02. Explain the difference between fiscal policy and monetary policy. Discuss how each of these approaches can be used to influence the state of economy.

Monetary policy and fiscal policy are both important to the U.S. economy. Each provides mechanisms for influencing growth. At any given time, both types of policies are in active use. Much media attention is given to economic indicators. Economists constantly predict the meanings of each statistical change. Monetary and fiscal policies are enacted based on these numbers. Each has a significant role that is not always independent of the other.

The primary tool central banks use to set monetary policy short-term interest rates. In the United States, this is referred to as the federal funds rate, or “fed funds” for short. By raising interest rates, a central bank can increase the cost of loans and thereby slow the pace of economic activity, which should – in theory – help contain inflation pressures. By cutting interest rates, a central bank lowers the cost of money. This stimulates the economy by making it easier for individuals and businesses to borrow money, which in turn fuels economic activity by making it less expensive to buy a house or fund a project.Traditionally, central banks haven’t sought to control long-term rates, but the unique circumstances that followed the 2008 financial crisis prompted the Fed to engage in policies known as quantitative easing (QE) and Operation Twist. With rates already at zero, the Fed was forced to take this route in order to suppress longer-term rates and help the economy recover from its post-crisis recession.

Fiscal policy refers to the actions of a government – not a central bank – as related to taxation and spending. The debate about the impact of fiscal policy on the economy has been raging for over a century, but in general it’s believed that higher government spending helps stimulate the economy, while lower spending acts a drag. At the same time, higher taxes are thought to limit economic growth, whereas lower taxes help stimulate it. Again, this is a matter of debate and opinions often vary based on an individual’s location on the political spectrum.

In explaining how the monetary and fiscal policy influence the state of economy we can as an example consider the case of a sluggish economy in which the government opts to increase spending in certain areas; for instance, building new bridges. This activity puts people to work, and they in turn spend money on goods and services, which helps put more people to work, and so on. This type of policy is referred to as “expansionary.” Conversely, the decision to reduce government spending is “contractionary.”

And finally between monetary and fiscal policy, the monetary policy is generally viewed as having the largest impact on the economy, while fiscal policy is seen as being the less efficient way to influence growth trends.An important aspect of monetary and fiscal policies is that neither occurs in a vacuum. Instead, the two work together to influence economic conditions. In terms of monetary policy, central banks such as the Fed need to assess how fiscal policy will affect the economy so they can adjust their approach accordingly. Along the same line, the economic results of central bank actions – higher growth and/or higher inflation vs. slower

growth and/or lower inflation – can affect policymakers’ approach to taxation and government spending.