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Economics and The Time Value of Money - Fiscal and Monetary Policy

Fiscal policy
Fiscal policy is the means by which a government adjusts its levels of spending and taxation in order to monitor and influence a nation's economy.
  • Examples include changing tax rates, increasing Social Security payments and increasing or decreasing government spending.
  • Based on the theories of English economist John Maynard Keynes.
  • Fiscal policy seeks to stimulate demand and output in periods of business decline by increasing government expenditures and cutting taxes as a means of increasing disposable income. The process is reversed to correct for overexpansion.
Monetary policy
Monetary policy refers to actions taken by the Federal Reserve (the Fed) to either increase or decrease the money supply in the economy.
  • The Fed uses the following strategies to expand or contract funds in the banking system:
    • Buying or selling government securities in the open market.
      • Buying government securities increases the money supply by injecting cash into the economy, and helps lead to lower interest rates.
      • Selling securities decreases the money supply by removing cash from the economy, helping to raise interest rates.
    • Increasing or decreasing member bank reserve requirements.
      • Higher reserve requirements, money supply is tightened.
      • Lower reserve requirements loosen the money supply.
    • Increasing or decreasing the discount rate to member banks who borrow reserves from the Fed. A higher discount rate tightens money supply; a lower discount rate loosens money supply.
    • Changing the percentage of credit required to buy securities on margin.

Interest Rates
Typically, when the supply of money increases, interest rates fall. And when the supply of money tightens, interest rates increase. So, the Fed actions discussed earlier have an impact on the following:
  • Consumer spending
  • Interest rates on newly issued bonds
  • Market prices of existing bonds: when interest rates rise, the prices of bonds with lower coupon rates decrease, and vice versa

Federal Reserve actions can also indirectly impact stocks:
  • When monetary policy expands credit, lower interest rates make bonds less appealing as investments, and stocks more appealing.
  • From the corporate perspective, company earnings may rise because of lower interest expense, which may cause the market price of the stock to rise.
  • Of course, when the opposite occurs and monetary policy tightens credit, interest rates will rise, earnings will decrease, and the market price of the stock is likely to decrease as well. As interest rates rise, bonds become more attractive to investors.

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