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Informing the public about the Federal Reserve

What is the difference between monetary policy and fiscal policy, and how are they related?

Monetary policy is a term used to refer to the actions of central banks to achieve macroeconomic policy objectives such as price stability, full employment, and stable economic growth. In the United States, the Congress established maximum employment and price stability as the macroeconomic objectives for the Federal Reserve; they are sometimes referred to as the Federal Reserve's dual mandate. Apart from these overarching objectives, the Congress determined that operational conduct of monetary policy should be free from political influence. As a result, the Federal Reserve is an independent agency of the federal government. Fiscal policy is a broad term used to refer to the tax and spending policies of the federal government. Fiscal policy decisions are determined by the Congress and the Administration; the Federal Reserve plays no role in determining fiscal policy.

The Federal Reserve uses a variety of policy tools to foster its statutory objectives of maximum employment and price stability. One of its main policy tools is the target for the federal funds rate (the rate that banks charge each other for short-term loans), a key short-term interest rate. The Federal Reserve's control over the federal funds rate gives it the ability to influence the general level of short-term market interest rates. By adjusting the level of short-term interest rates in response to changes in the economic outlook, the Federal Reserve can influence longer-term interest rates and key asset prices. These changes in financial conditions then affect the spending decisions of households and businesses.

Another key policy tool used by the Federal Reserve is the purchase of longer-term securities. Since December 2008, the Federal Reserve's target range for the federal funds rate has been near zero, and the Federal Reserve has undertaken purchases of longer-term securities to provide additional monetary policy stimulus to the economy. The Federal Reserve's purchases of longer-term securities are designed to help push longer-term interest rates lower. These actions encourage household and business spending through essentially the same channels as short-term interest rate policy. It is worth emphasizing that the monetary policy tool of purchases of longer-term securities is not comparable to ordinary government spending or other fiscal policy tools. In executing securities purchases, the Federal Reserve acquires financial assets that can be sold, not goods and services; thus, these purchases do not add to the government's deficit or debt.

The monetary policymaking body within the Federal Reserve System is the Federal Open Market Committee (FOMC). The FOMC currently has eight scheduled meetings per year, during which it reviews economic and financial developments and determines the appropriate stance of monetary policy. In reviewing the economic outlook, the FOMC considers how the current and projected paths for fiscal policy might affect key macroeconomic variables such as gross domestic product growth, employment, and inflation. In this way, fiscal policy has an indirect effect on the conduct of monetary policy through its influence on the aggregate economy and the economic outlook. For example, if federal tax and spending programs are projected to boost economic growth, the Federal Reserve would assess how those programs would affect its key macroeconomic objectives--maximum employment and price stability--and make appropriate adjustments to its monetary policy tools.

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Last update: July 21, 2014