The aim of fiscal and monetary policy is economic stability, but the individuals in charge of them use different approaches to achieving it. The titles of the two policies indicate the main distinction between monetary and fiscal policy. The term “monetary” describes the available funds, or the quantity that may be spent. Fiscal refers to the spending plan, or budget.
What is Monetary Policy?
The activities carried out by a country’s central bank to regulate the money supply, interest rates, and inflation—thus impacting the general activity of the economy—are referred to as monetary policy. In order to accomplish macroeconomic goals, including regulating employment levels, preventing inflation, and promoting sustainable economic development, this strategy is essential for preserving economic stability.
Monetary policy is carried out by central banks, like the Federal Reserve in the United States, the European Central Bank in the Eurozone, and others around the world. To affect the economy, they employ a variety of techniques. The discount rate, reserve requirements, and open market activities are the main instruments. Buying and selling government securities is known as open market activity, and it is used to modify the quantity of money in circulation within the economy. By purchasing assets, the central bank adds cash to the economy, expanding the money supply and perhaps bringing down interest rates. Selling securities, on the other hand, takes money out of the economy, reducing the amount of money in circulation and perhaps increasing interest rates.
Understanding How Monetary Policy Works
The interest rate that central banks charge on loans they make to commercial banks is known as the discount rate. Banks are encouraged to lend more to consumers and companies when the discount rate is lowered since it becomes more affordable for them to borrow money. This can boost economic activity. The converse occurs when the discount rate is raised, which might slow down economic growth.
The amount of money that commercial banks are required to keep in reserve against their deposits is referred to as the reserve requirement. Reducing reserve requirements makes it possible for banks to lend more money, expanding the money supply and promoting economic growth. Increasing reserve requirements limit the quantity of money that banks may lend, which can cause the economy to sputter.
Types of Monetary Policies
There are two types of monetary policies:
1) Expansionary
2) Contractionary
In order to promote economic growth, expansionary monetary policy seeks to cut interest rates and expand the money supply, especially during recessionary or slowing economic times.
On the other hand, contractionary monetary policy aims to limit inflation and avoid an overheated economy by decreasing the money supply and raising interest rates.
Additionally, central banks may affect expectations and economic decisions by announcing their future policy objectives through the use of forward guidance. This openness can improve the efficacy of monetary policy and control market expectations.
Monetary Policy Examples
1) US 2008 Financial Crisis
The United States Federal Reserve pursued an aggressive expansionary monetary policy in the wake of the 2008 financial crisis in order to counteract the severe economic slump. This program raised the money supply and lowered interest rates in an effort to boost economic expansion. The federal funds rate was cut to almost zero, which was one of the main instruments employed. Because borrowing became more affordable as a result, people and companies were encouraged to spend and invest, which increased economic activity.
The Federal Reserve also started a number of quantitative easing (QE) initiatives, through which it bought substantial amounts of mortgage-backed assets and government securities. Lowering long-term interest rates and expanding the money supply were the two main goals of this infusion of liquidity into the financial system. The intention was to boost asset values, revitalize the credit markets, and eventually win back the trust of businesses and consumers.
2) US 1970s and 1980s Inflation
The United States had a period of significant inflation in the late 1970s and early 1980s that reached double digit levels. Under Chairman Paul Volcker, the Federal Reserve pursued a contractionary monetary policy in order to counteract this. The federal funds rate was significantly raised as the main instrument. From around 11% in 1979 to a peak of 20% in 1981, the Fed increased the rate. The steep rise in interest rates increased the cost of borrowing, which in turn decreased company and consumer investment. Additionally, the higher rates promoted saving over consumption.
The Federal Reserve also tightened its control over the money supply in an effort to lower the quantity of money in circulation throughout the economy. Although the rising inflation was effectively controlled, this approach resulted in a severe recession with unemployment rates above 10%.
Why is Contractionary Monetary Policy Important?
Contractionary monetary policy is crucial for preserving economic stability because it prevents economic overheating, manages inflation, and promotes long-term, sustainable growth. To rein in excessive economic expansion, this strategy entails raising interest rates and decreasing the money supply.
1) Limit Inflation
One of the main justifications for contractionary monetary policy is to limit inflation. Overgrowth in the economy can result in a shortage of supply, which drives up prices. Excessive inflation reduces buying power, skews decisions about investments and spending, and can cause people to lose faith in the currency. Contractionary policy helps control demand, stabilize prices, and keep inflation within goal ranges by lowering the money supply and boosting interest rates, all of which contribute to maintaining the value of money.
2) Overheating of the Economy
Another crucial element is preventing an overheating of the economy. Excessive borrowing and spending can cause asset bubbles, in which the value of stocks and real estate skyrockets above their fundamental levels during times of strong economic expansion. When these bubbles collapse, they can cause catastrophic economic downturns and financial instability. By lowering growth rates, contractionary monetary policy lessens the likelihood that these bubbles will burst.
3) Sustainable Long Term Growth
Contractionary monetary policy is another tool used to support sustainable, long-term growth. It establishes a stable economic climate that is favorable to long-term planning and investment by guaranteeing that inflation stays under control. Stable pricing promotes a healthy economic environment by enabling consumers to plan their spending and companies to make educated decisions about employment and development.
4) Manages Inflation
Contractionary policy also contributes to the central bank’s continued legitimacy. Consumers, companies, and investors all become more trusting when inflation is consistently controlled. Because economic agents are more likely to match their expectations and conduct with the central bank’s aims when the central bank is credible, monetary policy is more successful.
Why is Expansionary Monetary Policy Important?
In times of economic downturns or recessions, expansionary monetary policy is crucial because it promotes economic growth, fights unemployment, and averts deflation. To promote borrowing, spending, and investment, this policy lowers interest rates and increases the money supply.
Using expansionary monetary policy is primarily done to stimulate economic development. Recessions and poor economic development are usually accompanied by a drop in corporate and consumer confidence, which discourages investment and expenditure. Central banks incentivize firms to engage in capital projects and boost consumer spending by decreasing interest rates, which in turn makes borrowing more affordable. This surge in economic activity encourages a return to strong growth and helps the economy emerge from recession.
Economic downturns are frequently accompanied by high unemployment when corporations reduce output and lay off employees. By facilitating easier access to credit, expansionary monetary policy seeks to boost demand for goods and services. Businesses recruit more people when they boost output in response to growing demand, which lowers unemployment and supports household incomes.
Another important justification for implementing expansionary monetary policy is to avoid deflation. A decline in the average level of prices for goods and services, or deflation, can set off a domino effect that results in decreased consumer spending, fewer company profits, and increased unemployment. Deflation is averted by expansionary policy, which lowers interest rates and increases the money supply while stabilizing prices and fostering demand.
Expansionary monetary policy can also enhance financial stability by reducing the cost of capital and easing the burden on families and firms with debt. By lowering the likelihood of defaults and bankruptcies, this can promote the financial system’s general health.
Drawbacks of the Monetary Policy
During the liquidity crisis, when interest rates are near zero and demand for money is very elastic, standard tactics such as rate cuts may fail to boost borrowing and spending.
In such cases, individuals and corporations may seek to hoard cash in anticipation of future economic downturns. Despite low or zero interest rates, demand for loans may remain low, making the central bank’s policy instruments less effective.
a) Time Lags and Uncertainties
Implementing adjustments in monetary policy does not provide instant results. There is frequently a lag between when a policy change is implemented and when its consequences are recognized in the larger economy.
This delay may make it difficult for central banks to properly respond to rapidly changing economic situations. Additionally, the precise duration and strength of these delays might be unknown, making it impossible for policymakers to forecast the specific impact of their policies.
In other circumstances, by the time the impacts are felt, the economic environment may have altered, necessitating a new governmental response.
b) Risk for Negative Side Effects
Long-term low interest rates can cause asset bubbles as investors seek greater yields in riskier assets. When such bubbles burst, they might cause an economic slump. Also, low interest rates might stimulate borrowing and investment, but they can also discourage savings.
Dependence on monetary easing can result in resource misallocation, with firms engaging in suboptimal projects due to the low cost of loans.
What is Fiscal Policy?
Fiscal policy is the use of taxing and spending by the government to affect the economics of a country. In order to achieve macroeconomic targets like full employment, price stability, and sustainable growth, it is essential to control economic activity and stabilize the economy. In contrast to monetary policy, which is carried out by a central bank, the legislative and executive arms of government usually develop and implement fiscal policy.
Taxation and government expenditure are the two primary pillars of fiscal policy. Expenditures on products and services, public works projects, social programs, and transfers like unemployment insurance and social security are all considered forms of government spending. Taxation is the process of obtaining money from people and companies through a variety of levies, including excise taxes, corporation taxes, sales taxes, and income taxes.
Benefits of Fiscal Policy
There are several benefits to fiscal policy. It can focus on certain economic sectors or people, such as tax credits for low-income households to raise their purchasing power or infrastructure projects to promote jobs in the construction industry. Furthermore, fiscal policy may offer direct and instant assistance in times of economic crisis, for example, by supporting enterprises in an emergency or by issuing stimulus cheques.
Fiscal policy, however, is not without its restrictions and possible downsides. Political procedures can cause implementation to lag, and there’s a chance that their influence will result in less-than-ideal choices. Furthermore, bigger budget deficits and public debt may result from lower taxes or higher government expenditure, which might have long-term negative effects on the economy. Excessive debt can lead to higher borrowing rates and less future budgetary flexibility.
Issues and Drawbacks of Fiscal Policy
Despite being an essential mechanism for controlling economic activity, fiscal policy has a number of potential downsides that might reduce its efficacy and provide long-term difficulties.
A notable drawback is the implementation’s delayed start. A long and sometimes acrimonious process, parliamentary approval is frequently needed for changes in fiscal policy, such as revisions to tax rates or government expenditures. Due to this delay, the policy’s efficacy may be diminished since the economic conditions it was intended to address may have altered by the time it is implemented.
The possibility of political interference and policy mismatches is another problem. Political factors frequently influence fiscal policy decisions, which can result in less-than-ideal economic consequences. Politicians may place more importance on initiatives or short-term advantages that please their constituents than on those that are best for the economy as a whole. This may lead to an ineffective distribution of resources and a worsening of economic disparities.
Public debt and budget deficits can both rise as a result of fiscal policies. Fiscal expansionary measures, such as tax breaks or increased government spending, frequently lead to larger deficits if they are not followed by increases in income. Long-term economic effects may result from persistent deficits’ contribution to the national debt’s ascent. High debt levels have the potential to cause a debt crisis if investors lose faith in the government’s capacity to manage its finances. They can also raise borrowing prices and limit fiscal flexibility.
The potential for squeezing out private investment is another drawback. Higher interest rates may result from the government borrowing money to fund its expenditures, as credit demand will rise as a result. Increased interest rates have the potential to deter private sector investment and hence mitigate some of the growth-promoting benefits of higher government spending. It can be especially troublesome for economies with low levels of investment to have this crowding-out effect.
Also, if fiscal policy is not well controlled, it may have inflationary implications. Fiscal expansion may cause inflation to soar and the economy to overheat, especially when it is already running close to full capacity. In order to tackle inflation, this may reduce buying power and call for contractionary monetary measures, which might lead to a policy dispute.
How Does Fiscal Policy Affect People?
People are directly impacted by fiscal policy since it has an impact on their income, employment prospects, and general financial well-being. Fiscal policy may affect people and families in both the short and long term through taxes and expenditures by the government.
Increases in government spending are frequently used to pay for public initiatives, including healthcare, education, and infrastructure development. In addition to increasing employment and income levels for individuals directly participating in the projects, these initiatives also benefit businesses that offer goods and services to them. Greater consumer spending results from higher employment and wages, which can further boost economic development and provide new job possibilities.
Individuals are also greatly impacted by tax policy. Tax cuts provide people with greater disposable income, which they might use to save money, invest, or spend more on goods and services. Spending more money may spur economic development, which is good for the whole economy. On the other hand, higher taxes diminish disposable income, which may result in reduced spending and slower economic expansion. Certain groups—such as low-income families or small businesses—may benefit financially from targeted tax credits or deductions, which will strengthen their financial stability.
Government transfers that directly assist those in need, such as welfare programs, social security, and unemployment insurance, lower poverty and economic disparity. These payments offer a safety net that enables people to maintain their standard of living in the event of personal or economic misfortune.
Fiscal Policy Examples
The United States’ reaction to the COVID-19 pandemic with the Coronavirus Aid, Relief, and Economic Security (CARES) Act of 2020 is an important example of fiscal policy in action. The aim of this legislation, which was enacted in March 2020, was to lessen the pandemic’s financial toll on people, companies, and the overall economy.
a) CARE Act
During a severe economic slump, the CARES Act constituted an expansionary fiscal policy intended to boost economic activity and offer financial assistance. The act’s main features included money for healthcare providers, higher unemployment benefits, help for small enterprises, and direct financial aid to individuals.
The direct transfer of funds to people was one of the most important measures. Depending on their income levels, eligible Americans might get payments of up to $1,200 for each adult and $500 for each kid. In order to maintain demand for products and services during the pandemic-induced economic downturn, this emergency cash support was intended to increase consumer spending. Additionally, the CARES Act improved unemployment benefits by giving state unemployment insurance recipients an extra $600 a week. This action was taken to provide assistance to those who lost their employment as a result of the epidemic, enabling them to cover their essential expenses and continue with some degree of consumption.
b) Paycheck Protection Program
The Paycheck Protection Program (PPP), which provides forgiven loans to meet payroll and other necessary obligations, was created for small enterprises. This initiative helped small firms that were having trouble making ends meet by giving them financial support in an effort to stop large-scale layoffs and company closures. In order to assist the healthcare system’s reaction to the pandemic and manage the increasing load of COVID-19 patients, the CARES Act also provided considerable funding to healthcare professionals.
The extensive fiscal measures included in the CARES Act played a critical role in preventing the worst consequences of the pandemic-induced economic crisis, stabilizing the economy, and assisting people and companies. In the midst of an unprecedented worldwide crisis, the legislation sought to maintain economic activity and foster recovery by offering direct financial aid, improving unemployment compensation, and assisting small enterprises.
Conclusion
The two most important instruments for controlling economic growth and stability are monetary and fiscal policy. In order to affect inflation and economic activity, central banks oversee monetary policy, which regulates the money supply and interest rates. The government implements fiscal policy, which modifies taxes and expenditures to have a direct impact on employment and economic demand.
Monetary policy may be less successful during severe downturns, despite the fact that it allows for rapid adjustments and is less susceptible to political influence. Fiscal policy can be used to target certain industries and offer quick assistance, but it frequently encounters political obstacles and implementation delays. The two policies have complementary effects, and it is essential to utilize them in tandem to solve different economic issues and foster sustainable growth.
FAQs
What Separates Monetary Policy from Fiscal Policy?
The term “monetary policy” describes the actions taken by central banks with the intention of affecting the amount of credit and money in an economy. Fiscal policy, on the other hand, describes the choices the government makes on taxation and expenditure. Over time, fiscal and monetary policies are both utilized to control economic activity.
Who is in Charge of Monetary Policy?
Monetary policy was delegated to the Federal Reserve by the Federal Reserve Act of 1913. The discount rate, reserve requirements, and open market operations are the three monetary policy instruments under the Federal Reserve’s jurisdiction.
What Advantages Does Monetary Policy Offer?
The economy may benefit greatly from monetary policy in a number of ways, including by supporting fiscal policy, promoting efficiency and innovation, stabilizing inflation expectations, and easing business cycles.
Who Creates Inflation?
Lax monetary policy is typically the cause of protracted periods of high inflation. The unit value of the currency decreases when the money supply increases excessively in relation to the size of the economy; in other words, prices rise and the currency’s buying power decreases.
Which is Better, Fiscal or Monetary Policy?
During a recession, monetary policy could be more effective in the near term. Lowering interest rates can stimulate investment and borrowing, which will swiftly add liquidity to the economy. Implementing fiscal policy may take longer, but by supporting significant industries and employment, it may have a long-lasting impact.