Monetary and fiscal policies are two of the most widely recognized tools that are used to influence and therefore control a country’s economic activity.
In a nutshell, monetary policy involves the management of interest rates and the total supply of circulating money. Such are a job for central banks like the European Central Bank and the US Federal Reserve. Meanwhile, fiscal policies largely concern tax and spending actions of the government.
In this article, we’re going to discuss the differences between the two kinds of policy.
What is Monetary Policy?
Central banks usually use monetary policy to either boost an economy or tame its growth.
To boost the economic activity, the central bank incentivizes people and businesses to borrow and spend. On the flipside, it restricts spending and incentivizes savings to serve as a curb to inflation and other similar issues that an overheated economy brings.
Monetary Policy Tools
In the US, the Fed often use three different policy instruments to influence the economy. These are: open market operations, reserve requirement changes for banks, and discount rate setting.
Open market operations refer to when the central bank buys government bonds to inject money into the economy or pull money out of circulation.
Reserve ratio is the percentage of deposits that banks must keep. By setting this ratio, the Fed directly influences the amount of money created when banks loan.
Lastly, the interest rate changes the central bank makes aim to influence the short-term interest rates across the entire economy.
In general, the goal of the majority of government fiscal policies is to target the total level of spending, the total composition of spending, or both.
The two most popular ways of affecting fiscal policy are changes in government spending policies or in government tax policies.
Fiscal Policy Tools
If the government thinks that business activity is insufficient, it can increase the amount of money that it spends. This is often called the stimulus spending.
Meanwhile, if there are inadequate tax receipts to pay for the spending increases, the government borrows some money. It does that by issuing some debt securities like government bonds. In the process, it accumulates debt. This is what we call deficit spending.
When the government increases taxes, it pulls out money from the economy and slows down business activity.
More often than not, the fiscal policy is used when the government wants to boost the economy.
It may impose lower taxes or give tax rebates in an effort to encourage economic growth. This is one of the core principles of the Keynesian economics.
When the government decides to spend more money or implement changes in tax policy, it has to choose where to spend and what to tax.
As a result, it can target specific communities, industries, investments, or commodities to favor or discourage production.
But there are times when fiscal policies are based on factors that are not entirely economic. Because of this, fiscal policies are usually a divisive topic among economists and political commentators.