How does the Government use Monetery and Fiscal Policies to Benefit the Economy? Our governments roll in the American economy extends far beyond its activities as a regulator of specific industries. The government also manages the overall pace of economic activity, seeking to maintain high levels of employment and stable prices. The government has two main tools for achieving these objectives: fiscal policies, through which it determines the appropriate level of taxes and spending; and monetary policies, through which it manages the supply of money.
Fiscal policy the use of government expenditures and taxes to influence the level of economic activity is the government counterpart to monetary policy. Like monetary policy, it can be used in an effort to close a recessionary or an inflationary gap The development of fiscal policy is an elaborate process. Each year, the president proposes a budget, or spending plan, to Congress. Lawmakers consider the president’s proposals in several steps. First, they decide on the overall level of spending and taxes.
Next, they divide that overall figure into separate categories — for national defense, health and human services, and transportation, for instance. Finally, Congress considers individual appropriations bills spelling out exactly how the money in each category will be spent. Each appropriations bill ultimately must be signed by the president in order to take effect. This budget process often takes an entire session of Congress; the president presents his proposals in early February, and Congress often does not finish its work on appropriations bills until September (and sometimes even later).
The federal government’s chief source of funds to cover its expenses is the income tax on individuals, which in 1999 brought in about 48 percent of total federal revenues. Payroll taxes, which finance the Social Security and Medicare programs, have become increasingly important as those programs have grown. In 1998, payroll taxes accounted for one-third of all federal revenues; employers and workers each had to pay an amount equal to 7. 65 percent of their wages up to $68,400 a year.
The federal government raises another 10 percent of its revenue from a tax on corporate profits, while miscellaneous other taxes account for the remainder of its income. (Local governments, in contrast, generally collect most of their tax revenues from property taxes. State governments traditionally have depended on sales and excise taxes, but state income taxes have grown more important since World War II. ) Over the years, lawmakers have carved out various exemptions and deductions from the income tax to encourage specific kinds of economic activity.
Most notably, taxpayers are allowed to subtract from their taxable income any interest they must pay on loans used to buy homes. Similarly, the government allows lower- and middle-income taxpayers to shelter from taxation certain amounts of money that they save in special Individual Retirement Accounts (IRAs) to meet their retirement expenses and to pay for their children’s college education. The Tax Reform Act of 1986, perhaps the most substantial reform of the U. S. ax system since the beginning of the income tax, reduced income tax rates while cutting back many popular income tax deductions (the home mortgage deduction and IRA deductions were preserved, however). The Tax Reform Act replaced the previous law’s 15 tax brackets, which had a top tax rate of 50 percent, with a system that had only two tax brackets — 15 percent and 28 percent. Other provisions reduced, or eliminated, income taxes for millions of low-income Americans.
While the budget remained enormously important, the job of managing the overall economy shifted substantially from fiscal policy to monetary policy during the later years of the 20th century. Monetary policy is the province of the Federal Reserve System, an independent U. S. government agency. “The Fed,” as it is commonly known, includes 12 regional Federal Reserve Banks and 25 Federal Reserve Bank branches. All nationally chartered commercial banks are required by law to be members of the Federal Reserve System; membership is optional for state-chartered banks.
In general, a bank that is a member of the Federal Reserve System uses the Reserve Bank in its region in the same way that a person uses a bank in his or her community. The Federal Reserve Board of Governors administers the Federal Reserve System. It has seven members, who are appointed by the president to serve overlapping 14-year terms. It’s most important monetary policy decisions are made by the Federal Open Market Committee (FOMC), which consists of the seven governors, the president of the Federal Reserve Bank of New York, and presidents of four other Federal Reserve banks who serve on a rotating basis.
Although the Federal Reserve System periodically must report on its actions to Congress, the governors are, by law, independent from Congress and the president. Reinforcing this independence, the Fed conducts its most important policy discussions in private and often discloses them only after a period of time has passed. It also raises all of its own operating expenses from investment income and fees for its own services. The Federal Reserve has three main tools for maintaining control over the supply of money and credit in the economy.
The most important is known as open market operations, or the buying and selling of government securities. To increase the supply of money, the Federal Reserve buys government securities from banks, other businesses, or individuals, paying for them with a check (a new source of money that it prints); when the Fed’s checks are deposited in banks, they create new reserves — a portion of which banks can lend or invest, thereby increasing the amount of money in circulation. On the other hand, if the Fed wishes to reduce the money supply, it sells government securities to banks, collecting reserves from them.
Because they have lower reserves, banks must reduce their lending, and the money supply drops accordingly. The Fed also can control the money supply by specifying what reserves deposit-taking institutions must set aside either as currency in their vaults or as deposits at their regional Reserve Banks. Raising reserve requirements forces banks to withhold a larger portion of their funds, thereby reducing the money supply, while lowering requirements works the opposite way to increase the money supply. Banks often lend each other money overnight to meet their reserve requirements.
The rate on such loans, known as the “federal funds rate,” is a key gauge of how “tight” or “loose” monetary policy is at a given moment. The Fed’s third tool is the discount rate, or the interest rate that commercial banks pay to borrow funds from Reserve Banks. By raising or lowering the discount rate, the Fed can promote or discourage borrowing and thus alter the amount of revenue available to banks for making loans. These tools allow the Federal Reserve to expand or contract the amount of money and credit in the U. S. economy.
If the money supply rises, credit is said to be loose. In this situation, interest rates tend to drop, business spending and consumer spending tend to rise, and employment increases; if the economy already is operating near its full capacity, too much money can lead to inflation, or a decline in the value of the dollar. When the money supply contracts, on the other hand, credit is tight. In this situation, interest rates tend to rise, spending levels off or declines and inflation abates; if the economy is operating below its capacity, tight money can lead to rising unemployment.