What are the tools of fiscal and monetary policy used to stimulate the economy during a recession?

I. THE BUSINESS CYCLE

Market economies have regular fluctuations in the level of economic activity which we call the business cycle. It is convenient to think of the business cycle as having three phases. The first phase is expansion when the economy is growing along its long term trends in employment, output, and income. But at some point the economy will overheat, and suffer rising prices and interest rates, until it reaches a turning point -- a peak -- and turn downward into a recession (the second phase). Recessions are usually brief (six to nine months) and are marked by falling employment, output, income, prices, and interest rates. Most significantly, recessions are marked by rising unemployment. The economy will hit a bottom point -- a trough -- and rebound into a recovery (the third phase). The recovery will enjoy rising employment, output, and income while unemployment will fall. The recovery will gradually slow down as the economy once again assumes its long term growth trends, and the recovery will transform into an expansion.

II. ECONOMIC POLICY AND THE BUSINESS CYCLE

The approach to the business cycle depends upon the type of economic system. Under a communist system, there is no business cycle since all economic activities are controlled by the central planners. Indeed, this lack of a business cycle is often cited as an advantage of a command economy. Both socialist and fascist economies have a mix of market and command sectors. Again, the command sector in these economies will not have a business cycle -- while the market sector will display a cyclical activity. In a full market economy -- like the United States -- the nation can suffer extreme swings in the level of economic activity.

The economic policies used by the government to smooth out the extreme swings of the business cycle are called contracyclical or stabilization policies, and are based on the theories of John Maynard Keynes. Writing in 1936 (the Great Depression), Keynes argued that the business cycle was due to extreme swings in the total demand for goods and services. The total demand in an economy from households, business, and government is called aggregate demand. Contracyclical policy is increasing aggregate demand in recessions and decreasing aggregate demand in overheated expansions.

In a market economy (or market sector) the government has two types of economic policies to control aggregate demand -- fiscal policy and monetary policy. When these policies are used to stimulate the economy during a recession, it is said that the government is pursuing expansionary economic policies. And when they are used to contract the economy during an overheated expansion, it is said that the government is pursuing contractionary economic policies.

III. FISCAL POLICY AND MONETARY POLICY

Fiscal policy is changes in the taxing and spending of the federal government for purposes of expanding or contracting the level of aggregate demand. In a recession, an expansionary fiscal policy involves lowering taxes and increasing government spending. In an overheated expansion, a contractionary fiscal policy requires higher taxes and reduced spending. According to Keynes, a recession requires deficit spending while an overheated expansion requires a budget surplus.

1) Discretionary Fiscal Policy. The first way this can be done is through the federal budget process. However, this process takes so long -- 12 to 18 months -- that it is difficult to match discretionary fiscal policy with the business cycle. The expansionary Kennedy tax cut of 1964 and later the contractionary Ford tax increase of 1974 hit the economy just when the opposite contracyclical policy was needed. As a result, the federal government will only use discretionary fiscal policy in a severe recession, such as 1981-82 and 2008-09. In both cases, the federal government resorted to a large fiscal stimulus – tax cuts in 1981-82 and increased spending in 2008-09. Both policies created large deficits, which is the appropriate stabilization policy during a severe downturn.

2) Automatic Stabilizers. A second type of fiscal policy is built into the structure of federal taxes and spending. This is referred to as "nondiscretionary fiscal policy" or more commonly as "automatic stabilizers". The progressive income tax (the major source of federal revenue) and the welfare system both act to increase aggregate demand in recessions, and to decrease aggregate demand in overheated expansions. These automatic changes in spending and taxes will generate a deficit in recessions and a surplus in overheated expansions. The size of these automatic changes can be quite large. In the 2008-09 recession the deficit stimulus due to the automatic stabilizers was much larger than the stimulus created by the legislative changes in taxes and spending (discretionary fiscal policy).

Monetary policy is under the control of the Federal Reserve System (our central bank) and is completely discretionary. It is the changes in interest rates and money supply to expand or contract aggregate demand. In a recession, the Fed will lower interest rates and increase the money supply. In an overheated expansion, the Fed will raise interest rates and decrease the money supply.

These decisions are made by the Federal Open Market Committee (FOMC) which meets every six to seven weeks. The policy changes can be done immediately, although the impact on aggregate demand can take several months. Monetary policy has become the major form of discretionary contracyclical policy used by the federal government. A source of conflict is that the Fed is independent and is not under the direct control of either the President or the Congress. This independence of monetary policy is considered to be an important advantage compared to fiscal policy.

Note that expansionary monetary policy is commonly called "easy money" while contractionary monetary policy is called "tight money". Other terms are also used.

In this reading, we have sought to explain the practices of both monetary and fiscal policy. Both can have a significant impact on economic activity, and it is for this reason that financial analysts need to be aware of the tools of both monetary and fiscal policy, the goals of the monetary and fiscal authorities, and most important the monetary and fiscal policy transmission mechanisms.

• Governments can influence the performance of their economies by using combinations of monetary and fiscal policy. Monetary policy refers to central bank activities that are directed toward influencing the quantity of money and credit in an economy. By contrast, fiscal policy refers to the government’s decisions about taxation and spending. The two sets of policies affect the economy via different mechanisms.

• Money fulfills three important functions: It acts as a medium of exchange, provides individuals with a way of storing wealth, and provides society with a convenient unit of account. Via the process of fractional reserve banking, the banking system can create money.

• The amount of wealth that the citizens of an economy choose to hold in the form of money—as opposed to, for example, bonds or equities—is known as the demand for money. There are three basic motives for holding money: transactions-related, precautionary, and speculative.

• The addition of 1 unit of additional reserves to a fractional reserve banking system can support an expansion of the money supply by an amount equal to the money multiplier, defined as 1/reserve requirement (stated as a decimal).

• The nominal rate of interest is comprised of three components: a real required rate of return, a component to compensate lenders for future inflation, and a risk premium to compensate lenders for uncertainty (e.g., about the future rate of inflation).

• Central banks take on multiple roles in modern economies. They are usually the monopoly supplier of their currency, the lender of last resort to the banking sector, the government’s bank and bank of the banks, and they often supervise banks. Although they may express their objectives in different ways, the overarching objective of most central banks is price stability.

• For a central bank to be able to implement monetary policy objectively, it should have a degree of independence from government, be credible, and be transparent in its goals and objectives.

• The ultimate challenge for central banks as they try to manipulate the supply of money to influence the economy is that they cannot control the amount of money that households and corporations put in banks on deposit, nor can they easily control the willingness of banks to create money by expanding credit. Taken together, this also means that they cannot always control the money supply. Therefore, there are definite limits to the power of monetary policy.

• The concept of money neutrality is usually interpreted as meaning that money cannot influence the real economy in the long run. However, by the setting of its policy rate, a central bank hopes to influence the real economy via the policy rate’s impact on other market interest rates, asset prices, the exchange rate, and the expectations of economic agents. 

• Inflation targeting is the most common monetary policy—although exchange rate targeting is also used, particularly in developing economies. Quantitative easing attempts to spur aggregate demand by drastically increasing the money supply.

• Fiscal policy involves the use of government spending and revenue raising (taxation) to impact a number of aspects of the economy: the overall level of aggregate demand in an economy and hence the level of economic activity; the distribution of income and wealth among different segments of the population; and hence ultimately the allocation of resources between different sectors and economic agents.

• The tools that governments use in implementing fiscal policy are related to the way in which they raise revenue and the different forms of expenditure. Governments usually raise money via a combination of direct and indirect taxes. Government expenditure can be current on goods and services or can take the form of capital expenditure, for example, on infrastructure projects.

• As economic growth weakens, or when it is in recession, a government can enact an expansionary fiscal policy—for example, by raising expenditure without an offsetting increase in taxation. Conversely, by reducing expenditure and maintaining tax revenues, a contractionary policy might reduce economic activity. Fiscal policy can therefore play an important role in stabilizing an economy.

• Although both fiscal and monetary policy can alter aggregate demand, they work through different channels, the policies are therefore not interchangeable, and they conceivably can work against one another unless the government and central bank coordinate their objectives.