Monetary Policy vs. Fiscal Policy

Monetary policy and fiscal policy are both tools used by governments to influence economic direction. While monetary policy involves adjusting the money supply and interest rates, fiscal policy involves controlling government spending and taxation. Both aim to achieve macroeconomic goals such as growth, stability, and full employment.

What is Monetary Policy?

Monetary policy refers to the activity that a government deliberately undertakes to manage the amount of money in a market or economy. This is done by primarily controlling interest rates and the supply of money. Raising interest rates encourages corporates and individuals to save more and borrow less as rates are relatively high. Lowering interest rates has the opposite effect and will encourage more spending in the economy. In addition, governments may undertake quantitative easing, which is the buying back of bonds to help bring down long term interest rates. Monetary policy is usually decided by a committee operating on behalf of the central bank.

What is Fiscal Policy?

Fiscal policy focuses on government’s revenue and expenditure as a way of managing economic growth. Increased government spending on projects such as healthcare, new developments or subsidies can be used to drive economic growth. If an economy is deemed to be expanding too rapidly, this spending can be curbed and taxes raised to slow the growth down. Raising taxes is an effective way to slow growth as companies and consumers will have less earnings to spend. Fiscal policy can be used to decrease unemployment as it stimulates the job market.

How Fiscal and Monetary Policy Work Together

Fiscal and monetary policies are both essential tools used to influence a nation’s economic direction. While fiscal policy involves government spending and taxation, monetary policy involves adjusting the money supply and interest rates. When these policies are coordinated effectively, they can complement each other to achieve macroeconomic stability, growth and full employment goals.

For example, during an economic downturn, the government might implement expansionary fiscal policy by increasing spending and cutting taxes to stimulate demand. At the same time, the central bank might lower interest rates to encourage borrowing and investment. This combined approach can provide a more robust stimulus to the economy than either policy could achieve on its own.

Impact on Economic Growth

Both fiscal and monetary policies play crucial roles in influencing economic growth. Fiscal policy can directly impact aggregate demand through government spending and taxation.

For instance, increased government spending on infrastructure projects can create jobs and boost economic activity. Similarly, tax cuts can increase disposable income for consumers, leading to higher consumption and investment.

Monetary policy, on the other hand, influences economic growth by affecting borrowing costs and investment decisions. Lower interest rates can encourage businesses to invest in new projects and consumers to spend more, thereby stimulating economic growth. Conversely, higher interest rates can help cool down an overheating economy and prevent inflation.

An Overview of Monetary Policy

Monetary policy involves the deliberate calibration of money supply and interest rates by a central bank to meet macroeconomic goals. It is a vital function in the economic steering process.

Types of Monetary Policy

There are two main types of monetary policy:

Expansionary Monetary Policy

This involves lowering interest rates to encourage borrowing and investment, thereby stimulating economic growth.

Contractionary Monetary Policy

This involves raising interest rates to temper an overly robust economy and help manage inflation.

Objectives of Monetary Policy

The primary objectives of monetary policy include:

• Preserving price stability by managing inflation.
• Mitigating economic fluctuations to foster steadier growth.
• Stimulating the economy to reduce unemployment and improve labor market health.
• Influencing the exchange rate through interest rate adjustments, affecting international trade and economic vitality.

Monetary Policy to Reduce Inflation

To reduce inflation, central banks typically implement contractionary monetary policy. This involves raising interest rates to decrease the money supply and reduce spending. Higher interest rates make borrowing more expensive, which can lead to lower consumer spending and business investment. As a result, demand for goods and services decreases, helping to bring down inflation.

Additionally, central banks may use other tools such as open market operations to sell government securities, thereby reducing the money supply. They may also increase reserve requirements for banks, limiting the amount of money available for lending.

Monetary Policy Examples

The tools of monetary policy include:

Interest Rate Changes: adjusting benchmark interest rates to influence economic activity (lowering interest rates will typically stimulate economic growth).

Forward Guidance: communicating the central bank’s monetary policy outlook to shape economic expectations.

Open Market Operations: daily transactions of government securities to adjust the money supply and short-term interest rates.

Reserve Requirements: dictating how much banks must hold in reserves, thereby expanding or contracting the money available for banks to lend.

Quantitative Easing: purchasing longer-term securities to boost the money supply and stimulate lending and investment, particularly when traditional interest rate policies reach their limits.

Monetary Policy Pros and Cons

The use of monetary policy has its pros and cons. Economists may advocate the use of monetary policy primarily to manage some situations, or they may prefer more use of fiscal measures.

Monetary Policy Pros:

• Helps preserve price stability and manage inflation in an economy.
• Mitigates economic fluctuations and fosters steadier growth.
• Stimulates the economy to reduce unemployment and improve labor market health.
• Influences the exchange rate, affecting international trade and economic vitality.

Monetary Policy Cons:

• Can lead to unintended consequences such as asset bubbles.
• May have limited effectiveness in certain economic conditions, such as during a liquidity trap.
• Requires accurate and timely data to make informed decisions.

An Overview of Fiscal Policy

Fiscal policy is the government’s approach to using its budgetary tools, primarily spending, and taxation to influence the economic landscape. It stands as a primary instrument in achieving economic targets.

Types of Fiscal Policy

There are three main types of fiscal policy:

Expansionary Fiscal Policy

This involves increased spending and lower taxes to increase aggregate demand in an economy.

Contractionary Fiscal Policy

If economic growth is looking unsustainable then governments may raise taxes to slow down spending as well as cut their own spending plans to slow the economy down. This can also be used to reduce government deficits.

Neutral Fiscal Policy

This is a scenario where the government’s spending and taxation are planned to be equal, therefore it is a balanced budget and neutral to the economy. This would usually be implemented if the macroeconomic environment was healthy and in line with growth expectations.

Objectives of Fiscal Policy

The primary objectives of fiscal policy include:

• Fiscal policy aims to stabilize the economy by managing growth dynamics, tackling unemployment, and keeping inflation in check
• This involves using government spending and taxation to influence economic activity and maintain a stable economic environment
• Fiscal policy can help achieve a more equitable society by redistributing income through taxation and government spending. This can reduce income inequality and provide support to disadvantaged groups.

Strategic fiscal measures can support certain industries or innovations, laying the groundwork for long-term economic growth. By investing in key areas, the government can stimulate economic development and enhance the nation’s economic potential. Government spending priorities can also channel resources to essential sectors like healthcare, education, or infrastructure. This reflects societal values and aspirations, ensuring that critical areas receive the necessary funding for development.

Fiscal Policy Examples

The primary tools of fiscal policy include:

Government Spending: this involves expenditures on infrastructure, healthcare, education, defense, and other public services. By increasing or decreasing government spending, the government can influence economic activity. For example, during a recession, the government might increase spending to stimulate the economy.

Taxation: adjustments to personal and corporate income tax rates can influence disposable income and business profitability. Lowering taxes can increase consumer spending and business investment, while raising taxes can help cool down an overheated economy.

Public Debt Management: this involves managing the government’s borrowing and debt levels. By issuing government bonds or other debt instruments, the government can raise funds to finance its spending plans.

Subsidies and Grants: these are financial aids provided by the government to support specific industries, businesses, or individuals. Subsidies can help lower the cost of goods and services, making them more affordable for consumers.

Automatic Stabilizers: these are mechanisms that automatically adjust government spending and taxation in response to economic changes. Examples include unemployment benefits and progressive tax systems, which help stabilize the economy without the need for active intervention.

Fiscal Policy Pros and Cons

Similar to monetary policy, there are economists who are advocates of fiscal policy and those which believe it is best suited to specific scenarios. Let’s look at the pro and cons of this policy:

Fiscal Policy Pros:

• It plays a stabilizing role by managing growth dynamics, tackling unemployment, and keeping inflation in check.
• Government spending priorities can channel resources to essential sectors like healthcare, education, or infrastructure.
• It can assist in the redistribution of income through fiscal measures can strive for a more equitable society.
• It can strategically support certain industries or innovations, laying the groundwork for long-term economic growth.

Fiscal Policy Cons:

• Persistent budget deficits can lead to escalating public debt.
• Excessive borrowing can result in higher interest rates, deterring private investment and suppressing economic potential.
• It requires careful management to ensure sustainability and avert constraints on future economic growth.

Conclusion

Both monetary and fiscal policies are essential tools for steering the economy towards growth, stability, and full employment. While monetary policy focuses on adjusting money supply and interest rates, fiscal policy involves government spending and taxation to achieve macroeconomic goals.

Often the policy used will depend on the economic climate and how much clarity the central bank and government have on the cause or main issue within the economy. For example, when looking to drive growth in an economy, monetary policy can be immediately implemented to lower interest rates if they are at high levels already. However, if the rates are already low, the government may be more effective by using strategic spending to drive growth.

Learn about specific examples of fiscal and monetary policy in global markets during recent years in the free download section.

Additional Resources

Fiscal Policy

Monetary Policy

Global Economics