Monetary Policy vs. Fiscal PolicySubmitted by Prosperity Advisors on January 21st, 2020
by Brent Evans, CFA
As we head into election season, these terms will pop up. But what do they mean for the economy and for you?
The aim of monetary policy is to manage inflation and economic growth using interest rates and other tools to influence the money supply. This is handled primarily by the Federal Reserve (aka: The Fed). If the Fed believes the economy is growing too quickly and inflation is rising, they can increase interest rates to remove money from the system and slow economic demand. As a consumer you see mortgage rates and car loan rates go up. As an investor, you see the interest you earn on savings money markets increase. Put simply, borrowers pay more, and savers earn more. The opposite would hold true when the fed lowers rates to stimulate the economy.
Fiscal policy involves government spending and taxation as tools to manage the economy. Higher government spending with lower taxes tends to expand growth but leads to budget deficits. Lower spending with higher taxes can shrink or slow economic growth but reduce a deficit. Increased fiscal spending can create job opportunities.
Fiscal and Monetary policy work in tandem. Tax cuts are most effective when tax rates are very high. The cuts are more meaningful, which can increase company and consumer spending, stimulating the economy. This was the case in 1981, but it was also followed by an extremely aggressive interest rate hike to curb high inflation. Tax cuts in 2001 and 2003 were accompanied by a significant drop in rates from 6% to 1%, providing a catalyst economic for growth and government revenues.