Who moves the economy: fiscal versus monetary policy

The Federal Reserve (the Fed) conducts U.S. monetary policy. The goals set for it by law include maximum employment, stable prices and moderate long-term interest rates. Maximum employment and stable prices are commonly called its dual mandate. The Federal Open Market Committee (FOMC) is the Fed committee that sets the target range for the federal funds rate, explained below. It judges that 2 percent inflation over the longer run, measured by the personal consumption expenditures price index, is consistent with price stability. These are policy goals, not promises of zero unemployment or investment profits.

The FOMC sets a target range for the federal funds rate. Banks and other eligible institutions keep balances in their accounts at the Fed; these balances are called reserves. The actual federal funds rate is a market rate: the rate on overnight, unsecured loans of those balances between institutions. When reserves are ample, the Fed steers rates mainly with rates it sets itself, called administered rates, such as interest on reserve balances. Interest on reserve balances is paid to eligible institutions on balances at the Fed; it is not a customer loan rate. Banks set their own prime lending rates.

Open market operations are a central bank’s purchases and sales of securities. A purchase paid through bank accounts adds reserve balances; a sale drains them. In the traditional model, where reserves are scarce (in short supply) and other policy settings stay the same, adding reserves tends to push short-term rates down and draining them tends to push rates up. With ample reserves, routine reserve changes need not move the federal funds rate. So a purchase made only to keep reserves ample is not, by itself, a rate cut. Asset purchases can also be used to ease financial conditions.

The discount window is direct lending by a Federal Reserve Bank to an eligible institution against collateral. The discount rate is the rate charged on that borrowing; it is established by each Reserve Bank’s board of directors, subject to the review and determination of the Board of Governors. This is different from the federal funds market. A lower discount rate makes that borrowing cheaper, but does not compel a bank to borrow or lend more.

Reserve requirements set the reserves a bank must hold against certain of its liabilities. The U.S. ratios have been zero since March 26, 2020. If a ratio were above zero and limited what a bank could lend, lowering it would reduce the required amount and could increase lending capacity. It does not guarantee new loans or remove capital and liquidity constraints. Reserve balances still serve payment and liquidity needs when the required ratio is zero.

To classify policy, identify the instrument (the tool used), the actor and the stated assumptions. A higher policy-rate target is tightening; a lower target is easing. Intended pressure on demand is different from a guaranteed or immediate change in jobs, prices or markets.

The Keynesian view emphasizes aggregate demand and the role fiscal policy can play when private demand is weak. Government spending or tax changes can support demand during a slump. This does not mean only government can spend, or that every Keynesian rejects monetary policy.

For the basic contrast here, an argument centered on money growth is monetarist; an argument centered on fiscal support for aggregate demand is Keynesian. Read the argument rather than assuming both descriptions are one school merely because they share a goal.