Monetary Policy vs. Fiscal Policy.

Monetary Policy vs. Fiscal Policy

People always struggled with an idea of prosperity and success, whether it was a personal goal or whether it was something major - like wealth of a country. Nowadays, we are studying a science, which is really significant and valuable - Economics. Economics is a tool for achieving those goals, knowledge that people can use and imply in real life, and at the present time probably undividable part of governments' performances around the world. For us, students, there are two different matters we study - Macroeconomics, the study of the performance of national economies and Microeconomics, which focuses on the behavior of individual households, firms, and markets.

During the fall quarter of 2001, I was exposed to the basic ideas and uses of the Macroeconomics. Macroeconomics policies - government actions to improve the performance of the economy - are of particular concern to macroeconomists, as the quality of macroeconomic policymaking as a major determinant of a nation's economic health. Monetary and Fiscal policies are two policies that we were concentrated on, and were the most significant part of the course for me. There is too much involved in these policies and they interact with each other consistently. I decided to write this paper, summarizing the basic functions of two policies, tried to explain what it is that makes them work, how effective these two policies can be, and how one relates to another.

In looking at the effectiveness of Monetary and Fiscal policies, it must be understood how the two relate to each other within the government structure. The Federal Open Market Committee - FOMC - is the most important monetary policy-making body of the Federal Reserve System. It is responsible for the formulation of a policy designed to promote economic growth, full employment, stable prices, and a sustainable pattern of international trade and payments. The seven Board members constitute a majority of the 12-member Federal Open Market Committee, the group that makes the key decisions affecting the cost and availability of money and credit in the economy. The other five members of the FOMC are Reserve Bank presidents, one of who is the president of the Federal Reserve Bank of New York. The Board sets reserve requirements and shares the responsibility with the Reserve Banks for discount rate policy. The FOMC is the policy arm of the Fed and the tasks of the Federal Reserve are to supervise banks, fixing maximum rates of interests.

The U.S Treasury, though it aids in much of the monetary management, represents the fiscal sector, which is the U.S Congress. Fiscal policy covers, such areas as taxation and other revenue gathering and spending measures. Fiscal policies are those actions that are enacted by the Legislative Branch of the U.S government, the Congress. Their fiscal policies are enacted through the U.S Treasury. Therefore, the Treasury is the arm of fiscal policy and the Federal Reserve is the arm of monetary policy. For example, even if Congress has allocated some amount of money to take over failing banks and savings and loans, and it is not enough, than the Fed can pump capital into the system by buying bank stocks. So, this is example of how the Fed interacts and influences the ups and downs of the economy.

In looking at the relationship between the Fed and The Treasury, essentially, the Fed was set up to provide the U.S Treasury with a more satisfactory fiscal agent. In acting as the fiscal agent for the U.S Treasury, or more specifically, as the primary banker for the federal government, the Fed acts as Financial advisor, depository and receiving agent, agent for issuing and retiring treasury securities, agent for other transactions involving purchases and sales of securities for Treasury account, agent for the government in purchasing and gold and foreign exchange, and lender to the Treasury.

The Treasury influences monetary and credit conditions as well, through its revenue and expenditure policies, its debt management policies relative to the size and location of its money balance, and so on. As an instrument of monetary management, the Treasury keeps its money balance in cash in the vaults as Treasury deposits at the Federal Reserve, and Treasury deposits at commercial banks.

Owing to the degree of Treasury operations, these policies have marked effect on monetary and credit conditions, especially over periods. Ordinarily, the Treasury does not use these powers for intentional and continuous monetary management; this is primarily the function of the Federal Reserve. However, it does try to use its powers in such a way as to avoid creating serious problems for the Federal Reserve, and on occasion, it uses them intentionally to supplement Federal Reserve policies.

The following is an example of how this occurs. The Treasury can implement restrictive actions. For example, the Treasury increases it money balance $1 billion by taxing the public or selling securities to the public. When the Treasury cashes the checks, the public loses $1 billion of its deposits. If the Treasury holds these deposits at commercial banks, this is the extent of the effect; the reserve positions of the banks are unaffected. But if the Treasury uses the $1 billion to build up its cash in vault or its deposits at the Federal Reserve, member banks reserves will be reduced by $1 billion.

Basically, if we find an increase in the Treasury's money balance, this tends to be restrictive unless the Treasury acquires the extra money by borrowing from the Federal Reserve. If it acquires the money balance by taxing the public or selling securities to it, the public's money supply is directly decreased. If it acquires money by selling securities to commercial banks, the public's money supply is not directly decrease, but the ability of the banks to create deposits for the public is reduced because they must use some their reserves to support the Treasury deposit. However, given the size of any increase in the Treasury's balance, the degree of restrictiveness depends on the form in which it is held. On the other hand, the Treasury can affect monetary policy, by easing restrictions as well. Sometimes the Treasury utilizes liberalizing actions in a positive way to ease credit to supplement Federal Reserve actions. More often, however, it uses them to avoid creating conditions that would make the job of the Federal Reserve more difficult.

Given, this information, we can see what the relationship is between the Federal Reserve and the U.S Treasury. They often complement each other and balance each other out. However, the prime job of the Federal Reserve is to act as the federal government bank, as well as regulating monetary policy, credit regulations, and supervising function of member banks. The U.S Treasury is the element of the government, which collects money from the public, either through the sale of securities or through taxation. The U.S Treasury is that arm of the government, which provides the government with money it needs to operate, which of course is part of fiscal policy operations. The Fed is the bank that the Treasury uses for its banking needs, to be it in the most simplistic terms.

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We were all shocked by tragedy that happened on September 11, 2001. There was a tremendous impact on the entire world by that event. People were heavily affected emotionally same as financially. Many lives were taken by the coward act of those who responsible for such disaster. The US faced a number of consequences followed by many bumps on its way to the future. Unbelievable economic downturn made all sectors of the economy to suffer this impact and force them to make decisions, which they probably didn't thought of. Because Fiscal and Monetary Policy have a straight connection to the several actions taken by the government to stimulate weakened economy, I decided to cover what is going on right now within government structure and briefly explain what people should expect from policymakers, who are doing their best to respond to these obstacles, which we are facing right now, as quick as possible.

Considering that today's U.S. economy is already in mild recession and many indicators show it might face the most severe economic downturn since 1970s of the last century, President Bush and his administration called for additional stimulus package for fiscal 2002. Policymakers in Washington are considering a number of actions that could stimulate the economy. Among them the options being considering are tax cuts that could spur consumption or investment, and additional federal spending that could directly increase economic activity. Republicans are the majorities in the House of Representatives and Democrats, who control the Senate, have very different and opposite visions about ways to stimulate the U.S. economy. Republicans consider that economic growth is generated through investments by businesses, which encouraged by cuts in taxes and tax rates. Democrats support the proposal that stimulates consumer spending such as through tax rebates for low-income, extensions of unemployment insurance, and government spending to promote construction and other infrastructure.

A several weeks ago, the House Ways and Means Committee have passed a $100 billion economic stimulus package main part of which - 85% - for permanent tax cuts, mostly for corporate tax cuts. The major components of this plan are:

Elimination of the corporate alternative minimum taxes and refunds AMT credits.

This is a most controversial point of the House Republicans proposal. The minimum tax was designed to make profitable companies to pay a basic amount even if they owe no corporate income tax because of some deductions. Democrats support the fairness of this tax cut but disagree with its retroactive method because although these refunds would effectively reduce the tax rate on corporate income but those compensations for the previous investment, not new investment.

Permit 30% immediate expensing write-off for purchase of capital assets over the next three years.

Reduce the maximum tax rate on long-term capital gain from 20% to 18%.

Deductions of net losses from taxes paid up to five years earlier.

Republicans argue that all these corporate tax cuts are necessary to encourage businesses to invest more into new capital because businesses would have more income or retained earnings. And as a result it would spur the economy. Democrats disagree. They tell that businesses would not necessary to invest; some of any tax cuts will be saved or businesses can simply to pay down their debts or to spend them for dividends to their stockholders and maybe only small part would go into new investment.

Permanent cut in the former 28% tax cut rate to 25% would be accelerated to 2002.

Democrats argue that this tax cut would be more effective if it will be temporary rather than permanent tax cut because this acceleration significantly shorten government revenue in later years and in the long run the government can't afford these rates cuts. Moreover, most of the tax relief would benefit only the top one-quarter of all income tax filers, who are likely to save more and spend less from tax cuts than those who have lower incomes and tend to spend whatever extra income they have. That is why Democrats support the proposal to send additional tax rebates for low-income workers, because the more rebate is spend the more effective it is as a stimulus. Democrats want to freeze marginal tax reduction in previous 39.6 bracket to 38.6% rather to decline it. It would save roughly $100 billion between 2002 and 2011.

Democrats have proposed a smaller package with far fewer and temporary tax cuts and significantly more new spending - 75% of the stimulus plan. They support the ways that spur consumer spending that has kept the economy afloat such as through tax rebates for lower income workers, expansions of unemployment insurance and government spending for construction and other infrastructure. For instance, temporary changes in the unemployment insurance program or any additional benefits provided would likely be spent and go directly to output. Public capital investments involve direct government purchases of goods and services and therefore directly add demand into economy.