The Federal Reserve's three main tools of monetary policy

Monetary policy and fiscal policy are the two main ways in which governments influence the health of the economy. Monetary policy is conducted by central banks, while other branches of the government are responsible for fiscal policy. The Federal Reserve illustrates the three major ways in which is uses monetary policy. Monetary policy reflects the amount of money that is in the economy, which in turn influences the health of that economy. The Fed sets monetary policy in line with seeking a stable rate of growth, controlled inflation and a healthy rate of job creation.

The primary means by which the Fed implements monetary policy is through open market transactions. These are the buying and selling of Treasury securities, or government debt. If the Fed wishes to increase the amount of money in the economy, it buys securities and if it wants to decrease the amount of money in the economy it sells them. Usually these are short-term securities, but there are longer-term Treasuries on the market as well.

The discount rate is another means by which monetary policy is enacted. According to the Federal Reserve website, "the discount rate is the interest rate Reserve Banks charge commercial banks for short-term loans" (Federal Reserve, 2016). Thus, the discount rate is literally the cost of money. The higher the cost of money, the less money the banks are willing to lend out. Basically, businesses and consumers will spend less if money is more expensive, and when banks pay more for money, they charge more for it. Thus, the discount rate influences the retail rates, which in turn will influence the amount of activity in the economy.

The third means by which the Federal Reserve influences monetary policy is the reserve requirements. These are the requirements for financial institutions with respect to how much of their deposits they must hold back. A bank takes in deposits, and makes its money by lending that money out again. The reserve requirement is theoretically a buffer that the bank cannot lend out, for safety reasons. The central bank seldom changes the reserve requirements, but if it does, that either frees up money for the bank to lend (spurring economic growth) or causes the bank to call in loans (cooling the economy).

Fiscal policy is entirely different from monetary policy, but it can also influence the overall health of the economy. Fiscal policy is the money that government spends. In some ways, it does not matter much what the government spends on, but rather how much is spends. Governments spend money on a wide range of activities, but to the extent that there is focus on spending that creates jobs or boosts exports, that spending can have a multiplier effect on fiscal policy, more than other forms of spending might. Thus, fiscal policy that serves as an investment is generally better for the economy than fiscal policy that does not. But almost all fiscal policy spending, save perhaps for overseas aid programs, has some sort of influence on the health of the economy.

The other element of fiscal policy besides government spending is taxation (Well, 2016). Taxation is the money that government takes out of the hands of people and businesses for its spending. Government is unique in that its spending is not just from taxation but also from deficit spending, paid for by debt issues.