Modern monetary and fiscal policies are based on the mandate of the Employment Act of 1946, which obligated the federal government to enact policies that would promote full employment. In the decades that have followed, the use of monetary and fiscal policies has been expanded to address other economic goals that support the basic call for full employment in an expanding economy, including controlling interest rates and inflation and promoting economic growth.
Monetary policies are conducted by the Federal Reserve. With a board of governors in Washington and 12 regional banks, the Fed has three tools at its disposal. It sets the reserve requirement, the amount that commercial banks must hold to back up their deposits. And it controls two key interest rates that banks must pay when they have a liquidity problem and must borrow to cover the shortfall. The discount rate -- what banks pay when they borrow from the Fed -- is set by the Fed. The federal funds rate -- what banks pay when they borrow from each other -- is set through the Fed's open market operations.
Open market operations are the buying and selling of U.S. government securities on the open market. When the Fed buys government bonds, it does so with newly created money. By injecting money into the economy, it keeps the Fed funds rate down and provides liquidity for the economy. When the Fed sells government securities, it pulls liquidity out of the economy and raises interest rates. Monetary policies effect the whole economy, and it can take months for their effects to ripple through the economy. You can follow the Fed's analysis in the Beige Book, a periodic review of the state of the economy.
Fiscal policies are the taxing and spending policies enacted by Congress and the president. When unemployment rises in a recession, government typically pursues expansionary policies. By increasing spending, the government pumps money into the economy. And since a large faction of that money is re-spent, the cumulative effect on the economy is greater than the initial injection. By cutting taxes and allowing people to keep more of their own money, the government helps stimulate economic activity. Conversely, when the economy is overheated, appropriate fiscal policies would be contractionary -- raising taxes and curtailing spending. Tax cuts under presidents Kennedy and Reagan are frequently cited for the economic growth that occurred in the years that followed.
Once enacted, the impact of fiscal policy can be felt fairly quickly. It can also be targeted toward specific sectors or regions of the economy. The major drawback is that politicians may lack the willpower to cut spending when sound policy calls for it.