Fiscal and Monetary Policies’ Effects on Economy

Effects of the Fiscal Policy and the Monetary Policy in the Economy

The monetary policy is a set of procedures through which a monetary authority (the central bank) controls the money supply in its country to manipulate the interest rate of its currency. The Federal Reserve is the governing authority in charge of the monetary policy in the United States (the United States’ central bank).

Fiscal policy is a set of measures taken by the government in a bid to influence the economy’s performance by altering the rate of taxation and the amount of government spending. This is usually done when concerned parties believe that the economy requires outside help to achieve certain standards.

The contractionary fiscal policy is when a government reduces its spending, increases taxes, or decreases the transfer of payments to reduce inflation. The main aim of the contractionary fiscal policy is to reduce the inflation gap and the rate of inflation. This policy is usually implemented when the rate of economic growth and unemployment is too high. To correct this, the government will reduce its spending and increase taxes on income.

The expansionary fiscal policy on the other hand is the opposite of the contractionary fiscal policy. This is where the government decides to increase its spending and reduces income tax. This policy is usually implemented to correct an economy that is in recession. This leads to an increase in the GDP and this will help the economy to grow.

As previously mentioned, the Federal Reserve was given the authority to manipulate the demand and supply of its currency, following the implementation of the 1913 Federal Reserve Act. To perform this, the Federal Reserve relies on three mechanisms; discount rates, open market operations, and reserve requirements. Using these instruments, the Federal Reserve can determine the amount of money that commercial banks and other financial institutions can deposit in the central banks’ vault. This amount then determines the federal fund rate (Parker, 2007).

As mentioned before, the Federal Reserve also relies on Open Market Operations to control the exchange rate of its dollar. Open Market Operations involves the buying and selling of government-issued securities by the United States’ central bank. This forms the foundation on which the monetary policy is formulated. The immediate goal of such operations is to alter the value of the American dollar by manipulating the federal fund rate. To reduce the interest rates on loans, the Federal Reserve buys government bonds, thereby increasing market liquidity. This leads to an increase in the money supply as people can borrow more money from financial institutions due to favorable interest rates (Ireland, 2013).

Alternatively, the Federal Reserve can use the discount rates to control the supply, and consequently the value of money. The interest rate is the levy that the Federal Reserve charges commercial banks for their overnight borrowing of money from its reserves. The Federal Reserve uses three main criteria to determine the amount of interest it will charge depository financial institutions that qualify for credit. These criteria are seasonal credit, secondary credit, and primary credit.

Monetary supply expansion leads to an increase in market liquidity. Thus more people can acquire extra money in the form of loans from financial institutions. Due to the high value of money in circulation, the interest rate generally reduces.


Ireland, P. (n.d.) Personal Web Server – ITS – Boston College. Web.