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Dear Mr. Berko: I keep hearing two new economic terms in the news: 鈥渇iscal policy鈥� and 鈥渕onetary policy.鈥� Please tell me what these terms mean.

I know you鈥檝e been negative on Alan Greenspan since 2000 and often ridiculed him with amazing accuracy on your several speaking engagements here and in your column. But isn鈥檛 there anything that you can say that he鈥檚 done right?

C.L.
Oklahoma City

Dear C.L.: Fiscal and monetary policy are economic concepts that have been around since before the first Caesar. And in the arena of nebulous economic theory these concepts are respected by both the pious and the raucous.

Monetary policy is the process by which our Federal Reserve controls the supply of money, the availability of money and interest rates to achieve a desired growth objective and a stable economy. Monetary policy is referred to as either 鈥渆xpansionary鈥� (easy money) or 鈥渃ontractionary鈥� (tight money). An expansionary policy increases the total supply of money in the economy while a contractionary policy decreases the total amount of money in our economy.

Expansionary policy is used primarily in a recession to stimulate the employment numbers. When easy money is available at cheap rates, it encourages businesses and manufacturers to produce more goods and services by borrowing more money and hiring more people.

Contractionary policy removes money from the economy when it begins to heat up and prices rise. It tends to slow down the production of goods and services by raising interest rates and making money more expensive. As a result of higher cost to the manufacturer and consumer, demand decreases, businesses will lay off employees until the economy begins to cool, easy credit becomes available again and interest rates move much lower.

Since last year, we have seen the Fed use monetary policy to increase the amount of dollars in circulation (over a trillion) and lower interest rates to reduce the cost of buying a new car or a home. And as demand for new cars and new homes improves, industry will hire more people and increase production. And along the way, peripheral industries, auto parts and homebuilding materials also experience a surge in demand as they hire more people who spend their wages to purchase more goods and services.

Fiscal policy is the use of taxation and government spending to influence the economy. Expansionary fiscal policy involves a net increase in government spending through an increase in borrowing or a decline in the tax rate or a combination of the two. This almost always leads to a larger budget deficit. Of course, increased government spending and a decrease in the tax rate puts more money in the economy and encourages more people to purchase goods and services, which encourages industry to expand production and hire more employees who in turn use their new wages to purchase additional goods and services. This increases the deficit and is a precursor to inflation.

A contractional fiscal policy occurs when total spending is reduced by either higher taxes or lower government spending or a combination of both. Spending slows because there is less money available, credit becomes tight and industry lays off employees who will soon have fewer dollars to spend. In most instances, this would reduce the budget deficit and lower the rate of inflation.

Now the objective of the Fed and the government is to fine-tune monetary and fiscal policy like a conductor leading an orchestra of strings and brass. But the government seldom gets it right because the real unemployment percentage, housing stats, GDP numbers, business statistics and inflation data are always fudged by the administration for political gain.

So the Fed either under-corrects or overcorrects, and Alan 鈥渢he Mumbler鈥� Greenspan succeeded brilliantly by overcorrecting and under-correcting every chance he got. In fact, the only thing he did correctly was retire. He just didn鈥檛 want to take the blame for what he knew would be a disastrous economy after he left the Fed.

Address your financial questions to Malcolm Berko, c/o The Daily Journal of Commerce, P.O. Box 8303, Largo, FL 33775, or e-mail him at [email protected].
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