Monetary and Fiscal Policy Tools

To reach macroeconomic goals, countries must often choose among conflicting alternatives. Sometimes political needs override economic needs. For example, bringing inflation under control may call for a politically difficult period of high unemployment and low growth. Or, in an election year, politicians may resist raising taxes to curb inflation. Still, the government must try to guide the economy to a sound balance of growth, employment, and price stability. The two main tools it uses are monetary policy and fiscal policy.

In the United States, the Federal Reserve System (the Fed) is the central bank. It prints money and controls how much of it will be in circulation, and it also regulates certain bank activities. When the Fed increases or decreases the amount of money in circulation, it affects interest rates—the cost of borrowing money and the reward for lending it. The Fed can change the interest rate on money it lends to banks to signal the banking system and financial markets that it has changed its monetary policy. These changes have a ripple effect: banks may pass along the change to consumers and businesses that receive loans. If the cost of borrowing increases, the economy slows because interest rates affect decisions to spend or invest. The housing industry, business, and investments react most to changes in interest rates.

The Fed can use monetary policy to contract or expand the economy. With contractionary policy, the Fed restricts, or tightens, the money supply by selling government securities or raising interest rates. The result is slower economic growth and higher unemployment. Thus, contractionary policy reduces spending and, ultimately, lowers inflation. With expansionary policy, the Fed increases, or loosens, growth in the money supply. An expansionary policy stimulates the economy. Interest rates decline, so business and consumer spending go up. Unemployment rates drop as businesses expand. But increasing the money supply also has a negative side: more spending pushes prices up, increasing the inflation rate.

The other economic tool used by the government is fiscal policy, its program of taxation and spending. By cutting taxes or by increasing spending, the government can stimulate the economy. The more government buys from businesses, the greater the business revenues and output. Likewise, if consumers or businesses have more money because taxes are cut, they spend more, which also stimulates the economy.

Which tool would the Fed use to cool an overheating economy?

As a result of the 2007–2009 recession and the global financial crisis that ensued, the Fed dropped the federal funds rate—the interest rate charged on overnight loans between banks—to 0 percent in December 2008 and kept the rate at zero until December 2015, when it raised the rate to 0.25 percent. This decision marked the first increase in the federal-funds rate since June 2006, when the federal funds rate was 5.25 percent. As the U.S. economy continues to show a slow but steady expansion, the Fed subsequently increased the federal funds rate to a range of 0.75 to 1 percent in March 2017. As expected, this change has a ripple effect: the regional Federal Reserve Banks increase the discount rate they charge commercial banks for short-term loans, many commercial banks raise the interest rates they charge their customers, and credit card companies increase the annual percentage rate (APR) they charge consumers on their credit card balances.

What happens to the economy when the Fed raises interest rates?