Fiscal Policy vs. Monetary Policy

Fiscal Policy
Monetary Policy

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 in recession.

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Fiscal Policy

Monetary Policy

Definition Fiscal policy is the use of government expenditure and revenue collection to influence the economy. Monetary policy is the process by which the monetary authority of a country controls the supply of money, often targeting a rate of interest to attain a set of objectives oriented towards the growth and stability of the economy.
Principle Manipulating the level of aggregate demand in the economy to achieve economic objectives of price stability, full employment, and economic growth. Manipulating the supply of money to influence outcomes like economic growth, inflation, exchange rates with other currencies and unemployment.
Policy-maker Government (e.g. U.S. Congress, Treasury Secretary) Central Bank (e.g. U.S. Federal Reserve or European Central Bank)
Policy Tools Taxes; amount of government spending Interest rates; reserve requirements; currency peg; discount window; quantitative easing; open market operations; signalling

Contents: Fiscal Policy vs Monetary Policy

The supply-demand model
The supply-demand model

edit Policy Tools

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.

edit Fiscal policy

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:

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.

edit Procyclical and Countercyclical Fiscal Policy

In an article for VOX on the tax cuts vs. stimulus debate, Jeffrey Frankel, Economics professor at Harvard University has said that sensible fiscal policy is countercyclical.

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.

edit Monetary policy

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:

edit Videos comparing fiscal and monetary policy

This video explains the different monetary and fiscal policy tools.

The following video is a little more technical. It explains the effects of fiscal and monetary policy measures using the IS/LM model.

edit Criticism

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.

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Anonymous comments (5)

June 17, 2014, 12:10am

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