Monetary policy functions as a set of instructions implemented by the Federal Reserve Bank. The Federal Reserve Act sets the goals of monetary policy, which strives to maximize employment levels, stabilize prices and maintain moderate levels of long-term rates of interest. The Federal Reserve Bank uses monetary policy to control and moderate the volume of money, as well as credit and interest rates. It uses these as vehicles to influence employment levels, manufacturing output and general price levels.
Fiscal policy is a set of decisions enacted by the government. Essentially, the decisions involve the purchase of goods and services, as well as spending on transfer payments, such as Social Security and welfare, and the type and amount of taxes charged.
Monetary policy changes normally take a certain amount of time to have an effect on the economy. The time lag could span anywhere from nine months up to two years. Fiscal policy and its effects on output have a shorter time lag. When monetary policy attempts to stimulate the economy by lowering interest rates, it may take up to 18 months for evidence of any improvement in economic conditions to show up. Additionally, if the government changes its fiscal policy and chooses to increase spending, for example, the fiscal stimulus may still take several months to have any effect on the economy.
As an example of a time lag in action, the Fed may cut interest rates, but it will take time to see these cuts reflected in the economy for the following reasons. First, homeowners with fixed-rate mortgages will not be able to take advantage of interest rate cuts until their loans come up for refinancing, which may take one to two years. During these two years, lower interest rates have not made any difference to the amount of disposable income for this group of individuals. Additionally, consumers and businesses may lack confidence in the economy, so even if interest rates become lower, they will look at the probability of future growth prospects before choosing to take advantage of the lower interest rates. Then, banks may not pass the full interest rate cut on to consumers, and any cuts they do pass on will happen slowly. Lastly, if the value of the dollar falls, this would make exports cheaper for other countries; however, other countries usually schedule orders in advance for several months or more and so will not benefit from the change in the dollar's value. Ultimately, the time lag has prevented this monetary policy from having any benefit for the economy in the near-term future.
One of the biggest issues with time lags is that they render attempts to improve the economy less effective. For example, if the economy experiences a recession, the Fed enforces a new monetary policy decision to cut interest rates, and the government enforces a new fiscal policy to cut taxes, the economy may not see any evidence of real effects for nine to 12 months. During this time, unemployment may rise, which becomes difficult to remedy. Conversely, another problem happens when the government is too aggressive in its efforts to stimulate the economy and then creates a situation where the next 12 months bring about inflation because of the current expansion.