Fiscal and monetary policy demystified
I think I take it for granted that people don’t understand the distinct differences between the two. People in the news, as well as people in everyday speech, seem to use the terms interchangeably to refer to the same thing. But they are indeed different.
Fiscal policy is the policy made by federal, state, and local governments to spend on so-called “government services.” It includes both the taxing and the spending of the taxes.
Monetary policy, on the other hand, is made by the Federal Reserve (the central bank of the United States). For the sake of simplicity, I don’t want to get into the nitty gritty of how this is done, but by buying and selling government bonds, the Federal Reserve adjusts the supply of money in the economy as well as influences loan interest rates.
What are the implications of these two types of policy?
Keynesian economics (named after British economist John Maynard Keynes — economists who follow Keynes are often called Keynesians) emphasizes government expenditures to give stimulation to the economy in the short run during economic depressions (the term recession is simply a euphemism). The total wealth of a country (its GDP) is a combination of factors, including what individuals, businesses, and government spend on consumption goods, services and investments. If taxes are reduced, people will be inclined to spend more on goods, services, and investments, so GDP should rise. Another option is for government to increase its spending, as government expenditures also trickle into the economy and boost the GDP.
Monetarists (Milton Friedman is probably one of the most famous in this group) emphasize expansionary monetary policy during depressions. By “pumping money into the economy,” interest rates are lowered and loans are more easily made. People can borrow now and pay back later when the economy recovers (as it always eventually does). In fact, as people borrow to spend on goods, services, and investments, this increases GDP in the short run and gets the country out of the funk it was in.
Although the exact causes of the Great Depression are still being debated to this day, most economists agree (at the very least) that a combination of several New Deal policies and abysmal Federal Reserve policy direction exacerbated and lengthened the problems we encountered.
Something must be noted about both the views of Keynesians and monetarists: both “solutions” only work in the short term. There is an optimal or equilibrium point that GDP naturally moves toward. Otherwise, economists could continually manipulate fiscal and monetary policy to achieve “super” rates of GDP growth. More importantly, both forms of “temporary stimulation” take the attitude of “borrow now, pay back… some day.”
Like an organic being, the economy can suffer many blows and recover naturally on its own. Anytime a foreign substance — a medicine (or in the case of the economy, economic stimuli) — is introduced into the being, good things, as well as unintended consequences, can occur. The unintended consequence of economic stimuli is that by unnaturally fixing the economy, it sets it up for bigger problems later on. The “boom and bust” business cycle is not a natural occurrence, but a byproduct of economic policies which artificially prop up failing or aged parts of the economy. Just like an occasional fire in the woods is a good, natural part of life, allowing new undergrowth to burgeon and expand, an economic depression shuts down floundering enterprises and replaces them with new entities.
After nearly a century of Federal Reserve monetary policy and more than a century of legislative bodies fixing fiscal policies, it is no wonder that we are facing such difficult economic times.
The hopeful part is that, like an organic being, the economy is a very strong and robust creature, able to withstand much. In time, this bust will again turn into a boom.