Economic policy-makers are said to have two kinds of tools to influence a country's economy: fiscal and monetary.
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.
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.
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.
Both fiscal and monetary policy can be either expansionary or contractionary. Policy measures taken to increase GDP and economic growth are called expansionary. Measures taken to rein in an "overheated" economy (usually when inflation is too high) are called contractionary measures.
The legislative and executive branches of government control fiscal policy. In the United States, this is the President's administration (mainly the Treasury Secretary) and the Congress that passes laws.
Policy-makers use fiscal tools to manipulate demand in the economy. For example:
- Taxes: If demand is low, the government can decrease taxes. This increases disposable income, thereby stimulating demand.
- Spending: If inflation is high, the government can reduce its spending thereby removing itself from competing for resources in the market (both goods and services). This is a contractionary policy that would lower prices. Conversely, when there is a recession and aggregate demand is flagging, increased government spending in infrastructure projects would lead to higher demand and employment.
Both tools affect the fiscal position of the government i.e. the budget deficit goes up whether the government increases spending or lowers taxes. This deficit is financed by debt; the government borrows money to cover the shortfall in its budget.
Procyclical and Countercyclical Fiscal Policy
When an economy is in a boom, the government should run a surplus; other times, when in recession, it should run a deficit.
[There is] no reason to follow a pro-cyclical fiscal policy. A procyclical fiscal policy piles on the spending and tax cuts on top of booms, but reduces spending and raises taxes in response to downturns. Budgetary profligacy during expansion; austerity in recessions. Procyclical fiscal policy is destabilising, because it worsens the dangers of overheating, inflation, and asset bubbles during the booms and exacerbates the losses in output and employment during the recessions. In other words, a procyclical fiscal policy magnifies the severity of the business cycle.
Monetary policy is controlled by the Central Bank. In the U.S., this is the Federal Reserve. The Fed chairman is appointed by the government and there is an oversight committee in Congress for the Fed. But the organization is largely independent and is free to take any measures to meet its dual mandate: stable prices and low unemployment.
Examples of monetary policy tools include:
- Interest Rates: Interest rate is the cost of borrowing or, essentially, the price of money. By manipulating interest rates, the central bank can make it easier or harder to borrow money. When money is cheap, there is more borrowing and more economic activity. For example, businesses find that projects that are not viable if they have to borrow money at 5% are viable when the rate is only 2%. Lower rates also disincentivize saving and induce people to spend their money rather than save it because they get so little return on their savings.
- Reserve requirement: Banks are required to hold a certain percentage (cash reserve ratio, or CRR) of their deposits in reserve in order to ensure that they always have enough cash to meet withdrawal requests of their depositors. Not all depositors are likely to withdraw their money simultaneously. So the CRR is usually around 10%, which means banks are free to lend the remaining 90%. By changing the CRR requirement for banks, the Fed can control the amount of lending in the economy, and therefore the money supply.
- Currency peg: Weak economies can decide to peg their currency against a stronger currency. This tool is usually used in cases of runaway inflation when other means to control it are not working.
- Open market operations: The Fed can create money out of thin air and inject it into the economy by buying government bonds (e.g. treasuries). This raises the level of government debt, increases the money supply and devalues the currency causing inflation. However, the resulting inflation supports asset prices such as real estate and stocks.
Videos Comparing Fiscal and Monetary Policy
For a general overview, see this Khan Academy video.
To learn about the different monetary and fiscal policy tools, watch the video below.
The following video is a little more technical. It explains the effects of fiscal and monetary policy measures using the IS/LM model.
Libertarian economists believe that government action leads to inefficient outcomes for the economy because the government ends up picking winners and losers, whether intentionally or through unintended consequences. For example, after the 9/11 attacks the Federal Reserve cut interest rates and kept them artificially low for too long. This led to the housing bubble and the subsequent financial crisis in 2008.
Economists and politicians rarely agree on the best policy tools even if they agree on the desired outcome. For example, after the 2008 recession, Republicans and Democrats in Congress had different prescriptions for stimulating the economy. Republicans wanted to lower taxes but not increase government spending while Democrats wanted to use both policy measures.