National economies are often volatile and unpredictable. Thus, at times economies must be stimulated or restrained through monetary policy and fiscal policy. Monetary policy is essentially economic policy instituted and directed by a central bank, while fiscal policy is economic policy instituted and directed by a national government. To be completely effective, these policies are ordinarily undertaken in concert with each other.
In the U.S., monetary policy is undertaken by the Federal Reserve Bank, called simply, the Fed. Guidelines for the Fed’s monetary policies are established and, occasionally, initiated by the Federal Open Market Committee (FOMC). All monetary policy is conducted between the Fed and the various commercial banks around the country. From this banking interaction, commercial bank lending policies, as well as, for instance, lending interest rates and deposit rates, trickle down to influence consumer spending habits, and thereby, the economy as a whole.
The methods of economic stimulus or, occasionally slow-down through monetary policy are four-fold. (1) The Fed may raise or lower the reserve ratio, the amount of money banks must deposited in the Federal Reserve. (2) Federal funding interest rates may be raised or lowered, thus making short-term borrowing rates between commercial banks less expensive, or more expensive, encouraging or discouraging borrowing between banks. (3) The Fed may also raise or lower the interest rates at which commercial banks may borrow from the Federal Reserve Bank. (4) Finally, the Fed may either sell or purchase government bonds in an effort to increase or decrease government cash reserves.
Fiscal policy, conversely, is established and initiated by the national government in the form of, for instance tax cuts. Instruments of government fiscal policy also include increased spending for government programs, and for pre-implemented, automatic fiscal measures, such as unemployment compensation or Social Security. The results of fiscal policy decisions on revenue and, therefore, on the economy, are felt more directly by the individual consumer than are results of the various monetary policies.
In virtually all instances of economic change effected through both monetary and fiscal policies, timing can be crucial in determining results. As a rule, the lag-time between the initiation of change and actual results seen in the economy is shorter through fiscal policy changes than through manipulation of monetary policy. Tax cuts, for instance, will affect consumer spending, and, therefore, the economy as a whole, much more quickly than will the amount of interest the local bank has to pay for a loan from the Fed, or from another commercial bank.
