Here’s how monetary and fiscal policy affects the US economy

Here’s how monetary and fiscal policy affects the US economy

It’s no secret that we are battling inflation that has reached a 40-year high, and the Federal Reserve has embarked on a historic increase in interest rates to combat inflation. Not only did they increase interest rates, but they also reduced the size of the Fed’s balance sheet by allowing securities to mature and thus tightening monetary policy (quantitative tightening).

On the other hand, fiscal policy has been largely expansionary. Preliminary Congressional Budget Office numbers for fiscal year 2023 showed the deficit at $2 trillion, nearly $1.1 trillion larger than last year excluding the impact of the administration’s student debt cancellation that the Supreme Court invalidated in June. Only the deficit in 2020 of $3.1 trillion and in 2021 of $2.8 trillion was higher as the government tried to stimulate the economy from the effects of the pandemic.

Essentially, the Fed is holding the economy back and the fiscal policy set by the government is driving the acceleration. Looking back, this stimulus caused GDP to grow by 4.9% in the third quarter of this year and kept the unemployment rate at 3.9% while the Fed tries to slow things down.

Let’s take a look at monetary and fiscal policy and how they work to influence a country’s economy.

Financial policy. Fiscal policy refers to the use of government spending and tax policies to influence economic conditions, especially macroeconomic conditions. These include aggregate demand for goods and services, employment, inflation, and economic growth. How does fiscal policy work? US fiscal policy is largely based on the ideas of John Maynard Keynes. He claimed that governments are capable of stabilizing the business cycle and regulating economic output rather than allowing markets to correct themselves. For example, when private sector spending declines, the government can spend more and/or tax less in order to directly increase aggregate demand. Conversely, when the private sector is overly optimistic and spends too much and too quickly on consumption and new investment projects, the government can spend less and/or tax more in order to reduce aggregate demand. This means that to help stabilize the economy, the government must run large budget deficits during economic downturns and run budget surpluses when the economy grows. These are known as expansionary or contractionary fiscal policies, respectively. The executive and legislative branches of government are responsible for fiscal policy, which is implemented by the Secretary of the Treasury.

Monetary policy. Monetary policy is a set of tools used by a country’s central bank to control the total money supply, promote economic growth, and use strategies such as reviewing interest rates and changing bank reserve requirements. In the United States, the Federal Reserve implements monetary policy through a dual mandate to maximize employment while keeping inflation under control. How does monetary policy work? Monetary policies are either expansionary or contractionary, depending on the level of growth or recession in the economy. Contractionary policy increases interest rates and reduces the money supply to slow growth and reduce inflation. Conversely, in times of slowdown or recession, expansionary policy grows economic activity. By lowering interest rates and increasing the money supply, saving becomes less attractive and consumer spending and borrowing increase.

As you can infer from the above, fiscal policy and monetary policy are not in sync. We have a highly politicized fiscal policy where both the legislative and executive branches of government want to stay in power and are trying to stimulate the economy to improve their chances of staying in office through expansionary policy. We have a Federal Reserve that is focused on combating inflation, and so far it has been somewhat successful in doing so through its deflationary policy. However, continued high deficits (not to mention our ever-increasing national debt) will put upward pressure on inflation and could have the effect of prompting the Fed to raise interest rates to higher levels. It currently appears that the Fed is done raising interest rates, but this may change if inflation continues.

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