CFA Program Level I

Monetary vs fiscal policy: CFA Level I explained

Monetary policy is the central bank's control of interest rates and money; fiscal policy is the government's decisions on taxes and spending. Monetary policy and automatic fiscal stabilizers act first because they are fast, while discretionary fiscal policy suffers long legislative lags. It becomes the main tool when the policy rate is at zero or the downturn is deep and long.

How monetary policy works

The Fed's goals are maximum employment and stable prices, with 2% PCE inflation as the price goal. Its main tool is the target for the federal funds rate, the overnight rate at which banks borrow reserves.

With reserves abundant, the Fed moves the federal funds rate by changing the interest rate it pays on reserve balances. Banks will not lend reserves for less than they can earn risk-free at the Fed, so raising that rate lifts the funds rate. Target changes are usually matched by changes in the rate on reserves.

Rate changes pass to other short-term rates quickly, then to longer-term rates through expectations, to stock and house prices, and to the exchange rate. An easing that lowers the dollar makes US goods cheaper relative to foreign goods. When the policy rate was near zero after 2008, the Fed bought about $3.7 trillion of longer-term securities to push down longer-term yields.

How fiscal policy works

Fiscal policy is government spending and taxes. An expansion raises spending or cuts taxes to lift demand and output.

Automatic stabilizers act without new laws: in a downturn unemployment benefits rise and tax receipts fall. Discretionary policy is a deliberate legislated change in spending or taxes.

The standardized budget balance adjusts the actual balance for automatic stabilizers, so its change shows discretionary policy. Example: in a recession the actual balance moves from a 1.0% of GDP surplus to a 2.0% deficit, while the standardized balance stays at a 0.5% surplus. The 3-point swing came from automatic stabilizers, and the discretionary stance did not change.

Which one, when

The FRBSF letter argues the main case against discretionary fiscal policy is the legislative lag: recognize the slowdown, propose, debate, pass and sign. For a typical mild recession, the economy is often recovering before the package arrives. The Fed can cut rates within weeks, as it did in January 2001.

So monetary policy and automatic stabilizers are the first line of defence. Discretionary fiscal policy matters more when the policy rate is at zero and monetary policy may be unable to do more, or when the downturn is severe enough that a stimulus would still arrive in time.

Expectations matter for fiscal policy. A temporary tax cut may have a smaller effect than a permanent one, and deficit spending can raise long-term rates if markets expect future tax increases or doubt solvency.

Where the exam catches people

Believing a wider actual deficit proves an expansionary fiscal stance: if the standardized balance is unchanged, the swing came from automatic stabilizers.
Believing the Fed raises the funds rate with ample reserves by draining reserves: its main means is raising the interest rate it pays on reserve balances.
Believing discretionary fiscal policy is the first response to every recession: legislative lags make it too slow for typical short downturns.
Believing tax and tariff rates are monetary policy tools: they are set by the government, as fiscal and trade policy.
Believing an easing helps only through domestic interest rates: a lower dollar also makes US products cheaper relative to foreign ones.

Written from CFA Institute's documentation

Try 3 questions on this

Pick an answer to see why each option is right or wrong.

In a year when its economy slips into recession, Country H's actual budget balance moves from a surplus of 1.0% of GDP to a deficit of 2.0% of GDP. Its standardized budget balance, which strips out the cyclical swings in tax receipts and benefit payments, stays at a surplus of 0.5% of GDP. The change in the government's discretionary fiscal stance is best described as:
Right. In the game that’s Renown for your Economics building.
Not that one: C is right. In the game your Economics building would lose a little Renown, and this question would come back later.
Your answerA.An expansionary shift, as the actual deficit widenedThe actual deficit widened by 3 percentage points of GDP, but the standardized balance, which measures discretionary moves, did not change. The widening came from automatic stabilizers, so it is no evidence of deliberate easing.Your answerB.A contractionary shift, as the standardized balance shows a surplusA contractionary shift would show as a rise in the standardized surplus. It stayed at 0.5% of GDP, so there was no shift either way; the level of the surplus alone is not a change in stance.The answerC.No shift, as automatic stabilizers caused the swingThe standardized (cyclically corrected) balance removes the budget changes that happen automatically over the cycle, such as higher unemployment benefits and lower tax receipts in a recession, so its change measures discretionary policy.
Show the full explanation and doc quotes
It stayed at a 0.5% of GDP surplus, so the 3-point swing in the actual balance came from automatic stabilizers, and discretionary stance was unchanged.
Written from www.frbsf.org/research-and-insights/publications/economic-letter/2002/09/the-role-of-fiscal-policy/
Country Q is in a deep recession that forecasters expect to last several years. Its central bank has already cut its policy rate to zero and judges that it is unable to lower it further. An economist notes that new spending or tax laws usually take so long to pass that they arrive after a typical short downturn has ended. The most appropriate policy response is most likely to:
Right. In the game that’s Renown for your Economics building.
Not that one: A is right. In the game your Economics building would lose a little Renown, and this question would come back later.
The answerA.Enact a discretionary fiscal expansionAutomatic stabilizers and monetary policy are normally the first line of defence, because legislative lags make discretionary fiscal policy too slow for typical short recessions.Your answerB.Raise taxes to shrink the budget deficitA tax-financed deficit cut reduces demand. Evidence cited by the San Francisco Fed finds that deficit reductions achieved through tax increases tend to be contractionary, the wrong direction in a recession.Your answerC.Rely on automatic stabilizers aloneAutomatic stabilizers help, but the case for relying on them assumes monetary policy can still ease and the recession is short. Here the policy rate is at zero and the downturn is long, which is when discretionary fiscal action is called for.
Show the full explanation and doc quotes
When the policy rate is already at zero, monetary policy may be unable to stimulate further, and discretionary fiscal policy is needed. A deep, multi-year recession also removes the lag objection, since the stimulus would still arrive while output is weak.
Written from www.frbsf.org/research-and-insights/publications/economic-letter/2002/09/the-role-of-fiscal-policy/
US banks hold abundant reserve balances at the Federal Reserve, and the FOMC decides to increase its target for the federal funds rate by 0.25 percentage point. In this setting, the Fed's main means of moving the federal funds rate higher is most likely to:
Right. In the game that’s Renown for your Economics building.
Not that one: A is right. In the game your Economics building would lose a little Renown, and this question would come back later.
The answerA.Raise the interest rate it pays on reserve balancesWith abundant reserves, the Fed influences the federal funds rate by changing the interest rate it pays on reserve balances.Your answerB.Buy securities to add to banks' reservesBuying securities adds to bank reserves and puts downward pressure on rates. With reserves already abundant, the Fed moves the federal funds rate mainly through the rate it pays on reserve balances.Your answerC.Lower the interest rate it pays on reserve balancesCutting the rate paid on reserve balances would let banks lend reserves more cheaply, pulling the federal funds rate down rather than up.
Show the full explanation and doc quotes
Banks have little reason to lend reserves to one another for less than the Fed pays them on reserves, so raising that rate lifts the federal funds rate; changes in the target are typically matched by changes in the rate paid on reserves.
Written from www.federalreserve.gov/monetarypolicy/monetary-policy-what-are-its-goals-how-does-it-work.htm