Joe Mann Monetary and Fiscal Policy

Professor Harpaz

Monetary policy involves changing the interest rate and influencing the money supply. On the other hand, Fiscal policy involves the government changing tax rates and levels of spending to influence aggregate demand in the economy. They are similar in the fact that both used to pursue policies of higher economic growth or controlling inflation.

Monetary policy is usually carried out by the Central Bank. They usually set the base interest rate, like the Federal Reserve does in the US. Monetary policy also entails influencing the money supply; for example the policy of quantitative easing to increase the money supply. They also can control inflation, where if economic growth is too quick they can increase the interest rates, which would increase the cost of borrowing and reduce consumer spending and investment. On the other hand if the economy went into a recession, then the Central Bank would decrease the interest rates to facilitate business and borrowing. Monetary policy can affect stock prices in many ways. If the central bank issued a policy of quantitative easing, this would inject money into the market causing stock prices to rise. Also if they lower interest rates, this would also lead to stock prices rising, because this would facilitate trade within the market. However, if they higher the interest rates this would most likely decrease stock prices because people would invest in bonds since they could receive returns from a risk free rather than taking on more risk in the stock market.

Fiscal policy is carried out by the government, since fiscal policy controls the level of government spending and the level of taxation. Fiscal Policy is used to increase demand and economic growth, the government will cut tax and increase spending, which will lead to a higher budget deficit. It is also used to reduce demand and reduce inflation; the government can increase tax rates and cut spending, which leads to a smaller budget deficit. An example of fiscal policy would be in a recession, the government may decide to increase borrowing and spend more on infrastructure spending. The idea is that this increase in government spending creates an injection of money into the economy and helps to create jobs. There may also be a multiplier effect, where the initial injection into the economy causes a further round of higher spending. This

increase in aggregate demand can help the economy to get out of recession. If the government felt inflation was a problem, they could pursue deflationary fiscal policy (higher tax and lower spending) to reduce the rate of economic growth. Fiscal policy can sometimes cause stock prices to decrease, like recently due to the fiscal cliff, the stock market suffered due to the increase of tax on capital gains. Therefore the government was forced to change the policy to avoid the fiscal cliff. However, if the government would lower taxes, this enables people to have more capital to invest and would inject more money into the market, causing stock prices to rise.