Monetary and Fiscal Policy, Essay Example

Monetary policy refers to the actions of the central bank to achieve macroeconomic objectives such as price stability, full employment, and stable economic growth. In the U.S. monetary policy is usually carried out by the U.S. Federal Reserve System, usually called the Fed. Congress has delegated two major macroeconomic goals to the Fed which are maximum employment and price stability. Fed is an independent agency of the federal government to ensure freedom from undue political influence.

In order to achieve the objectives set under the monetary policy, Fed utilizes a variety of tools. One such tool is setting a target for federal funds rate, a key short-term interest rate. Fed’s influence over the federal funds rate also allow it to influence long-term interest rates and key asset prices. Another tool used by the Fed to conduct monetary policy is purchase of long-term securities. The purchase of long-term securities is primarily intended to influence long-term interest rates.

Fiscal policy refers to the revenue generation (taxation) and spending policies of the federal government. Fiscal policy is shaped by the U.S. Congress and the Administration.

Expansionary monetary policy refers to an increase in the supply of money in the economy and contractionary monetary policy refers to a decrease in the supply of money in the economy. The Fed can pursue an expansionary monetary policy in a number of ways. It may purchase securities in the open market. Similarly, lowering the federal discount rate would also lead to increasing borrowing activity in the economy. Fed can also lower the reserve requirement to increase money supply in the economy. Lower reserve requirement means banks can lend more. Expansionary monetary policy tends to increase bond prices because bond prices and interest rates have opposite relationship.

Contractionary monetary policy on the other hand requires opposite actions to what are taken to expand monetary policy. One way may be for the Fed sell securities in the market place, reducing the quantity of money in the economy. Similarly, Fed may increase federal discount rate which would discourage borrowing by making it more expensive. Fed may also increase the reserve requirement which means banks would have fewer funds to lend. Since contractionary policy increases interest rate, it causes decline in bond prices.

Expansionary fiscal policy is meant to increase the level of aggregate expenditures and demandto boost economic growth. It may be achieved through greater levels of government spending or a decrease in tax rates or both. Lower tax rates mean the business and consumers are left with higher disposable income to spend on consumption and investment activities. In addition to government spending and lower tax rates, expansionary fiscal policy also involves transfer payments such as social security and unemployment benefits. These transfer payments also left certain group of citizens with more income to spend. Similarly, contractionary fiscal policy is meant to prevent an overheating of the economy through reduced government spending, higher tax rates, or both. These measures discourage expenditures and aggregate demand and, thus, help reduce inflationary pressures as well as potential asset bubbles. The government may also scale back on transfer payments to reduce levels of expenditures and aggregate demand.

Works Cited

AMOSWEB. Expansionary Fiscal Policy. [online]. [Accessed 9 February 2014]. Available from World Wide Web: <http://www.amosweb.com/cgi-bin/awb_nav.pl?s=wpd&c=dsp&k=expansionary+fiscal+policy>

Board of governors of the federal reserve system. What is the difference between monetary policy and fiscal policy, and how are they related? [online]. [Accessed 9 February 2014]. Available from World Wide Web: <http://www.federalreserve.gov/faqs/money_12855.htm>

Moffatt, Mike. Expansionary Monetary Policy vs. Contractionary Monetary Policy. [online]. [Accessed 9 February 2014]. Available from World Wide Web: <http://economics.about.com/cs/money/a/policy.htm>