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What is the difference between fiscal and monetary policy?

Monetary policy is typically implemented by a central bank, while fiscal policy decisions are set by the national government. However, both monetary and fiscal policy may be used to influence the performance of the economy in the short run. Basics In general, a stimulative monetary policy is expected to improve the economy's rate of growth of output (measured by Gross Domestic Product or GDP) in the quarters ahead; tight or restrictive monetary policy is designed to slow the economy in the future to offset inflationary pressures. Likewise, stimulative fiscal policies, tax cuts, and spending increases are normally expected to stimulate economic growth in the short run, while tax increases and spending cuts tend to slow the rate of future economic expansion.1 In 2001 the Federal Reserve made 11 reductions in the overnight interbank interest rate or federal funds ratethese actions were designed to stimulate growth in the face of a slowing economy.2 In contrast, in 1999 and 2000 when the economy was experiencing very rapid growth and a potentially unsustainable expansion without an increase in the rate of inflation, the Federal Reserve raised the federal funds rates in an effort to slow the overheated economy. (See Chart 1.) Chart 1

Fiscal policy in 2001 also helped stimulate the slowing economy with a combination of tax cuts and spending increases. Spending increases take effect relatively quickly, while tax cuts may take several quarters to affect overall spending and output. (See Chart 2.) Chart 2

Monetary Policy Monetary policy's impact on the economy is described in the Federal Reserve System's Purposes and Functions publication. The Federal Reserve Act lays out the goals of monetary policy. It specifies that, in conducting monetary policy, the Federal Reserve System and the Federal Open Market Committee should seek "to promote effectively the goals of maximum employment, stable prices, and moderate long-term interest rates." Using the tools of monetary policy, the Federal Reserve can affect the volume of money and credit and their price-interest rates. In this way, it influences employment, output, and the general level of prices. The Federal Open Market Committee (FOMC), the Fed's monetary policy-making body, issues a statement following each of its eight annual meetings. The statements describe economic conditions, monetary policy, and the actions the FOMC took with respect to the federal funds rate and the discount ratethe rate the Fed charges depository

institutions for overnight borrowing . Those statements may be viewed on the Federal Reserve Board's website. For a general introduction to monetary policy issues, let me recommend the Federal Reserve Bank of San Francisco's publication, U.S. Monetary Policy, an Introduction. Fiscal policy Samuelson and Nordhaus, in their text Economics (1998), define fiscal policy as follows: A government's program with respect to (1) the purchase of goods and services and spending on transfer payments, and (2) the amount and type of taxes. Over the past year the U.S. budget has shifted from a surplus to a deficit, in part as a result of changes in fiscal policy. A combination of tax reductions, increased spending, and the 2001 recession caused the shift. The tax cuts and increased spending are part of the government's fiscal policy that is designed to increase short-run economic growth. For an update on the state of the U.S. budget in 2002, please review the FRB SF Economic Letter by Carl E. Walsh titled, "The Changing Budget Picture." In addition, the Congressional Budget Office prepares a "Monthly Budget Review" that evaluates current tax receipts and spending outlays and compares estimated and actual budget figures.

The government uses both fiscal and monetary policy to stimulate the economy (get it growing) and also to slow the rate of growth down when it gets overheated. With fiscal policy the government influences the economy by changing how the government collects and spends money. The most common tools that the government enacts to effect fiscal policy include: Increased Spending on new government programs and initiatives (such as job creation programs). This has the effect of increasing demand for labor and can result in lower unemployment levels Automatic Fiscal Programs are programs that take effect immediately to help correct the slide in the economy. Probably the single best example of this is unemployment insurance which a person can file for as soon as they lose their job. Tax Cuts are another tool that government uses to stimulate demand for goods and services when the economy takes a turn for the worse. The effect of a tax break is to put more money back in the pockets of businesses and consumers which they can spend and put back to work in the economy. Monetary Policy, on the other hand, involves the manipulation of the available money supply within the economy. In the United States, the role of manipulating the money supply falls to the Fed or the central bank in the US. Not only does the Fed have overall responsibility for the country's monetary policy, but it also has responsibility for issuing currency and overseeing bank operations. An increasing money supply puts more money in the hands of consumers which they turn around and spend - a decreasing money supply does just the opposite. In order to increase or decrease the money supply, the Fed has four principal levers which it pulls to try and effect change. The first thing that the Fed can do is to alter the reserve ratio which is the percentage of assets that commercial banks have to keep on deposit at one of the Federal Reserve Banks - the higher the reserve ratio, the less money that banks can lend out to the general public. Another way the Fed can control the money supply is by adjusting the federal funds rate (fed funds

rate). The federal funds rate is a short-term borrowing rate that banks have established amongst themselves for short-term borrowing. Another way the Fed can adjust the money supply is by raising or lowering the discount rate which is the rate at which commercial banks can borrow money from the Fed. The higher the rate (or interest charged on the loan), the less inclined commercial banks are to borrow and a smaller amount of money will be available in the market. And lastly, the Fed can buy and sell government bonds. The buying of bonds translates into income for the US government, which can in turn put more money into the economy

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