Economic Policies
Government and central bank policies have a profound impact on securities markets. Understanding monetary policy and fiscal policy is essential for the SIE exam — and for understanding why markets move.
Two Types of Economic Policy
| Policy Type | Who Controls It | Primary Tools |
|---|---|---|
| Monetary Policy | Federal Reserve (the Fed) | Interest rates, money supply |
| Fiscal Policy | Congress and the President | Taxes, government spending |
Both aim to promote economic stability, but they work through different mechanisms.
Monetary Policy
Monetary policy refers to actions by the Federal Reserve to influence money supply, credit conditions, and interest rates. The Fed has a dual mandate from Congress:
- Maximum employment — Keep unemployment low
- Price stability — Keep inflation in check
The Fed's Policy Tools
| Tool | How It Works |
|---|---|
| Federal Funds Rate | Target rate for overnight bank lending |
| Open Market Operations | Buying/selling Treasury securities |
| Reserve Requirements | Cash banks must hold (rarely changed) |
| Discount Rate | Rate Fed charges banks for emergency loans |
Open Market Operations
The Fed's most frequently used tool is open market operations — buying and selling Treasury securities:
- To stimulate the economy: Fed buys securities → increases money supply → lowers interest rates
- To slow inflation: Fed sells securities → decreases money supply → raises interest rates
Expansionary vs. Contractionary
| Expansionary Policy | Contractionary Policy |
|---|---|
| Lower interest rates | Raise interest rates |
| Buy securities (inject money) | Sell securities (remove money) |
| Stimulate borrowing and spending | Cool down overheating economy |
| Combat recession/unemployment | Combat inflation |
Federal Funds Rate
The federal funds rate is the interest rate banks charge each other for overnight loans. It's the Fed's primary policy lever.
Why It Matters
- Changes in the fed funds rate ripple through the entire economy
- Affects consumer loans, mortgages, credit cards, and business borrowing
- Influences stock and bond prices
Rate Changes and Securities
| Fed Action | Bond Prices | Stock Prices |
|---|---|---|
| Raises rates | Generally fall | Often fall (higher borrowing costs) |
| Lowers rates | Generally rise | Often rise (cheaper borrowing) |
Quantitative Easing (QE)
When traditional tools aren't enough, the Fed may use quantitative easing — large-scale purchases of securities.
How QE Works
- Fed creates new money electronically
- Uses it to buy Treasury bonds and mortgage-backed securities
- Increases money supply and lowers long-term interest rates
- Aims to stimulate lending and investment
Recent History
The Fed used QE extensively after the 2008 financial crisis and during the COVID-19 pandemic, growing its balance sheet from under $1 trillion to over $8 trillion.
Fiscal Policy
Fiscal policy involves government decisions about taxing and spending. Unlike monetary policy (controlled by the Fed), fiscal policy is determined by Congress and the President.
Fiscal Policy Tools
| Tool | Expansionary | Contractionary |
|---|---|---|
| Taxes | Cut taxes | Raise taxes |
| Spending | Increase spending | Decrease spending |
| Goal | Stimulate economy | Slow inflation |
Fiscal vs. Monetary: Key Differences
| Aspect | Monetary Policy | Fiscal Policy |
|---|---|---|
| Controlled by | Federal Reserve | Congress/President |
| Independence | Independent of politics | Subject to political process |
| Speed | Can act quickly | Often slow (legislation required) |
| Primary tools | Interest rates | Taxes and spending |
How Policies Affect Securities
Impact on Stocks
| Policy Action | Typical Stock Market Effect |
|---|---|
| Fed cuts rates | Positive — lower borrowing costs |
| Fed raises rates | Negative — higher costs, lower valuations |
| Tax cuts | Positive — higher corporate profits |
| Increased government spending | Positive — more economic activity |
Impact on Bonds
Bond prices have an inverse relationship with interest rates:
- When rates rise → Existing bond prices fall
- When rates fall → Existing bond prices rise
This is because newly issued bonds offer better (or worse) rates than existing bonds.
Impact on Different Sectors
| Sector | Rate Sensitivity |
|---|---|
| Financials | Benefit from higher rates (wider margins) |
| Utilities | Hurt by higher rates (dividend competition) |
| Real Estate | Hurt by higher rates (higher mortgage costs) |
| Technology | Hurt by higher rates (future earnings worth less) |
Policy Coordination
Monetary and fiscal policy can work together — or at odds:
Aligned Policies
- During recessions, both may be expansionary (low rates + stimulus spending)
- This combination can be very stimulative
Conflicting Policies
- Fed tightening while government increases spending
- Can create uncertainty and mixed market signals
The Fed's Independence
The Federal Reserve operates independently from political branches:
- Fed Chair appointed by President, confirmed by Senate
- But day-to-day decisions made without political interference
- Independence helps maintain credibility on inflation control
Why Independence Matters for Markets
- Markets trust the Fed to focus on economic fundamentals
- Political interference could lead to short-term thinking
- Credibility helps anchor inflation expectations
Key Takeaways
- Monetary policy is controlled by the Federal Reserve and focuses on interest rates and money supply
- Fiscal policy is controlled by Congress/President through taxes and spending
- The Fed's dual mandate is maximum employment and price stability
- Open market operations (buying/selling securities) is the Fed's primary tool
- Interest rate changes affect both stocks and bonds, often in opposite directions
- The Fed's independence from politics is crucial for market confidence
Which entity is responsible for monetary policy in the United States?
When the Federal Reserve wants to stimulate the economy, it typically:
What is the dual mandate of the Federal Reserve?
1.8 Interest Rates
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