By Aniket Bose. Edited by Arjun Chandrasekar.
Monetary policy and fiscal policy are the two most recognized tools used to influence a nation’s economic activity, also known as macroeconomic tools. Monetary policy is essentially associated with the management of interest rates and the total supply of money in circulation which is typically carried out by central banks such as the U.S. federal reserve. Fiscal policy is a collective term for the taxing and spending actions carried out by governments. In the U.S, the national fiscal policy is determined by the executive and legislative branches of the government. Both of these policies together greatly influence a nation’s economy, businesses, and consumers. Fiscal policies generally have a greater impact on consumers than monetary policies as they can lead to an increase in employment and income.
What is Monetary Policy?
The monetary policy is most commonly used by central banks to stimulate an economy or check its growth. The policy incentivizes individuals and businesses to borrow and spend money, as the monetary policy aims to encourage economic activity. At the same time, by limiting the amount of spending and prioritizing to save more money, this policy can act as a stopping point on inflation and other issues that are associated with a declining economy.
The Federal Reserve, also known as the “Fed,” has frequently used 3 different policy tools to influence the economy: open market operations, changing reserve requirements for banks, and setting the discount rate. These open market operations are carried out daily when the Fed buys and sells U.S. government bonds either to input money into the economy or withdraw money out of its circulation. By setting the “reserve ratio” for banks, also known as the percentage of deposits banks are required to hold in reserve, the Fed directly influences the amount of money created when banks create loans. The Fed also can target changes in the discount rate that are applied on loans from financial institutions. The discount rate is intended to impact all the short-term interest rates across the entire economy.
Monetary policy is more of a boring tool in terms of expanding and contracting the money supply for influencing inflation and the growth of the economy. This policy does not have a huge impact on the economy. For example, during the financial recession of 2008, the Fed was very aggressive. The decisions and actions they made prevented deflation from occurring and the collapse of the economy, but it didn’t generate significant economic growth and resulted in a lot of people losing their jobs. Monetary policy can have limited effects on economic growth by increasing the prices of assets and lowering the costs of borrowing money, resulting in companies being much more profitable.
What is the Fiscal Policy?
The main goal of most government fiscal policies is to target the total amount of spending money, the total composition of spending, or both in a nation’s economy. The two most widely used means of affecting fiscal policies are making changes in government spending policies and government tax policies. When governments believe that there is not enough business activity in their economy, they can increase the amount of money it spends, known as stimulus spending.
If there are not enough tax receipts to pay for the increase in spending money, governments have to borrow money by issuing debt securities such as government bonds and in this process, the governments accumulate debt. This is called deficit spending. Governments will usually increase taxes while they pull money out of the economy and slow business activity. Usually, fiscal policies are used when governments want to stimulate the economy. It may result in lower taxes to encourage the growth of the economy. When a government spends money or changes its tax policy, it has to choose where to spend money or what to tax. In this process, government fiscal policy can target specific communities, investments, commodities, industries, or commodities either to favor or discourage production. For this reason, fiscal policies are often debated and negatively connotated among economists and political observers.
Both fiscal and monetary policies play a very big role in managing the economy and they both have direct and indirect impacts on personal and household finances. Fiscal policies involve more tax and spending decisions issued by the government and impact individuals’ tax bills or provide them with employment by working on government projects. Monetary policies are set by the central bank of a nation and they can boost consumer spending through low-interest rates, which make borrowing money cheaper from credit cards to mortgages.