Monetary and Fiscal Policy

The Monetary and Fiscal Policies, although controlled by two

different organizations, are the ways that our economy is kept under

control. Both policies have their strengths and weaknesses, some

situations favoring use of both policies, but most of the time, only

one is necessary.

The monetary policy is the act of regulating the money supply

by the Federal Reserve Board of Governors, currently headed by Alan

Greenspan. One of the main responsibilities of the Federal Reserve

System is to regulate the money supply so as to keep production,

prices, and employment stable. The “Fed” has three tools to manipulate

the money supply. They are the reserve requirement, open market

operations, and the discount rate.

The most powerful tool available is the reserve requirement.

The reserve requirement is the percentage of money that the bank is

not allowed to loan out. If it is lowered, banks are required to keep

less money, and so more money is put out into circulation

(theoretically). If it is raised, then banks may have to collect on

some loans to meet the new reserve requirement.

The tool known as open market operations influences money and

credit operations by buying and selling of government securities on

the open market. This is used to control overall money supply. If the

Fed believes there is not enough money in circulation, then they will

buy the securities from member banks. If the Fed believes there is too

much money in the economy, they will sell the securities back to the

banks. Because it is easier to make gradual changes in the supply of

money, open market operations are use more regularly than monetary

policy.

When member banks want to raise money, they can borrow from

Federal Reserve Banks. Just like other loans, there is an interest

rate, or a discount rate, the third tool of the monetary policy. If

the discount rate is high, then fewer banks will be inclined to

borrow, and if it is low, more banks will (theoretically) borrow from

the reserve banks. The discount rate is not used as frequently as it

was in the past, but it does serve as an indicator to private bankers

of the intentions of the Fed to constrict or enlarge the money

supply.

The monetary policy is a good way to influence the money

supply, but it does have its weaknesses. One weakness is that tight

money policy works better that loose money policy. Tight money works

on bringing money in to stop circulation, but for loose policy to

really work, people have to want loans and want to spend money.

Another problem is monetary velocity. The number of times per year a

dollar changes hands for goods and services is completely independent

of the money supply, and can sometimes contradict the efforts of the

Fed. The benefits of the monetary system are that it can be enacted

immediately with quick results. There are no delays from congress.

Second, the Fed uses partisan politics, and so has no ties to any

political party, but acts in the best interests of the U.S. Economy.

The second way to influence the money supply lies in the hands

of the government