When Policies Collide: Fiscal/Monetary Mixer
Federal Reserve policy does not exist in a political vacuum. Instead, monetary policy functions alongside government's fiscal policies. At times the two are at odds, but most of the time monetary policy is used to accommodate fiscal policy. For this to work, the Fed chairman, the president, the Treasury secretary, and key members of Congress communicate to create a coherent policy that addresses the fundamental goals of price stability, full employment, and economic growth.
During periods of recession, expansionary fiscal policy is reinforced with expansionary monetary policy. As government spending increases and taxes decrease, upward pressure is placed on interest rates, which may “crowd-out” private investment and consumption and reduce net exports. Expansionary monetary policy offsets the upside pressure on interest rates by expanding the money supply and lowering short-term interest rates. This allows for fiscal policy to be more effective.
Monetary policy is conducted by the Fed, and fiscal policy is conducted by the government. The coordination of the two requires communication. The chairman of the Fed gives a report to Congress twice a year.
Inflationary periods are more problematic for presidents and lawmakers. The contractionary fiscal policy prescription calls for reduced spending and increased taxes, which are politically unpopular. Contractionary monetary policy is effective at stopping inflation, and the Fed's insulation from political pressure makes it perfectly suited for the task. Former Fed chairman Paul Volcker was credited with whipping inflation when government was unable to do so. Problems arise when government maintains an expansionary policy while the Fed is engaging in contractionary policy. President George H. Bush credits some of his defeat to President Bill Clinton on the Fed's contractionary policy stance during the election of 1992.
