the aim of most government fiscal policies is to target the total level of spending, the total composition of spending, or both in an economy. The two most widely used means of affecting fiscal policy are changes in the role of government spending or in tax policy.

If a government believes there is not enough spending and business activity in an economy, it can increase the amount of money it spends, often referred to as "stimulus" spending. If there are not enough tax receipts to pay for the spending increases, governments borrow money by issuing debt securities such as government bonds and, in the process, accumulate debt, or "deficit" spending.

By increasing taxes, governments pull money out of the economy and slow business activity. Governments might lower taxes in an effort to encourage more activity, hoping to boost economic growth. When a government spends money or changes tax policy, it must choose where to spend or what to tax. In doing so, government fiscal policy can target specific communities, industries, investments, or commodities to either favor or discourage production. These considerations are often determined based on considerations that are not entirely economic.

Learn more about how the economy is controlled by reading A Look at Fiscal and Monetary Policy.

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