Two Levers, Two Different Hands

Monetary policy is the management of interest rates and the money supply by a country’s central bank, which in the United States is the Federal Reserve. Fiscal policy is the use of government spending and taxation, decided by Congress and the President, to influence the economy.

Both aim to support steady growth, high employment and stable prices, but they work through different channels. Monetary policy changes the cost and availability of credit, while fiscal policy changes how much the government spends and how much it takes from households and businesses in taxes.

Understanding which lever is being used, and how markets react, helps advisers explain interest rate moves, bond prices and economic headlines to clients. For the full route from the exam to a career giving that advice, our complete guide to how to become an investment adviser representative covers every step.

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How Monetary Policy Works

The Federal Reserve has a dual mandate from Congress: maximum employment and stable prices. It interprets stable prices as inflation of 2 percent over time, measured by the personal consumption expenditures price index.

Monetary policy decisions are made by the Federal Open Market Committee, which has 12 voting members: the seven members of the Board of Governors, the president of the Federal Reserve Bank of New York and four other regional bank presidents who vote on a rotating basis. The committee holds eight scheduled meetings a year.

Its main tool is the target range for the federal funds rate, the rate banks charge each other for overnight loans. The Series 65 Exam Preparation course at FRC covers the Fed’s structure and tools, which appear regularly on the exam.

The Federal Reserve’s Tools

The Fed steers the federal funds rate mainly by setting the interest it pays banks on the reserves they hold at the Fed, and the rate on its overnight reverse repurchase facility. Raising these rates pushes market rates up, and lowering them pushes market rates down.

Open market operations, the buying and selling of Treasury and agency securities, remain an important tool. Large-scale purchases, known as quantitative easing, add money to the financial system and push down longer-term rates, while allowing securities to run off, known as quantitative tightening, does the reverse.

The discount rate is the rate the Fed charges banks that borrow directly from it. Reserve requirements, once a classic exam topic, were reduced to zero in March 2020, so they no longer play an active role in policy.

How Fiscal Policy Works

Fiscal policy is set through the federal budget. Congress passes laws on spending and taxes, and the President signs or vetoes them, so fiscal changes usually require political agreement.

Expansionary fiscal policy increases government spending, cuts taxes or both, putting more money into the economy. Contractionary fiscal policy does the opposite, cutting spending or raising taxes to cool the economy or reduce a deficit.

When the government spends more than it collects, it runs a deficit and borrows by issuing Treasury securities. Large and persistent deficits increase the supply of Treasuries, which can push up interest rates over time.

Monetary Policy and Fiscal Policy Compared

Worked Example: How a Rate Cut Reaches Households

The Fed lowers its policy rate, and mortgage rates fall from 7 percent to 6 percent over the following months. Step one: on a $400,000, 30-year fixed-rate mortgage, the monthly payment falls from about $2,661 to about $2,398.

Step two: the borrower saves about $263 a month, or about $3,160 a year, money that can be spent elsewhere in the economy. Step three: multiplied across millions of new and refinanced loans, lower rates support consumer spending and housing activity.

This is the channel through which monetary policy works: cheaper borrowing encourages spending and investment. Rate rises work in reverse, making borrowing more expensive and slowing demand.

Worked Example: The Fiscal Multiplier

When the government spends money, the people who receive it spend part of it, and those who receive that spending spend part of it again. The simple multiplier formula is one divided by one minus the marginal propensity to consume.

Step one: if people spend 80 percent of each extra dollar they receive, the simple multiplier is one divided by 0.2, or 5. Step two: in theory, $100 billion of new spending could raise total economic output by up to $500 billion.

Step three: in practice, the effect is much smaller, because some money is saved, spent on imports or offset by higher interest rates. The multiplier helps explain why fiscal stimulus can be powerful, but real-world estimates are far below the simple formula.

Study Economics With FRC

Economics questions on the exam often ask who controls a policy tool, what effect an action has on interest rates and bond prices, or which policy is expansionary. Our Series 65 course explains both policies clearly, with examples that link them to client portfolios.

Consider studying with FRC for every exam on your route. Explore our USA exam courses, from the SIE through the Series 7, Series 63 and Series 65.

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Inflation Expectations and Fed Communication

Much of the Fed’s influence comes from what it says, not just what it does. If households and businesses expect inflation to stay near 2 percent, they set wages and prices accordingly, which helps keep inflation stable.

The Fed publishes a statement after each meeting, holds press conferences and, four times a year, releases projections from committee members for growth, unemployment, inflation and the future path of interest rates. Markets study these signals closely, and bond yields often move more on a change in guidance than on the rate decision itself.

This is why advisers pay attention to the tone of Fed communications. A shift from talking about fighting inflation to supporting employment can signal that rate cuts are coming, well before the first cut happens.

What Each Policy Means for Bond Prices

Monetary policy has its most direct effect on short-term interest rates, but expectations about future policy move longer-term rates too. When the Fed is expected to cut rates, bond prices usually rise; when it is expected to raise them, bond prices usually fall.

Worked example: a client holds a bond fund with a duration of 6, and yields fall by 0.5 percentage points after the Fed signals rate cuts. Step one: the fund would be expected to rise by about 6 times 0.5, or 3 percent. Step two: on a $200,000 holding, that is a gain of about $6,000, as explained in our article on Macaulay duration vs modified duration.

Fiscal policy affects bonds through the supply of government debt. Large deficits mean more Treasury issuance, which can push yields up, especially if investors worry about inflation or the government’s long-term finances.

What Each Policy Means for Stocks

Lower interest rates tend to support stock prices, because they reduce companies’ borrowing costs and make future earnings worth more in today’s terms. Higher rates tend to weigh on stocks, especially growth companies whose earnings lie far in the future.

Fiscal policy affects stocks through demand and taxes. Higher government spending can boost sales in particular industries, such as infrastructure or defence, while changes in corporate tax rates directly affect after-tax profits.

Markets often react more to surprises than to the policies themselves. A rate cut that investors already expected may barely move prices, while an unexpected change in policy can cause sharp moves.

What Policy Changes Mean for Cash and Savings

Money market funds, savings accounts and Treasury bills respond quickly to changes in the Fed’s policy rate. When the Fed raises rates, their yields rise within weeks; when it cuts, their yields fall just as fast.

For savers, that makes cash attractive when rates are high but exposes them to reinvestment risk when rates are falling. Locking in yields with longer-term bonds or certificates of deposit before cuts arrive can help, but it gives up flexibility.

Fiscal policy affects savers less directly, through taxes on interest income and through its influence on inflation and interest rates. Changes in tax rates on interest, dividends or capital gains can shift which accounts and investments make most sense for each client.

Deficits, Debt and Interest Costs

When the government runs a deficit, it borrows the difference by selling Treasury securities, adding to the national debt. Each year’s interest on that debt becomes part of future government spending.

Worked example: suppose a government has $10 trillion of debt and the average interest rate it pays rises from 2 percent to 3 percent as old debt is refinanced. Step one: annual interest costs rise from $200 billion to $300 billion. Step two: that extra $100 billion must be covered by higher taxes, lower spending elsewhere or more borrowing.

Rising interest costs can limit how much room a government has to use fiscal policy in the next downturn. They are also one reason higher interest rates set by the Fed can affect the government’s own budget.

When the Two Work Together or Against Each Other

The most powerful responses come when both levers move in the same direction. During the 2020 pandemic, the Fed cut rates to near zero and bought large amounts of securities, while Congress passed large spending packages, together supporting the economy through a severe shock.

The two can also pull against each other. If the government is running large deficits that add to demand while the Fed is trying to bring inflation down, the Fed may need to keep rates higher for longer than it otherwise would.

An even harder problem arises in stagflation, when inflation is high and growth is weak. Our comparison of stagflation vs recession explains why neither lever offers an easy answer in that situation.

Automatic Stabilisers and Time Lags

Some fiscal policy works automatically. Unemployment benefits rise and tax receipts fall when the economy weakens, supporting incomes without any new law, and the reverse happens in a boom; these are called automatic stabilisers.

Both policies work with time lags. It takes time to recognise a problem, time to decide on action and time for the action to affect the economy, and for monetary policy the full effect on inflation can take a year or more.

Because of these lags, policymakers try to act on forecasts rather than waiting for problems to become obvious. That is one reason the Fed pays close attention to inflation expectations and leading economic indicators.

The Memory Aid

Remember “the Fed sets the price of money, Congress sets the budget”: monetary policy works through interest rates and money supply, fiscal policy through spending and taxes.

For expansionary policy, remember “lower rates, more spending, lower taxes”, and for contractionary policy, the reverse.

For bond prices, remember “rates down, bonds up”.

Exam Traps to Avoid

The first trap is saying the Treasury Department sets monetary policy. The Federal Reserve does; the Treasury manages government borrowing and finances.

The second trap is treating tax changes as monetary policy. Taxes and spending are fiscal policy.

The third trap is still treating reserve requirements as an active policy tool. They were reduced to zero in 2020, and the Fed now relies mainly on interest on reserve balances and open market operations. The fourth trap is forgetting that rate cuts usually raise existing bond prices, because yields and prices move in opposite directions.

A Client Scenario

A client hears that the Federal Reserve is expected to cut rates several times over the coming year and asks whether she should move her savings from a money market fund into longer-term bonds. She also asks whether a new government spending bill will affect her investments.

The adviser explains that if rates fall, money market yields will drop quickly, while longer-term bonds would likely rise in price, but that markets may already have priced in expected cuts. The adviser also notes that higher government spending could add to Treasury supply and limit how far long-term yields fall.

The adviser recommends gradually extending part of her cash into a mix of short- and intermediate-term bonds, keeping an emergency reserve in cash, rather than making a single large move based on a forecast. The recommendation and the reasoning are documented in her file.

The Dictionary as a Video Library

The FRC dictionary is a study tool, not just a glossary. Every entry pairs a written explanation with deep-dive video, on-page quizzes and interactive flash cards, so you can read a concept, watch it explained and test yourself in one place.

Rules are covered in the same depth: open a rule and you will find the full explanation alongside video walk-throughs of how it applies in practice. Use the dictionary to explore the economic and policy terms in this article as their own explanations, videos and quizzes.

Practice Questions to Test Yourself

Question one: Which body sets monetary policy in the United States? The Federal Reserve, through the Federal Open Market Committee.

Question two: A government cuts taxes and increases spending. What type of policy is this? Expansionary fiscal policy.

Question three: What usually happens to existing bond prices when the Fed cuts interest rates? They rise.

Question four: If people spend 75 percent of each extra dollar, what is the simple fiscal multiplier? 4, because one divided by 0.25 is 4.

Question five: What are unemployment benefits and progressive income taxes that adjust automatically to the economy called? Automatic stabilisers.

Turn Economic Knowledge Into Career Evidence

Clients often ask advisers what the latest Fed decision or government budget means for them, and clear answers build lasting trust. FRC’s Digital Profile shows employers the courses you are actively studying and the progress you have earned through assessed learning, verified by FRC, and a QR code on your resume takes them straight to it.

The FRC Video Resume lets a hiring manager hear you before the interview. Explaining how a rate cut flows through to a client’s mortgage and bond fund shows the practical economic understanding advisory firms look for.

Related Questions

Treasury and agency securities are the main instruments the Fed buys and sells in its market operations, and our comparison of agency bonds vs Treasury bonds explains how they differ.

Key Points to Retain

Monetary policy is set by the Federal Reserve, which pursues maximum employment and stable prices mainly by setting its policy interest rates and through asset purchases and sales. Fiscal policy is set by Congress and the President through spending and taxes, and large deficits are financed by issuing Treasury securities.

Expansionary policy lowers rates or raises spending and cuts taxes, while contractionary policy does the reverse, and both work with time lags. Rate cuts usually lift bond prices and support stocks, fiscal policy affects demand and the supply of government debt, and the two levers are most powerful when they move together.

For the role the exam leads to, read our guide to what an investment advisor representative is.