There are two powerful tools our government and the Federal Reserve use to steer our economy in the right direction: fiscal and monetary policy. When used correctly, they can have similar results in both stimulating our economy and slowing it down when it heats up. The ongoing debate is which one is more effective in the long and short run.

Fiscal policy is when our government uses its spending and taxing powers to have an impact on the economy. The combination and interaction of government expenditures and revenue collection is a delicate balance that requires good timing and a little bit of luck to get it right. The direct and indirect effects of fiscal policy can influence personal spending, capital expenditure, exchange rates, deficit levels, and even interest rates, which are usually associated with monetary policy.

Fiscal Policy and the Keynesian School

Fiscal policy is often linked with Keynesianism, which derives its name from British economist, John Maynard Keynes. His major work, "The General Theory of Employment, Interest, and Money," influenced new theories about how the economy works and is still studied today. He developed most of his theories during the Great Depression, and Keynesian theories have been used and misused over time, as they are popular and are often specifically applied to mitigate economic downturns.

In a nutshell, Keynesian economic theories are based on the belief that proactive actions from our government are the only way to steer the economy. This implies that the government should use its powers to increase aggregate demand by increasing spending and creating an easy money environment, which should stimulate the economy by creating jobs and ultimately increasing prosperity. The Keynesian theorist movement suggests that monetary policy on its own has its limitations in resolving financial crises, thus creating the Keynesian versus the Monetarists debate.

While fiscal policy has been used successfully during and after the Great Depression, the Keynesian theories were called into question in the 1970s after a long run of popularity. Monetarists, such as Milton Friedman, and supply-siders claimed the ongoing government actions had not helped the country avoid the endless cycles of below-average gross domestic product (GDP) expansion, recessions, and gyrating interest rates.

Some Side Effects

Just like monetary policy, fiscal policy can be used to influence both expansion and contraction of GDP as a measure of economic growth. When the government is exercising its powers by lowering taxes and increasing its expenditures, they are practicing expansionary fiscal policy. While on the surface, expansionary efforts may seem to lead to only positive effects by stimulating the economy, there is a domino effect that is much broader reaching. When the government is spending at a pace faster than tax revenues can be collected, the government can accumulate excess debt as it issues interest-bearing bonds to finance the spending, thus leading to an increase in the national debt.

When the government increases the amount of debt it issues during an expansionary fiscal policy, issuing bonds in the open market will end up competing with the private sector, which may also need to issue bonds at the same time. This effect, known as crowding out, can raise rates indirectly because of the increased competition for borrowed funds. Even if the stimulus created by the increased government spending has some initial short-term positive effects, a portion of this economic expansion could be mitigated by the drag caused by higher interest expenses for borrowers, including the government.

Another indirect effect of fiscal policy is the potential for foreign investors to bid up the U.S. currency in their efforts to invest in the now higher-yielding U.S. bonds trading in the open market. While a stronger home currency sounds positive on the surface, depending on the magnitude of the change in rates, it can actually make American goods more expensive to export and foreign-made goods cheaper to import. Since most consumers tend to use price as a determining factor in their purchasing practices, a shift to buying more foreign goods and a slowing demand for domestic products could lead to a temporary trade imbalance. These are all possible scenarios that have to be considered and anticipated. There is no way to predict which outcome will emerge and by how much because there are so many other moving targets, including market influences, natural disasters, wars, and any other large-scale event that can move markets.

Fiscal policy measures also suffer from a natural lag or the delay in time from when they are determined to be needed to when they actually pass through Congress and, ultimately, the president. From a forecasting perspective, in a perfect world where economists have a 100% accuracy rating for predicting the future, fiscal measures could be summoned up as needed. Unfortunately, given the inherent unpredictability and dynamics of the economy, most economists run into challenges in accurately predicting short-term economic changes.

Monetary Policy and the Money Supply

Monetary policy can also be used to ignite or slow the economy and is controlled by the Federal Reserve with the ultimate goal of creating an easy money environment. Early Keynesians did not believe monetary policy had any long-lasting effects on the economy because: 

• Since banks have a choice whether or not to lend out the excess reserves they have on hand from lower interest rates, they may just choose not to lend; and
• Keynesians believe consumer demand for goods and services may not be related to the cost of capital to obtain these goods.

At different times in the economic cycle, this may or may not be true, but monetary policy has proven to have some influence and impact on the economy, as well as equity and fixed income markets.

The Federal Reserve carries three powerful tools in its arsenal and is very active with all of them. The most commonly used tool is their open market operations, which affect the money supply through buying and selling U.S. government securities. The Federal Reserve can increase the money supply by buying securities and decrease the money supply by selling securities.

The Fed can also change the reserve requirements at banks, directly increasing or decreasing the money supply. The required reserve ratio affects the money supply by regulating how much money banks must hold in reserve. If the Federal Reserve wants to increase the money supply, it can decrease the amount of reserves required, and if it wants to decrease the money supply, it can increase the amount of reserves required to be held by banks.

The third way the Fed can alter the money supply is by changing the discount rate, which is the tool that is constantly receiving media attention, forecasts, speculation. The world often awaits the Fed's announcements as if any change would have an immediate impact on the global economy.

The discount rate is frequently misunderstood, as it is not the official rate consumers will be paying on their loans or receiving on their savings accounts. It is the rate charged to banks seeking to increase their reserves when they borrow directly from the Fed. The Fed's decision to change this rate does, however, flow through the banking system and ultimately determines what consumers pay to borrow and what they receive on their deposits. In theory, holding the discount rate low should induce banks to hold fewer excess reserves and ultimately increase the demand for money. This begs the question: which is more effective, fiscal or monetary policy?

Which Policy Is More Effective?

This topic has been hotly debated for decades, and the answer is both. For example, to a Keynesian promoting fiscal policy over a long period of time (e.g. 25 years), the economy will go through multiple economic cycles. At the end of those cycles, the hard assets, like infrastructure, and other long-life assets, will still be standing and were most likely the result of some type of fiscal intervention. Over that same 25 years, the Fed may have intervened hundreds of times using their monetary policy tools and maybe only had success in their goals some of the time.

Using just one method may not be the best idea. There is a lag in fiscal policy as it filters into the economy, and monetary policy has shown its effectiveness in slowing down an economy that is heating up at a faster-than-desired pace, but it has not had the same effect when it comes to rapid-charging an economy to expand as money is eased, so its success is muted.

The Bottom Line

Though each side of the policy spectrum has its differences, the United States has sought a solution in the middle ground, combining aspects of both policies in solving economic problems. The Fed may be more recognized when it comes to guiding the economy, as their efforts are well-publicized and their decisions can move global equity and bond markets drastically, but the use of fiscal policy lives on. While there will always be a lag in its effects, fiscal policy seems to have a greater effect over long periods of time and monetary policy has proven to have some short-term success.