The U.S. Federal Reserve, known as the Fed, sets monetary policy by adjusting the federal-funds rate. This affects other short-term and long-term rates, including credit-card rates and mortgages. Governments define fiscal policy by setting taxation levels and writing legislation and regulation for everything from health care to the environment. Fiscal and monetary policy changes can affect businesses directly and indirectly, although competitive factors and management execution are also important factors.
Businesses go through cycles of expansion, recession and recovery. Monetary and fiscal policies can affect the timing and length of these cycles. In the expansion phase, the economy grows, businesses add jobs and consumer spending increases. At some point, known as the peak, the economy overheats and the Fed increases interest rates to stave off inflation. Factories shut down, job losses rise and business sales fall. Fed rate cuts and government spending, or both, are often necessary to recharge the economy. Eventually, the economy hits rock bottom, known as the trough, and gradually starts to recover. The business cycle then resumes with a new expansion phase.
Fiscal Policy Impact
Fiscal policy usually involves changes in taxation and spending policies. Lower taxes mean more disposable income for consumers and more cash for businesses to invest in jobs and equipment. Stimulus-spending programs, which are short-term in nature and often involve infrastructure projects, can also help drive business demand by creating short-term jobs. Increasing income or consumption taxes usually mean less disposable income, which, over time, can decelerate business activity. In congressional testimony in early February 2011, Fed Chairman Ben Bernanke observed that the twin challenges of increasing budget deficits and the aging population must be addressed to sustain long-term growth. He suggested such measures as investments in research, education and new infrastructure.
Monetary Policy Impact
Changes in short-term interest rates influence long-term interest rates, such as mortgage rates. Low interest rates mean lower interest expense for businesses and higher disposable income for consumers. This combination usually means higher business profits. Lower mortgage rates may spur more home-buying activity, which is usually good news for the construction industry. Lower rates also mean more refinancing of existing mortgages, which may also enable consumers to consider other purchases. High interest rates can have the opposite impact for businesses: higher interest expenses, lower sales and lower profits. Interest-rate changes can affect stock prices, which can impact consumer spending. Rate changes may also impact exchange rates -- higher rates increase the value of the dollar relative to other currencies, which lowers import costs and increases export costs for U.S. businesses; lower rates may have the opposite impact, namely higher import costs and lower export costs.
For businesses, inflation means higher costs and unemployment means declining sales. Inflation and unemployment usually move in opposite directions. However, unemployment may be high in a period of high inflation because of a mismatch between the skills required for vacant jobs and the skills of the unemployed labor pool. For example, an unemployed accountant cannot apply for a vacant nursing position. Monetary policy tightening, meaning increasing short-term rates, controls inflation. Fiscal policy measures, such as retraining unemployed workers in specific job skills that are in demand, can help bring the unemployment levels down over the long term.
Based in Ottawa, Canada, Chirantan Basu has been writing since 1995. His work has appeared in various publications and he has performed financial editing at a Wall Street firm. Basu holds a Bachelor of Engineering from Memorial University of Newfoundland, a Master of Business Administration from the University of Ottawa and holds the Canadian Investment Manager designation from the Canadian Securities Institute.