Definition
Fiscal policy refers to government efforts to influence the economy through taxation and spending decisions, primarily controlled by legislative bodies. On the other hand, monetary policy involves management of the money supply and interest rates to control inflation and stabilize the economy, typically handled by a central bank like the Federal Reserve in the U.S. The two policies are tools used by authorities to steer the economic growth and stability of a country.
Key Takeaways
- Fiscal Policy refers to the use of government spending and taxation to influence the economy. Government typically uses fiscal policy to promote economic growth, stimulate development, and manage inflation. It involves adjusting the levels of government spending and taxation, directly affecting public expenditure, infrastructure development, and social welfare services.
- Monetary Policy, on the other hand, is administered by the central bank and involves the management of the money supply, interest rates and banking regulations to control inflation and stabilize the currency. It serves to influence the economy by adjusting the cost of borrowing, thereby shifting levels of consumption, investment, and economic activity as a whole.
- The major difference between the two lies in the entities that execute them and their primary tools. While Fiscal Policy is implemented by the government using spending and tax decisions, Monetary Policy is carried out by the central bank, adjusting the money supply through varying interest rates and other banking tools.
Importance
Understanding the difference between fiscal and monetary policy is essential as they represent the two most prominent types of economic intervention used by governments to manage and influence a nation’s economy. Fiscal policy relates to government spending and revenue collection and is primarily managed by the legislative branch.
It includes taxes, spending on infrastructure, public services, and social welfare programs. In contrast, monetary policy includes controlling inflation, managing exchange rates, and controlling the money supply, mostly through interest rates.
It’s predominantly controlled by a nation’s central bank or Federal Reserve. The balance between these two can significantly impact an economy’s health, affecting employment rates, business growth, and consumer spending, hence understanding this is pivotal for policymakers, economists, and investors.
Explanation
Fiscal policy and monetary policy are two key strategies used by the government to manage a country’s economy. The central purpose of fiscal policy, which is managed by the government or the Department of Treasury, is to use government revenue collection (taxation) and expenditure (spending) to influence the nation’s economy.
This is achieved by altering tax rates and public spending levels to curb inflation, increase employment, and maintain a healthy value of money. Fiscal policy can be used for redistributing wealth, managing the economy’s aggregate demand, and influencing the pattern of economic activity within a fiscal year.
On the other hand, monetary policy, administered by a country’s central bank such as the Federal Reserve in the U.S., primarily aims to control the supply and demand for money. The central bank uses tools like altering interest rates, buying or selling government bonds, and changing the amount of money banks are required to keep in their reserves, to maintain economic stability.
This policy is essential for keeping inflation in check, managing exchange rates, and generally ensuring a stable and predictable economic environment, which is beneficial for businesses and consumers. While fiscal policy lays the roadmap for broader economic policy and development strategy, monetary policy is more focused on fine-tuning economic issues through controls on money supply.
Examples of Fiscal Policy vs Monetary Policy
Great Recession (2007-2009): During the Great Recession, both fiscal and monetary policy were put into action. Monetary policy came in the form of Quantitative Easing by the Federal Reserve. The Fed bought large amounts of government bonds and other financial securities in an effort to lower interest rates, promote more lending and inject money into the economy. On the fiscal front, the government passed the American Recovery and Reinvestment Act of 2009, which included increased government spending and tax cuts in an effort to stimulate the economy.
COVID-19 Pandemic (2020 – Present): In response to the economic fallout from the COVID-19 pandemic, central banks worldwide, including the Federal Reserve, drastically cut interest rates and took other measures to boost liquidity and lending. This is an example of monetary policy. In parallel, governments globally also enacted large fiscal stimulus measures to support their economies. In the United States, significant fiscal measures were taken with the CARES Act and subsequent relief bills, providing direct payments to individuals, extended unemployment benefits, and aid to businesses and state and local governments.
Post World War II (1945 – 1960s): After World War II, the U.S profoundly used Fiscal Policy to facilitate rapid economic growth and prosperity. Under this policy, the government spent heavily on infrastructure and welfare, leading to the creation of jobs and enhanced consumer spending, thereby triggering economic growth. Meanwhile, the Federal Reserve kept interest rates low to ensure full employment until the mid-1960s, effectively implementing monetary policy to maintain economic stability.
Frequently Asked Questions: Fiscal Policy vs Monetary Policy
What is Fiscal Policy?
Fiscal Policy refers to the measures employed by governments to stabilize the economy, specifically by manipulating the levels and allocations of taxes and government expenditures. Fiscal policy can influence macroeconomic productivity levels by increasing or decreasing tax levels and public spending.
What is Monetary Policy?
Monetary Policy is the process by which the monetary authority of a country, like the central bank, manages the supply of money in order to control inflation, stabilize the currency, and create economic growth. This is typically managed by altering interest rates and purchasing or selling government bonds.
What are the main differences between Fiscal Policy and Monetary Policy?
Fiscal Policy is managed by the government, whereas Monetary Policy is handled by the central bank. Fiscal policy focuses on taxation and government spending, whereas monetary policy manipulates the supply of money in the economy, primarily through interest rates.
How does Fiscal Policy affect the economy?
Fiscal Policy influences saving, investment, and consumption levels within an economy, by altering tax policies and public expenditure. These changes can influence economic factors like unemployment rates, inflation, and the level of economic growth.
How does Monetary Policy affect the economy?
By managing interest rates and the supply of money, Monetary Policy can maintain price stability, control inflation, and stabilize the financial system. These adjustments can affect variables like employment rates, gross domestic product growth, and business prices.
Can Fiscal and Monetary policy be used together?
Fiscal and Monetary Policies are both tools used to influence a country’s economic performance. They are typically used in combination, complementing each other to achieve economic stability and growth.
Related Entrepreneurship Terms
- Government Expenditure
- Inflation Rate
- Interest Rates
- Taxation Policy
- Money Supply Management
Sources for More Information
- Investopedia: A trusted international website committed to investing and financial education for traders of all levels. From Fiscal Policy to Monetary Policy, this site does not disappoint.
- Khan Academy: A non-profit educational organization that provides free video tutorials and interactive exercises. Their offerings include courses on both Fiscal and Monetary Policy.
- The Balance: Detailing essential up-to-date information on Fiscal and Monetary Policies, The Balance offers a comprehensive take on finance, investing, and economics topics.
- Federal Reserve: The central bank of the United States provides insightful information on American Monetary Policy and how it interacts with the Fiscal Policy of the country.
