I was never a smooth talker. I can’t give smooth responses or give clever retorts. I’m too honest, direct, sarcastic, and analytical, so I guess it makes sense that I ended up in Engineering!
While my lack of silver tongue will never change, changes in the economy are constantly happening. Whether it’s in response to the natural boom and bust phases of a business cycle, or to black swan unexpected economic events, there are usually some proactive sort of measures in place to maintain financial stability and to manage risk in the economy. While it is the role of your financial planner or investment portfolio manager to be regularly in tune to these events to manage and make adjustments to your portfolio accordingly, there is value in understanding the macroeconomic implications of policies to maintain financial stability of your overall portfolio.
So what do these “responses” look like to macroeconomic events? Monetary and fiscal policy are the policies by which financial stability is maintained within an economy. This could be at a national level, continental level, or even international level.
In this article we will be comparing the objectives of monetary and fiscal policy, the parties involved, the tools used under each policy to maintain financial stability, and the potential negative consequences of each policy.
Monetary Policy
Both fiscal and monetary policy’s primary objective is the same, however the main difference between the two is the party that carries out the policy action. Under monetary policy, central banks carry out policies to ensure financial stability.
A central bank’s roles can be summarized into 4 points:
Control production and distribution of money and credit
Regulate commercial banks in terms of reserve requirements and overnight lending rates between banks
Act as advisers to the government
Act as a Lender of Last Resort, or LoR, to banks or other institutions who are experiencing financial difficulty or who are deemed to have a high risk of default. In the US, the Federal Reserve acts as an LoR.
What exactly does financial stability mean in this context? Think about the boom and bust cycles of the economy, as pictured in Figure 1. Ideal stability would be the “smoothening” out of the peaks and valleys into more of a flat horizontal line, and monetary policy would be the response to do the smoothening.
Although this is theoretical, it does provide insight into how central banks can behave during peaks and troughs in the business cycle. In a nutshell, financial stability means that inflation and liquidity is maintained and controlled. During boom cycles, inflation rises as money and investment is being spent and created, which in turn raises asset prices (think supply and demand). During bust cycles, less money is being spent and more money is being saved, thus demand for goods is lower and prices fall. This may result in an inflation level that is less than a central bank’s target or what they deem to be acceptable, and in same cases, a negative inflation (deflation).
To effectively carry out its roles, there are three main mechanisms that central banks use to implement monetary policy.
Interest Rate Policy: central banks have control over the overnight lending rates between financial institutions. These are short term borrowing rates that banks charge each other for “overnight” lending to ensure liquidity and reserve requirements are met. When these overnight lending rates change, treasury rates will usually adjust accordingly, as well as consumer loan rates (i.e. the prime rate offered at banks). Interest Rate Policy therefore by proxy influences treasury bond rates (or risk free rates), and consumer lending rates. And remember, risk free rates are used in pretty much every asset price and valuation model out there, so it has a lot of importance (more on risk free rates in a future lesson)
Open Market Operations: central banks can buy and sell securities to financial institutions and commercial banks. This is referenced way back in Lesson 22 regarding the cycle of money. The involvement in open market operations has direct influence on asset prices, and indirectly on yields or treasury rates. If central banks purchase more treasury bonds and mortgage backed securities, prices of these securities will increase with this increase in demand. As a result, the underlying rates for these securities will fall. This is perhaps less directive than interest rate policy, but it is an alternative to impact interest rates and encourage, or discourage, consumer spending and investment in other areas of the market.
Reserve Requirements: Central banks set the reserve requirements for banks. All banks must at all times maintain a reserve requirement, or an amount of money on hand (deposits). Reserve ratios (sometimes called the cash reserve ratio) must be maintained as well, which is simply the ratio of deposits on hand to the amount of money being lent out at any given time. By changing reserve requirements, central banks can indirectly “Create money” in the economy. If reserve ratios are lessened, that means for the same amount of deposits on hand that the bank has, they are now able to lend out MORE money into the economy, thus “creating money”. Lowering reserve requirements increases money velocity, or the rate at which money flows through the economy. Again from Lesson 22, the rate at which money flows impacts economic growth, inflation, and asset price growth.
There are limitations to utilizing these three mechanisms to carry out monetary policy. Too much or too little of any of these three mechanisms can have serious consequences to the overall economic growth of a country.
Reducing interest rates too quickly or to zero can actually lead to deflation, which asset prices over time will actually decrease. The purchasing power of consumers will also decrease. Short term deflation is fine, but long term deflation is difficult to get out of. How do you raise interest rates while asset prices are decreasing already and unemployment is rising, along with debt obligation defaults?
Too much monetary policy around interest rates can actually lead to decreased lending by financial institutions. Combating inflation by raising interest rates too quickly can lead to a decrease in consumer loan demand (who wants to borrow at higher rates?). Not only would bank profits suffer, but reserve ratios would probably drop as central banks combat inflation with higher interest rates, which means less “created money” in the economy.
Another backfire of monetary policy is referred to as the “liquidity trap”, where central banks reduce interest rates to near 0, or 0, levels to encourage consumer spending and spur economic growth and activity. However, if liquidity is being increased and consumer demand stagnates or unemployment continues to rise, central banks are trapped since the best way to combat demand stagnation and rising unemployment is to lower rates. If low interest rates are not enough to stimulate consumer spending and keep the workforce near full employment, then this liquidity trap could set off a deflationary domino effect where asset prices fall coupled with a consumer base that is already delaying spending, which makes asset prices fall even more, and so on.
Fiscal Policy
Like monetary policy, fiscal policy aims at maintaining economic and financial stability by managing inflation rates and encouraging investment and spending in the economy. Under fiscal policy, governments are the ones carrying out the policies. It is another response to “smoothening” the business cycle
A government and law maker’s roles in fiscal policy can be summarized into 2 items:
Manage government spending
Control Tax Rates for Consumers and Businesses
To effectively achieve these objectives and carry out its roles, there are two main mechanisms that governments and law makers use to implement fiscal policy.
Government spending: The government can inject money and liquidity into the system simply by spending. Spending can take the form of long-term capital investments such as infrastructure, short term spending such as business and wage subsidies, or transfer payments through social security and welfare systems to increase employment. Increase employment means more people are earnings wages, which means increased spending in the economy and growth in asset prices.
Tax Policy: Governments can also carry out fiscal policy through taxation policies. Changing tax rates will change the money flow to the government, or in other words, from the economy. Lower tax rates encourage consumer and business spending and investment elsewhere, while increasing tax rates helps curb inflation. The challenge that law makers have to deal with is coming up with a tax policy that not only maximizes tax revenue, but minimizes the impact on economic growth.
Like monetary policy, there are limitations to fiscal policy if not implemented and carried out effectively that could pose harm to a country’s economy. For one, it takes time for fiscal policy to have an impact to economic growth, and positive change may not happen immediately. Recognizing economic patterns is important to forecast what will happen in the near future in terms of economic growth and business cycle periods. This can help governments prepare their fiscal policy measures appropriately to be prepared for such anticipated future patterns. If the time lag between policy implementation and economic impact is not fully understood, then this could lead to ineffective fiscal policy due to improper timing of policy implementation, or use of inaccurate and irrelevant economic data. As much as recognizing economic patterns from the past is important for forecasting the future of an economy, there is always uncertainty in what this future state could look like, and this risk must be continuously monitored and managed appropriately by law makers.
A summary comparison is shown below in Table 1 to highlight the similarities and differences between fiscal and monetary policy:
Table 1: Monetary and Fiscal Policy Comparison Summary
Having an awareness around these economic stability levers is helpful when making long term decisions around your investments and financial planning. With the help of a financial planner, this added awareness of fiscal and monetary policies can help reduce the sensitivity to changes in these policies when measuring the feasibility of reaching your retirement goals. This kind of insight will not only make you more aware of the world around you but it may even help with having those difficult conversations with your financial advisor about investment reallocations, fund withdrawals, and investment rationale.