Fiscal Policy and Monetary Policy

Following the 1989 collapse of the Soviet Union, many of the market from becoming dangerously severe. The people cited the United States’ free market as its key government primarily influences the economy through its advantage over the state-controlled economy of the use of the federal monetary and fiscal policies. USSR. Capitalism seemed to have won the day and many Americans reaped the benefits of an unfettered Fiscal Policy market. U.S. fiscal policy is simply how the government uses taxation and spending (i.e. the U.S. budget) to influence But it is a mistake to believe that our “free market” the economy. When the economy is running above or stands completely detached from the government. The below its optimal level, the government can alter the truth is the government uses numerous policies and budget to influence its level of output. plans to influence the economy and keep swings in the market from getting out of hand. If, for instance, the economy is on a powerful upswing and in danger of overheating, the government may Government and the Economy choose to raise taxes or decrease spending to remove The drawback to the fierce competition and effort some money from the market. Or, if the economy is required by capitalism is that the economy can be slow, the government might increase its spending as a subject to boom and bust cycles. When an economy is way to create jobs until consumer demand rises. strong, people tend to spend more and invest in long- term plans. This optimism pushes the economy faster and faster, causing spikes in inflation and interest rates. Eventually, the economy slows and people begin to hold The U.S. government likes to see fiscal and on to more of their money. monetary policy working together to create an economy that behaves reasonably under More often than not, the drop in market participation causes a sudden, brief economic recession. Workers all conditions. lose jobs, businesses are reevaluated—with some closing—borrowing drops and people consume fewer goods. If the conditions are right, the economic pause can lead to a downward spiral of dropping demand and Fiscal policy is often described as either being “loose” or increased unemployment. “tight.” Loose fiscal policy means the government is increasing spending or cutting taxes in hopes of spurring During the Great Depression, the government started to the economy. Since the goal is for the government to put take on the responsibility of influencing the economy for more money into the economy than it takes out, loose the good of citizens. The goal was not to change the fiscal policy usually means government deficit spending. process of free trade, but to keep the inevitable swings

Northern Oak Wealth Management, Inc. This article was written by Advicent Solutions, an entity unrelated to Northern Oak Wealth Management, Inc.. The information contained in this article is not intended to be tax, investment, or 555 E. Wells St. Suite 1625 legal advice, and it may not be relied on for the purpose of avoiding any tax penalties. Northern Oak Milwaukee, WI 53202 Wealth Management, Inc. does not provide tax or legal advice. You are encouraged to consult with your tax advisor or attorney regarding specific tax issues. ©2013 Advicent Solutions. All rights reserved.

www.northern-oak.com (414) 278-0590 Not surprisingly, “tight” fiscal policy is the opposite of and allow for the automatic tightening of the policy (less loose policy. Tight fiscal policies usually result in higher people using assistance, higher tax revenues). tax rates or the termination of tax loopholes. The government may also choose to slow programs or close A secondary problem with fiscal expansion is the public works projects that are no longer needed. A possibility that government spending will cause direct or tighter budget reduces deficits and potentially creates indirect damage to companies trying to expand. The budget surpluses that can offset the debt caused when deficits that accompany loose fiscal policy require an loose policy was needed. increase in government-issued bonds. Some claim that the increased availability of government bonds drives Temporary measures to tighten or loosen fiscal policy down or “crowds out” the demand for private bonds, may be effective, but they are not always timely. New making it harder for companies sell the bonds needed to legislation on spending or tax hikes can easily take over fund growth. a year to move through Congress, and may miss the point when it would do most good. Monetary Policy U.S. monetary policy takes a less direct approach to Fortunately, some parts of fiscal policy are automatic. influencing the economy. Whereas fiscal policy controls These are programs or rates, which are always in effect, how the government spends money in the economy, but become more used as the economy moves up or monetary policy attempts to control how easy it is for down. For instance, during an economic downturn, more people and companies to access money they need to people lose their jobs and require government expand. assistance. As program use increases, the budget loosens as more money is put into the pockets of people The control of monetary policy largely comes down to who need it. This not only helps preserve citizen well- the Federal Reserve (commonly referred to as “the being but also supplies money to the economy and Fed”). The Fed is a quasi-government system of 12 keeps demand from falling too low. banks that provide economic stability to the various regions of the country. They act as a backstop for private On the other end, income tax brackets help tighten fiscal banks and are willing to loan out money to them if they policy when the economy picks up speed. An economic run short on cash. boom means higher wages for employees—and higher wages mean higher nominal taxes. The new tax revenue Its role as the nation’s cash reserve gives the Fed the can help the government get a budget surplus and put unique ability to manipulate the average interest rates on money aside for future needs. loans in the country. When the Fed decides interest rates need to go lower, it drops the rate at which it loans The general goals of fiscal policy are usually simple: out money to banks or provides them with an excess of either speed up or slow down the economy. However, cash through bond-buying programs. The banks, eager the government is able to target specific industries or to put the new cash to use, loan it out to individuals at groups to stimulate some forms of economic behavior decreased rates. Alternatively, the Fed can also over others. Usually, this type of specific fiscal policy withdraw money and raise its loan rates, driving up the takes the form of targeted tax breaks or hikes, such as cost of private borrowing. middle-class tax breaks, green energy tax credits, etc. Like with fiscal policy, monetary policy is referred to as Potential Problems with Fiscal Policy either being “loose” or “tight.” The low rates of loose The problems associated with fiscal policy usually occur policy encourage people to take out loans for business with a prolonged policy of overspending. Chronic expansion or to purchase goods they had been saving government deficits can damage the credibility of a up to buy. It is meant to make people more inclined to government and make repayment of debt difficult. spend rather than save, which can help jumpstart However, many hold the belief that in most situations, it consumer demand in a declining economy. is better to fix economic problems first so that debt can be reduced faster later on. If a government is able to pull Tight monetary policy is usually used when the Fed a country out of a recession, they can cease stimulus wants to protect the economy from excessive growth. When an economy is allowed to expand too quickly, it can have serious inflation issues and hurt average consumers. If the Fed sees the economy (or inflation) is increasing at a dangerous rate, it can tighten monetary policy, make some loans impractical and limit growth at safe levels.

Since fiscal policy can take over a year to implement, monetary policy is usually the first tool the government uses to adjust the economy. However, monetary policy is less direct and less precise than fiscal policy; it tries to change overall market climate rather than increase or decrease the amount of cash in people’s pocket.

Potential Problems with Monetary Policy Many economists argue that the biggest risk from monetary policy is inflation-related. Keeping a loose policy during a growing economy will almost certainly lead to high inflation. However, if policy is tightened too much or is not allowed to loosen during a weak economy, the country might experience “deflation,” which can lead to money hoarding and a further economic contraction.

Working Together The government likes to see fiscal and monetary policy working together to create an economy that behaves reasonably under all conditions. It must tighten or loosen both policies as needed to combat the unique threats of each economic situation. Each policy may be enough to combat problems on its own, but goals are met much quicker when both policies are in use.

Unfortunately, the government is not always able to reach a consensus on the proper course of action for its policies. Monetary policy may be loosened or tightened as long as inflation is kept in check, but fiscal policy cannot be changed until Congress agrees that the changes are in the best interest of the people.

Citizens should remember that fiscal and monetary policy are tools the government uses to influence the economy, not control every aspect of it. The U.S. government might like to encourage growth or slow inflation, but it cannot decide what people do and how they respond to economic challenges. The consumers are in charge of the free market system, and they decide how far it goes. Fiscal and monetary policies are meant to protect our economy and make sure we keep the right momentum to continue moving forward.