Fiscal & Monetary Policies

Fiscal and Monetary Policies

Fiscal Policy: An Overview
The Effectiveness of Discretionary Fiscal Policy
Monetary Policy Tools
Using Monetary Policy Tools to Achieve Policy Goals

Governments have three sources of funds to pay for expenditures: printing money, borrowing money, and collecting taxes.

In the United States, only the federal government is allowed to print money. Also, state and local governments in the United States are limited by law in the types of borrowing and taxation that they are allowed to use.

Fiscal and monetary policies are involved in every aspect of the operation of governments. These policies are often thought of in terms of discretionary policies. Discretionary fiscal and monetary policies involve government's active role in the economy in an attempt to create a specific outcome.


Economic growth, employment, and stable prices are goals that fiscal and monetary policies attempt to achieve. In the United States, these goals have been codified into law with the Employment Act of 1946.

Discretionary fiscal and monetary policies can be used to achieve other outcomes as well. Wealth distribution, market failures, and infrastructure are among the possible targets of government policy.


Basic public institutions and facilities including an education system and a system of roads and bridges.

Fiscal Policy: An Overview

Fiscal policy is the policy of the government relating to government spending and taxing decisions. The entire budget of the government is the result of fiscal policy.

Fiscal policy affects the economy's total output (real GDP) and price level because it affects aggregate demand both directly and indirectly. Because fiscal policy can change aggregate demand, it has been called demand side economics, or Keynesian Economics.

Fiscal policy includes components that are discretionary in nature. Discretionary fiscal policies are policies that are designed to achieve specific economic outcomes; decreasing unemployment, for example. Discretionary fiscal policies are deliberate government interventions in the economy.

Fiscal policy also includes automatic stabilizers. These are policies which kick in whenever aggregate income changes. Automatic stabilizers work to offset the effects of changes in income.

For example, unemployment compensation will partially offset lost income, and the associated loss of consumer demand, when people lose jobs. When the unemployment rate increases, so does the aggregate amount of unemployment compensation paid by the government. Similar types of automatic stabilizers are welfare payments and food stamps.

These automatic stabilizers are transfer payments. Transfer payments represent money that government collects in taxes from one group of people and pays out in benefits to another group of people. Since transfer payments do not represent government purchases of goods and services, and do not reflect current production, they are not included in GDP.

Transfer payments do not affect aggregate demand directly, but they do change aggregate demand indirectly through changes in disposable income. For example, if the transfer is from a group with a relatively low MPC (people who tend to save a large portion of their disposable income) to a group with a relatively high MPC (people who tend to spend a large portion of their disposable income), then aggregate consumption spending will increase.

Marginal Propensity to Consume (MPC)

Marginal Propensity to Save (MPS)

Consumers have two choices when it comes to disposable income: they can either spend it or they can save it. The portion that they spend goes directly into consumption spending, increasing aggregate demand and GDP, as well as keeping the money in the circular flow. The portion that they save becomes a leakage in the circular flow: it is not subject to the multiplier effect. When disposable income increases, the portion of the increase that is spent is called the marginal propensity to consume (MPC). The portion of the increase that is saved is called the marginal propensity to save (MPS). Both are measured as a fraction of disposable income, so that MPC plus MPS equals one. Since these are marginal measurements, they can change as the level of income changes.

Another type of automatic stabilizer is a progressive income tax. When incomes fall, taxpayers are moved into a lower tax bracket. The amount of taxes collected from income falls. This partially offsets the loss of disposable income, and helps offset the decrease in consumption spending caused by a recession.

Government Spending

Government purchases (but not transfer payments) are part of real GDP. They are the G in C + I + G + (X-M). Government purchases form an autonomous portion of aggregate demand.

Government spending is not affected by the price level, but it can change the equilibrium price level. A change in government spending will shift the aggregate demand curve.

If equilibrium real GDP is below potential real GDP, then a recessionary gap exists. The amount by which real GDP is below potential GDP is called a GDP gap.

An increase in government spending can shift the aggregate demand curve to the right, increasing equilibrium real GDP towards the level of potential real GDP, closing the GDP gap.

The Effectiveness of Discretionary Fiscal Policy

Discretionary fiscal policy can influence the level of aggregate demand, and real output, both directly and indirectly. The effectiveness of fiscal policy in achieving policy goals depends on a number of factors: the slope of the aggregate supply curve; the multiplier effect; and the method of financing government purchases.

The slope of the aggregate supply curve

John Maynard Keynes developed this model by holding the price level constant. In effect, he assumed an aggregate supply curve that is a horizontal line set at a given price level. The level of real GDP, then, would depend entirely on aggregate demand.

This assumption is not entirely unrealistic for what Keynes was trying to show. Keynes was dealing with the Great Depression. He was trying to show why the self-correcting mechanism of classical economic theory did not kick in to fix the economy. Classical economic theory could not explain the magnitude or the length of the Great Depression. Keynes developed a theory to both explain why the classical theory did not work, and to show how fiscal policy could work to end the Great Depression.

Holding the price level constant emphasized the relationship between aggregate demand and real output. Keynes' theory emphasized that wages and prices are not free to adjust downward. In his model, during recessionary times wages and prices will not adjust upward either.

Evidence seems to suggest that when real GDP is well below potential GDP, an increase in aggregate demand will have little effect on the price level. This means that the aggregate supply curve is mostly flat (horizontal) in recessionary times. But as output increases, the aggregate supply curve steepens. An increase in government spending to stimulate aggregate demand will be more effective in increasing real GDP during a recession but more inflationary as real GDP nears potential GDP. This can be explained, at least in part, by the fact that more excess capacity exists during a recession. When many unemployed workers are available, and equipment and land sit idle, then output can be increased without putting upward pressure on prices in the factor markets. But when excess capacity is not available, then output can only be increased by bidding up prices in the factor markets.

The multiplier effect

Government spending is an autonomous portion of aggregate demand. It's effect on the economy, however, may be more than the original amount of government spending. This is because government purchases become income for somebody in the economy (the circular flow model); a portion of this income will be spent, creating income for somebody else; and this process continues to multiply throughout the economy.
How much is the multiplier effect? This can be shown with a simple mathematical formula.

Recall that in the circular flow model, leakages and injections exist. Leakages are savings, taxes, and imports. Injections are investments, government purchases, and exports. In equilibrium, total leakages equal total injections. Since taxes are used to finance government spending, they will have their own offsetting multiplier effect. The rest of the leakages and injections are incorporated into the formula:

Spending Multiplier = 1 / leakages = 1 / (MPS + MPI)

Where MPS is the fraction of new income that will be saved instead of being spent, and MPI is the fraction of new income that will be spent on imports, or goods that are not produced domestically.

The amount that government spending would have to increase in order to close a GDP gap is called a recessionary gap.

A recessionary gap is equal to the GDP gap divided by the spending multiplier.

Methods of financing government purchases

Governments have three methods of raising funds to pay for purchases: taxing, borrowing, and printing money.

Government purchases financed by taxing

An increase in taxes decreases disposable income, which decreases consumption spending. This is a decrease in aggregate demand that will offset the increase in aggregate demand created by an increase in government spending, but only partially.

An increase in aggregate demand caused by government spending is larger than the decrease in aggregate demand caused by taxes because not all taxes will be paid for with a decrease in consumption. A portion of an increase in taxes will be paid for with a decrease in savings. The net effect is that aggregate demand will increase by the marginal propensity to save (MPS). Aggregate demand can be increased further if taxes are targeted towards demographics with a relatively high MPS.

An increase in taxes may also decrease aggregate supply. With a smaller disposable income, the incentive to work will be lower. The opportunity cost of time away from work will decrease.

If an increase in taxes causes the amount of labor input to decrease, then a decrease in aggregate supply will result. This will offset, at least partially, any gains in real GDP caused by an increase in government spending.
This will also create inflation, based on the slopes of the aggregate supply and aggregate demand curves. The magnitude of the effect that an increase in taxes has on aggregate supply is open to debate. Supply-side economists believe that this effect is very significant. Keynesian economists believe that it is insignificant.

Government purchases financed by borrowing

Governments borrow money by selling government bonds in the open market. To the purchasers of the bonds, this represents a financial investment. To the government that issues the bonds, this represents a loan that has to be repaid. Each bond has specified dates in which the government must make interest and principle payments to the investor. When these payments come due, the government can choose to finance the payments by issuing new bonds. Of course, this would be additional deficit spending that increases the national debt.

Eventually, the money that the government borrows must be paid for with tax collections. A few economists believe that consumers will take these future tax payments into consideration when making spending decisions. They will reduce consumption and put money into savings in order to pay for a future tax increase that has yet to be announced.

This concept is called the Ricardian Equivalence. The effect of borrowing on aggregate demand would be the same as the effect of a tax increase. Most economists do not believe that the Ricardian Equivalence holds true.

Government borrowing can also reduce aggregate demand due to crowding out of private investment. A sale of government bonds is often large enough to influence the market price in the overall bond market. A large increase in the supply of bonds will decrease the prices of all bonds in the market. Lower bond prices mean higher interest rates. An increase in interest rates will increase the cost of borrowing for private firms. Since most private investment is financed with borrowed funds, an increase in interest rates will increase the cost of investment spending and reduce the profitability of investment projects. This will reduce the amount of private investment spending, and aggregate demand.

Crowding out:

A reduction in consumption or investment spending caused by an increase in government borrowing.

The evidence for the crowding out effect is inconclusive. Considerable disagreements exist among economists regarding its importance.

Government purchases financed by printing money

Financing government expenditures with new money involves monetary policy.

Monetary Policy Tools

Monetary policy is an alternative to discretionary fiscal policy for governments to influence real output and price levels. In the United States, monetary policy is conducted independently from fiscal policy.

Much disagreement exists among economists as to the relative effectiveness of monetary vs fiscal policy, the relative effectiveness of specific policy tools, and the wisdom of using these tools in the first place. These different opinions are the reason why different economics schools of thought exist. These different opinions also constitute a sizable portion of different political positions.

Different countries have different monetary and banking systems. The discussion in this section will be limited to the tools of monetary policy within the United States' Federal Reserve System (the Fed).

This discussion requires prior knowledge of topics covered in the section entitled ”Banking”.

The Fed has a degree of power to control the money supply in the economy. The level of the money supply influences the level of real GDP as well as the price level.

The tools that the Fed uses to control the money supply are: open market operations, changes in the reserve requirement, and changes in the discount rate.

Open market operations

The main tool used by the Fed to control the money supply is open market operations. This tool involves the Fed buying or selling government bonds on the open market.

If the Fed wants to increase the money supply, it will buy government bonds on the open market.

When the Fed buys bonds, the money paid for the bonds is deposited into the accounts of brokers at various commercial banks. These deposits become new additions to the money supply and new excess reserves for the banks to lend out. This makes the amount spent on the purchase of bonds subject to the money multiplier.

Banks sometimes borrow overnight funds from each other in order to cover deficiencies in reserves caused by unexpected withdrawals. The rate that they charge each other is called the federal funds rate. With an increase in excess reserves in the banking system caused by the Fed buying bonds, the cost of borrowing for banks becomes lower. This lowers the federal funds rate. A lower federal funds rate decreases bank costs, and banks can charge lower interest rates to their borrowing customers. This in turn lowers the cost of private business investment, resulting in more investment spending in the economy.

If the Fed wants to decrease the money supply, the opposite occurs. The Fed sells bonds, and the money it receives from the proceeds is deducted from the broker accounts. This decreases the money supply, excess reserves, and the amount of reserves subject to the money multiplier. This also increases the federal funds rate and commercial interest rates, decreasing investment spending.

The Fed compares the federal funds rate to a target rate in order to determine when to engage in open market operations.

Open market operations can also influence long term bond rates to move in the same direction as the overnight (short term) federal funds rate. When the Fed buys bonds, its actions increase the demand for bonds. With the laws of supply & demand in effect, an increase in the demand for bonds will increase the prices of bonds on the open market. An increase in the prices of bonds will decrease their yields, or interest rates. When the Fed sells bonds, it increases the supply of bonds. This decreases the prices of bonds, increasing their interest rates.

The Fed is able to influence bond rates because of market power. Transactions by the Fed can be a relatively large portion of the overall bond market. In addition, the Fed makes open market decisions without regard for any profit motive, but competes in the bond market with investors who are guided by profits.

The "government bonds" in this discussion of open market operations refers to U.S. Treasury securities.

These include Treasury Bills, which are short term instruments maturing in less than one year; Treasury Notes, which are bonds generally maturing within one to ten years; and Treasury Bonds, which are long term bonds generally maturing in twenty to thirty years.

Treasury Bills pay no interest. Instead, they are issued at a discount from par value, and pay the full par value upon maturity.

Treasury Notes and Treasury Bonds pay interest based on a stated percentage of par value once every six months. The full par value is paid upon maturity.

Changes in the reserve requirement

When the reserve requirement increases, excess reserves decrease. This decreases the amount of reserves available for banks to loan out. This in turn decreases the ability of individual commercial banks to create new money. This decreases the amount of money subject to the deposit expansion multiplier.

When the reserve requirement decreases, excess reserves increase, new money created from bank loans increases, and the amount of money subject to the deposit expansion multiplier increases.

Changes in the discount rate

The discount rate affects the money supply in the same way that the federal funds rate does. The difference is that the federal funds rate is a market interest rate that banks use to borrow funds from each other, while the discount rate is an interest rate that the Fed sets for funds that banks borrow directly from the Fed.

The discount rate is slightly higher than the federal funds rate. The Fed actually uses two different discount rates. It charges a lower rate to banks in good financial condition (banks with high credit ratings). This lower discount rate is the lowest interest rate that the Fed has direct control over.

Liquidity Trap

Liquidity trap is a theory that expansionary monetary policy may be ineffective after a certain point.

The liquidity trap theory states that when nominal interest rates are close to zero, monetary policy tools are ineffective in lowering them further.

This can become an issue during times of expected deflation.

When the economy is in a recession - without the presence of a liquidity trap - monetary policy can be used in order to try to increase private business investment. The cost of investment is interest, and an increase in investment spending can increase output, jobs, and income.

Monetary policy during recessionary times would involve lowering interest rates.

However, if prices are expected to fall, then the nominal interest rate is lower than the real interest rate [nominal rate = real rate plus expected inflation, with expected inflation negative]. The lower limit for nominal interest rates is zero (because if the nominal interest rate were less than zero, it would mean that creditors would be paying debtors for the use of the creditors' money, which wouldn't make sense).

Nominal interest rates cannot fall below zero. With expected deflation, and nominal interest rates lower than real interest rates, there would exist a real interest rate that cannot be reduced with the use of monetary policy.
When interest rates cannot be lowered using monetary policy, then monetary policy cannot be effective in increasing investment, output, jobs, and income.

Using Monetary Policy Tools to Achieve Policy Goals

The Relationship Between the Money Supply, Output, and the Price Level

The tools of monetary policy used by the Fed are designed to control the money supply. But the goal of monetary policy is to influence the level of real output (real GDP) and the price level. How does the money supply affect these primary goals? The answer is that the size and growth of the money supply is an intermediate target.

The relationship between the intermediate target of the money supply and the goals of output and stable prices can be explained by showing how changes in the money supply affect the aggregate demand / aggregate supply model.

Start with the demand for money. People hold money balances in order to pay for transactions (the transaction demand for money); to be prepared for emergencies (the precautionary demand for money); and as a hedge against price changes in other financial assets (the speculative demand for money). The amount of money that people want to hold for these purposes depends on the interest rate and nominal income. When interest rates increase, so does the value of holding assets that pay more in income than money deposits. The opportunity cost of holding money increases. Therefore, an inverse relationship exists between interest rates and the demand for money.

A direct relationship exists between nominal income and the demand for money. Money is needed to finance transactions, and at higher nominal levels the value of transactions increases. Either the higher nominal income will mean higher real income, in which case consumers will purchase more goods and services in order to increase their standard of living; or higher nominal income will mean higher prices, in which case consumers will spend more income for the same amount of goods and services.

A graph showing the demand for money is a downward sloping curve with the interest rate on the price (vertical) axis and the quantity of money demanded on the horizontal axis. As interest rates change, the quantity of money demanded will move up and down the money demand curve. As nominal income changes, the quantity of money demanded will change at every interest rate level, and the money demand curve will shift.

The supply of money is controlled by the Fed. The money supply curve is a vertical line at the level of the money supply set by the Fed. When the money demand curve and the money supply curve are combined on one graph, equilibrium is the point where these two curves intersect. The equilibrium quantity of money is the quantity set by the Fed. The equilibrium interest rate is the interest rate where the money demand curve crosses the equilibrium quantity of money.

Finally, all of this information can be incorporated into the aggregate demand / aggregate supply model to show the relationship between the money supply, output, and the price level.

Notice from the explanation that with different monetary policy tools, an inverse relationship exists between the money supply and the interest rate. Also, an inverse relationship exists between the interest rate and the level of private investment. Since private investment is a portion of aggregate demand, a positive relationship exists between the money supply and aggregate demand.

The larger the money supply, the higher the aggregate demand. This relationship is what the Fed relies on when it decides to use its monetary policy tools.

As aggregate demand increases, equilibrium real output (real GDP) increases and the equilibrium price level increases. The magnitude of each increase is subject to debate, and depends on the slopes of the aggregate demand and aggregate supply curves.

Some economic schools of thought argue that an increase in the money supply is mostly inflationary. Other schools of thought argue that an increase in the money supply will mostly increase real output. Evidence is unclear, but seems to suggest that an increase in the money supply becomes more inflationary as equilibrium real GDP increases, and nears potential real GDP. This involves the relationship between inflation and unemployment.

Also, large increases in the money supply in a short period of time can possibly cause a jolt to the economy and become inflationary as well.