Monetary and Fiscal Policy

Monetary policy

Monetary policy is conducted by the Federal Reserve Board and its Federal Open Market Committee. It works on the money supply and the cost of credit, and it has three tools.

Open market operations — buying and selling government securities, generally through repurchase agreements — is the principal tool and is used continuously. Buying securities puts money into the banking system, adds reserves and eases policy. Selling securities drains reserves and tightens.

The discount rate is the rate the Federal Reserve charges banks that borrow directly from it. Raising it tightens; lowering it eases. It is used far less frequently than open market operations.

Reserve requirements set the proportion of deposits banks must hold rather than lend. Raising the requirement contracts lending; lowering it expands it. It is the bluntest tool and is changed rarely.

The rates candidates confuse, stated apart:

The federal funds rate is the rate at which banks lend reserves to each other overnight. It is a market rate, and it is what the FOMC targets.

The discount rate is what the Fed itself charges. It is set by the Fed directly.

The prime rate is what banks charge their most creditworthy corporate customers. It is set by banks, and it is a lagging indicator.

The call rate, or broker call loan rate, is what banks charge broker-dealers on loans collateralized by securities, and it is the base for margin interest.

The federal funds rate is normally the lowest of these.

Fiscal policy

Fiscal policy is taxation and government spending, set by Congress and the President. The Federal Reserve has no role in it.

An expansionary fiscal policy increases spending or cuts taxes, raising aggregate demand. A contractionary one does the reverse.

The practical exam consequence is a sorting exercise: if the question names a tax change, a spending programme or a deficit, it is fiscal. If it names an interest rate, the money supply, reserves or the purchase of government securities, it is monetary.

The theories the outline names sit behind these levers. Keynesian economics holds that aggregate demand drives output and that fiscal policy should manage it. Monetarism holds that controlling the growth of the money supply is what matters, and is sceptical of active fiscal management. Supply-side economics emphasizes reducing taxes and regulation to increase production.

What policy does to markets

An easing policy lowers interest rates. Because bond prices move inversely to rates, existing bond prices rise. Longer maturities and lower coupons rise most, for the reasons covered in the debt lesson. Equities generally benefit, because borrowing is cheaper and future earnings are discounted less severely — which helps growth stocks more than value stocks.

A tightening policy raises rates, and everything above runs in reverse.

Inflation erodes the real value of a fixed stream of payments, so it is bad for long-dated fixed income and is the specific risk that Treasury Inflation Protected Securities and, over long horizons, equities are used against.

A weaker dollar makes US exports cheaper abroad and imports more expensive at home, which helps US exporters and hurts US importers. A stronger dollar reverses it. That mapping is worth memorizing in one direction and deriving the other.

And note the causal chain the exam likes to test in pieces: the Fed buys securities, reserves rise, the federal funds rate falls, credit becomes cheaper, borrowing and spending rise, bond prices rise, and equity markets generally rise. Each link is a possible question.