Fiscal vs. Monetary Policy: Know the Difference
Both fiscal and monetary policy are tools used to keep the U.S. economy healthy. Both can affect your personal economy. But that’s where the similarities end.
There’s actually a big difference between fiscal and monetary policy and how these policies are implemented. Understanding the difference can help you make better decisions about your own finances.
What Is Fiscal Policy?
Fiscal policy refers to the tax and spending policies of Congress and the administration. If the federal government wants to spur economic growth and boost gross domestic product, it can lower taxes and increase spending. It can take the opposite approach by raising taxes and reducing spending if it needs to help cool down the economy — which can be necessary to limit inflation, reduce its trade deficit or manage government debt.
The coronavirus relief bills passed by Congress in 2020 are an example of fiscal policy. More than $2 trillion in federal spending was approved to aid Americans and limit the impact of the recession caused by the COVID-19 pandemic.
Fiscal policy often isn’t the fastest way to impact the economy. In fact, the legislative process that is needed to approve changes to tax rates and government spending can be slow. Plus, fiscal policy can have unintended negative effects — such as rising interest rates and budget deficits.
What Is Monetary Policy?
Monetary policy refers to actions taken by central banks to achieve price stability, full employment and stable economic growth. They do this by managing the supply of money.
In the U.S., the Federal Reserve is the central bank. It was created by Congress in 1913 as the nation’s central bank and given what often is referred to as a dual mandate of fostering maximum employment and price stability. The Federal Reserve uses a variety of tools to achieve these monetary policy goals:
- Open market operations, which involve buying and selling U.S. government securities to affect the amount of money and credit banks have on hand
- Setting a target range for the federal funds rate, the rate banks charge each other for overnight loans
- Determining reserve rates, the portions of deposits banks must hold in cash
- Setting the interest rate on excess reserves to encourage banks to hold more excess reserves or lend excess reserve
The Federal Open Market Committee is the body within the Federal Reserve System that sets monetary policy during eight regularly scheduled meetings throughout the year. To spur economic growth, it uses its tools to increase the supply of money and influence interest rates. Low rates typically fuel consumer spending, foster low unemployment and help the economy grow. To slow down the economy and keep inflation in check, it can tighten the nation’s money supply and seek to boost interest rates.
FOMC members consider fiscal policy when setting monetary policy, but they don’t coordinate with the federal government. In fact, the Federal Reserve is an independent agency that is supposed to be free from political influence.
Keep Reading: Here’s How Fed Rate Hikes and Cuts Impact Your Wallet
How Fiscal and Monetary Policy Affect You
Fiscal policy can affect your income. It can affect it directly by the amount of taxes you have to pay–or not pay. It can put money into your wallet through stimulus checks or government assistance programs. Fiscal policy also can affect your income indirectly when government spending helps boost the overall economy.
Monetary policy affects the rates you pay on the money you borrow. Many banks base their prime rate, which they use as a base rate for a variety of loans and credit cards, on the federal funds rate. When the Fed lowers the target range on the federal funds rate and lenders lower their prime rate, it can be cheaper for you to borrow money to buy consumer goods.
Of course, fiscal and monetary policy can have a negative impact on you if, for example, taxes or interest rates rise. Although painful for you and your pocketbook, unpopular policies can be needed to help the economy as a whole.
This article is part of GOBankingRates’ ‘Economy Explained’ series to help readers navigate the complexities of our financial system.
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