Monetary and Fiscal Policy

Monetary policy and fiscal policy refer to the two most widely recognized tools used
to influence a nation's economic activity. Monetary policy is primarily concerned
with the management of interest rates and the total supply of money in circulation
and is generally carried out by central banks, such as the U.S. Federal Reserve.

Fiscal policy is a collective term for the taxing and spending actions of governments.
In the United States, the national fiscal policy is determined by the executive and
legislative branches of the government.
Fiscal policy refers to the government’s decisions about taxation and spending.
Both monetary and fiscal policies are used to regulate economic activity over time.
They can be used to accelerate growth when an economy starts to slow or to
moderate growth and activity when an economy starts to overheat. In addition, fiscal
policy can be used to redistribute income and wealth.
Fiscal policy relates to government spending and revenue collection. For
example, when demand is low in the economy, the government can step in and
increase its spending to stimulate demand. Or it can lower taxes to increase
disposable income for people as well as corporations.
These methods are applicable in a market economy, but not in
a fascist, communist or socialist economy. John Maynard Keynes was a key
proponent of government action or intervention using these policy tools to
stimulate an economy during a recession.
Fiscal policy refers to the tax and spending policies of the federal government. Fiscal
policy decisions are determined by the Congress and the Administration; the Fed
plays no role in determining fiscal policy.

Monetary policy refers to central bank activities that are directed toward influencing
the quantity of money and credit in an economy. Monetary policy relates to the
supply of money, which is controlled via factors such as interest rates and reserve
requirements (CRR) for banks. For example, to control high inflation, policy-makers
(usually an independent central bank) can raise interest rates thereby reducing
money supply.
Monetary policy refers to the actions of central banks to achieve macroeconomic
policy objectives such as price stability, full employment, and stable economic
growth.
The U.S. Congress established maximum employment and price stability as the
macroeconomic objectives for the Federal Reserve; they are sometimes referred to
as the Federal Reserve's dual mandate. Apart from these overarching objectives, the
Congress determined that operational conduct of monetary policy should be free
from political influence. As a result, the Federal Reserve is an independent agency of
the federal government.
The Federal Reserve uses a variety of policy tools to foster its statutory objectives of
maximum employment and price stability. Its main policy tools is the target for the
federal funds rate (the rate that banks charge each other for short-term loans), a key
short-term interest rate. The Federal Reserve's control over the federal funds rate
gives it the ability to influence the general level of short-term market interest rates.
By adjusting the level of short-term interest rates in response to changes in the
economic outlook, the Federal Reserve can influence longer-term interest rates and
key asset prices. These changes in financial conditions then affect the spending
decisions of households and businesses.
The monetary policymaking body within the Federal Reserve System is the Federal
Open Market Committee (FOMC). The FOMC currently has eight scheduled
meetings per year, during which it reviews economic and financial developments and
determines the appropriate stance of monetary policy. In reviewing the economic
outlook, the FOMC considers how the current and projected paths for fiscal policy
might affect key macroeconomic variables such as gross domestic product growth,
employment, and inflation. In this way, fiscal policy has an indirect effect on the
conduct of monetary policy through its influence on the aggregate economy and the
economic outlook. For example, if federal tax and spending programs are projected
to boost economic growth, the Federal Reserve would assess how those programs
would affect its key macroeconomic objectives--maximum employment and price
stability--and make appropriate adjustments to its monetary policy tools.

Difference between monetary and fiscal policy

Monetary policy and fiscal policy are two different tools that have an impact on the
economic activity of a country.
Monetary policies are formed and managed by the central banks of a country and
such a policy is concerned with the management of money supply and interest rates
in an economy.
Fiscal policy is related to the way a government is managing the aspects of spending
and taxation. It is the government’s way of stabilising the economy and helping in the
growth of the economy.
Governments can modify the fiscal policy by bringing in measures and changes in
tax rates to control the fiscal deficit of the economy.
Below are certain points of difference between the monetary and fiscal policy
 Monetary Policy Fiscal Policy

Definition

It is a financial tool that is used by the central banks It is a financial tool that is used by the central
in regulating the flow of money and the interest rates government in managing tax revenues and policies
in an economy related to expenditure for the benefit of the economy

Managed By

Central Bank of an economy Ministry of Finance of an economy

Measures

It measures the interest rates applicable for lending It measures the capital expenditure and taxes of an
money in the economy economy

Focus Area

Stability of an economy Growth of an economy

Impact on Exchange rates

Exchange rates improve when there is higher interest It has no impact on the exchange rates
rates

Targets

Monetary policy targets inflation in an economy Fiscal policy does not have any specific target

Impact

Monetary policy has an impact on the borrowing in Fiscal policy has an impact on the budget deficit
an economy

 Monetary policy involves changing the interest rate and influencing the
money supply.
 Fiscal policy involves the government changing tax rates and levels of
government spending to influence aggregate demand in the economy.
They are both used to pursue policies of higher economic growth or controlling
inflation.

Monetary policy
Monetary policy is usually carried out by the Central Bank/Monetary
authorities and involves:

 Setting base interest rates (e.g. Bank of England in UK and Federal

Reserve in the US)
 Influencing the supply of money. E.g. Policy of quantitative easing to
increase the supply of money.

How monetary policy works

 The Central Bank may have an inflation target of 2%. If they feel
inflation is going to go above the inflation target, due to economic
growth being too quick, then they will increase interest rates.
 Higher interest rates increase borrowing costs and reduce consumer
spending and investment, leading to lower aggregate demand and
lower inflation.
 If the economy went into recession, the Central Bank would cut interest
rates.
Fiscal policy
Fiscal policy is carried out by the government and involves changing:

 Level of government spending

 Levels of taxation

1. To increase demand and economic growth, the government will cut tax
and increase spending (leading to a higher budget deficit)
2. To reduce demand and reduce inflation, the government can increase
tax rates and cut spending (leading to a smaller budget deficit)
This shows that in 2009/10 the UK ran a budget deficit of 10% of GDP. This
was caused by the recession and also the government’s attempt to provide a
fiscal stimulus (VAT tax cut) to try and get the economy out of recession.

If the government felt inflation was a problem, they could pursue deflationary
fiscal policy (higher tax and lower spending) to reduce the rate of economic
growth.

Which is more effective monetary or fiscal policy?

In recent decades, monetary policy has become more popular because:

 Monetary policy is set by the Central Bank, and therefore reduces

political influence (e.g. politicians may cut interest rates in the desire to
have a booming economy before a general election)
 Fiscal policy can have more supply side effects on the wider economy.
E.g. to reduce inflation – higher tax and lower spending would not be
popular, and the government may be reluctant to pursue this. Also,
lower spending could lead to reduced public services, and the higher
income tax could create disincentives to work.
  Monetarists argue expansionary fiscal policy (larger budget deficit) is
likely to cause crowding out – higher government spending reduces
private sector expenditure, and higher government borrowing pushes up
interest rates. (However, this analysis is disputed)
 Expansionary fiscal policy (e.g. more government spending) may lead
to special interest groups pushing for spending which isn’t really helpful
and then proves difficult to reduce when the recession is over.
 Monetary policy is quicker to implement. Interest rates can be set every
month. A decision to increase government spending may take time to
decide where to spend the money.

However, the recent recession shows that monetary policy too can have many
limitations.

 Targeting inflation is too narrow. During the period 2000-2007, inflation

was low but central banks ignored an unsustainable boom in the
housing market and bank lending.
 Liquidity trap. In a recession, cutting interest rates may prove
insufficient to boost demand because banks don’t want to lend and
consumers are too nervous to spend. Interest rates were cut from 5% to
0.5% in March 2009, but this didn’t solve recession in the UK.
 Even quantitative easing – creating money may be ineffective if banks
just want to keep the extra money on their balance sheets.
 Government spending directly creates demand in the economy and can
provide a kick-start to get the economy out of recession. Thus in a deep
recession, relying on monetary policy alone, may be insufficient to
restore equilibrium in the economy.
 In a liquidity trap, expansionary fiscal policy will not cause crowding out
because the government is making use of surplus saving to inject
demand into the economy.
 In a deep recession, expansionary fiscal policy may be important for
confidence – if monetary policy has proved to be a failure.