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Monetary and Fiscal Policy

By rsbthompson Nov 18, 2009 1965 Words
Monetary and Fiscal Policy - Working Together
Monetary and Fiscal policy are important to every economy. The Federal Reserve and Government are in charge of monetary and fiscal policy respectively. The Federal Reserve has three tools to control monetary policy: open market operations, reserve requirements, and the discount rate. The Government is in charge of fiscal policy and uses taxes and spending as tools to change policy. Monetary and Fiscal policy are adjusted when signs of inflation, deflation, stagflation or hyperinflation start to arise or are in full swing. Monetary and Fiscal policy matter to everyone because they affect everyone.

Monetary and Fiscal policy are important to every country and every economy. When changes to these policies are made everyone is affected because we all use money. The authorities in place do their best to maintain a balance in the economy where there is growth, but not too fast or too slow. The decisions that are made through monetary and fiscal policy direct and persuade people to act a certain way with their money (either keep or spend it) to help the economy stay as stable as possible. In the United States the Federal Reserve and the Government try to make these decisions with people’s best interest in mind. The goal of monetary policy is to keep unemployment low, inflation low, encourage economic growth and keep a balance of external payments (Financial Pipeline, n.d.). According to the Federal Reserve website, “The term "monetary policy" refers to the actions undertaken by a central bank, such as the Federal Reserve, to influence the availability and cost of money and credit to help promote national economic goals” (Federal Reserve n.d). The Federal Reserve (“Fed”) is the authority over monetary policy. There are seven members that make up the Fed board, and constitute the majority on the Federal Open Market Committee (FOMC). The FOMC is comprised of twelve people all together; the other five people are Federal Reserve Bank presidents. The Fed controls monetary policy using three tools: 1. Open Market Operations; 2. Reserve Requirements; 3. Discount Rates. The FOMC is responsible for open market operations, while the Federal Reserve Board is in charge of reserve requirements and discount rates. Open Market Operations occur when the FOMC decides to take money out of, or put money into the economy. This is accomplished by either selling or buying bonds, bills or other financial instruments. There are eight scheduled meetings per year of the FOMC where that decision is made. According to the Federal Reserve website, “At these meetings, the Committee reviews economic and financial conditions, determines the appropriate stance of monetary policy, and assesses the risks to its long-run goals of price stability and sustainable economic growth” (Federal Reserve n.d.). Currently the Federal Reserve Bank of New York is being kept busy with open market operations. Investors are running to the safety of Treasury’s because of the exposure financial institutions have to soured mortgages, and the fact they fear a recession (Ip, 2007). The second tool in the Federal Reserves control is the amount of money banks need to keep in reserves (reserve requirement). Banks are responsible for reporting to the Fed annually, quarterly, or weekly their cash position through the FR2900. The Fed looks at the net transaction accounts, total deposits, and vault cash to determine how often banks need to report their cash levels. Calculations are then made off of these reports to determine what reserves should be kept at the Federal Reserve Bank. The level and amount a bank should keep is called a reserve tranche (a portion of something, especially money) and the following levels are: Banks with $0-$8.5million 0% in reserve, $8.5million to (and including) $45.8million 3% in reserve, above $45.8million 10% in reserve (Frs Reporting Reserves, n.d.). If the Fed is trying to slow the economy down they will have banks hold more money in reserves; however if the Fed determines the economy needs to be stimulated they will require less reserve money be kept thereby making more funds available for loans to increase consumer or commercial spending. The reserve requirement is rarely changed because it causes a shift in the money supply for the short and long run. The third main way the Fed controls the money supply is through the discount rate. This is the rate that banks use when their reserves dip below the Federal Reserve required balance. It is only used as a last resort though because banks borrow money from each other before they would go to the big “Central Bank”. This is a short term borrowing option, money is usually given for a 1-2 week period. When every other borrowing possibility is exhausted, then money will be borrowed from the Federal Reserve. The Federal Reserve has great power through these three tools of monetary policy. In times of great crisis they can use these tools to instill confidence in the financial system. A good example of this was after September 11th when the Fed maintained stability while the financial world was shaking. In a speech Ferguson Jr.(2003) explained how this was done:

First, as central bank we needed to provide sufficient liquidity through as many means as possible to maintain stability. In doing so, we would further our obligation to the broader citizenry to maintain public confidence so that the crisis in New York and Washington, D.C. would not spread across the country. Second, as operator and overseer of key payment systems we had to ensure that our systems, as well as those in the private sector, were operational. Third, we worked with critical public- and private-sector participants to keep markets open or, if circumstances forced them to close, to return them quickly to normal operations (Ferguson Jr., 2003).

Throughout the years the Fed has learned what measures work to get the market stable again; and in turn the public knows when the Fed makes a decision they can have confidence in it. Fiscal Policy is the Government’s responsibility, which is a sister strategy to monetary policy. The government and the Federal Reserve work independently from each other when determining the stance of the economy, however the core goals of keeping inflation and unemployment low, and maintaining economic growth are the same. Heakal (2004) wrote, Macroeconomic productivity levels are influenced by increasing or decreasing taxes and government spending. “This influence, in turn, curbs inflation (generally considered to be healthy when at a level between 2-3%), increases employment and maintains a healthy value of money”. The stance of fiscal policy can be neutral, expansionary or contractionary. In a neutral stance the budget is balanced and the government does not need to make any changes to fiscal policy. If taxes are lowered and there is increased government spending an expansionary policy is being implemented trying to help the economy grow. People are more likely to spend money, stimulating the economy. Likewise, if taxes are raised and there is decreased government spending a contractionary policy is being implemented trying to slow the economy down. People are more likely to hold on to their money, and the economy will start to slow. Every year a budget is proposed for how much the government will spend and in what way. This is an elaborate process which sets the tone for the year of how the government sees the economy and what direction they are going in reaction. The policies that the Federal Reserve and the government implement to balance and stabilize the economy are created when signs of inflation, deflation, stagflation or hyperinflation start to occur. Ranson writes that, “Inflation is the loss in purchasing power of a currency unit such as the dollar, usually expressed as a general rise in the prices of goods and services” (Ranson, n.d.). It’s hard to identify the root causes of inflation, so reactive approaches are taken to correct the economy when it’s moving too quickly or too slowly. Since it’s hard to predict what could cause inflation a proactive approach is not usually possible. Deflation on the other hand is caused by a decline in the money supply and/or an increase in the supply of goods (Moffatt, n.d.). Businesses, such as banks, are hit harder when deflation occurs. If a loan is taken out and deflation starts to occur, it is still expected that the same or higher loan payments will be made, while the asset purchased with the loan decreases in value. Stagflation is described as slow economic growth and unemployment, combined with high inflation. In the 1970’s stagflation was a huge issue. Paul Volcker who was the Fed chairman at the time raised interest rates to create a recession to halt the problems in the economy. It took many years, and may have been an unpopular course of action, but his solution eventually did help the economy become stable again. Hyperinflation is the rapid production of money, rapidly increasing the total supply of money. Governments usually do this to cover a large amount of expenditures they incur. The only way to correct this problem is for the government to make the choice and effort to stop creating money. Ultimately, effective monetary and fiscal policies matter to everyone. It’s important that the economy stays stable because every change with inflation, unemployment and economic growth impacts businesses and individuals. The changes throughout the economy affect how decisions are made today and how plans are made for the future when dealing with money, the job or housing market, and so on. Economics does not measure personal happiness or contentment with situations, but when the money supply and economic growth are healthy it can also have a positive affect everyone personally.

Financial Pipeline. (). Retrieved November 17, 2007, from Answers.Com. (). US History Encyclopedia. Retrieved November 25, 2007, from (). Retrieved November 19, 2007, from The Federal Reserve. (). Federal Reserve System Reporting & Reserves. Retrieved November 19, 2007, from Federal Reserve. (2007, November 20). Board of Governors of the Federal Reserve System. Retrieved November 13, 2007, from The Federal Reserve Web Site: Ferguson Jr., R. W. (2003, February 5). September 11, the Federal Reserve, and the Financial System. Retrieved November 26, 2007, from The Federal Reserve Board Web Site: Heakal, R. (2004, May 19). What Is Fiscal Policy? Retrieved November 25, 2007, from Heyne, P. T., Boettke, P. J., & Prychitko, D. L. (2007, November 20). Wikipedia. Retrieved November 24, 2007, from Ip, G. (2007). It's Official: Wall Street Correction. In P. Steiger (Ed.), The Wall Street Journal (p. C1). New York, New York: Dow Jones & Company. Moffatt, M. (). What is deflation and how can it be prevented? Retrieved November 25, 2007, from Ranson, D. (). Inflation. The Concise Encyclopedia of Economics. Library of Economics and Liberty. Retrieved November 25, 2007, from Sparknotes. (1999). Retrieved November 24, 2007, from Us Info. (). Retrieved November 16, 2007, from Wheelan, C. (2002). Chapter 10 the Federal Reserve: Why that dollar in your pocket is more than just a piece of paper. In Naked Economics (pp. 168-186). New York, New York: W. W. Norton & Company Ltd.

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