When it comes to influencing macroeconomic outcomes, governments have typically relied on one of two primary courses of action: monetary policyorfiscal policy.
Monetary policy involves the management of the money supply and interest rates by central banks. To stimulate a faltering economy, the central bank will cut interest rates, making it less expensive to borrow while increasing the money supply. If the economy is growing too rapidly,the central bank can implement a tightmonetary policy by raising interest rates and removing money from circulation.
Fiscal policy, on the other hand, determines the way in which the central government earns money through taxation and how it spends money. To stimulate the economy, a government will cut tax rates while increasing its own spending; while tocool down an overheating economy,it will raise taxes and cut back on spending.
There is much debate as to whether monetary policy or fiscal policy is the better economic tool, and each policy has pros and cons to consider.
Key Takeaways
- Central banks use monetary policy tools to keep economic growth in check and stimulate economies out of periods of recession.
- While central banks can be effective, there could be negative long-term consequences that stem from short-term fixes enacted in the present.
- Fiscal policy refers to the tools used by governments to change levels of taxation and spending to influence the economy.
- Fiscal policy can be swayed by politics and placating voters, which can lead to poor decisions that are not informed by data or economic theory.
- If monetary policy is not coordinated with a fiscal policy enacted by governments, it can undermine efforts as well.
An Overview of Monetary Policy
Monetary policyrefers to the actions taken by a country's central bank to achieve its macroeconomic policy objectives. Some central banks are tasked with targeting a particular level of inflation. In the United States, the Federal Reserve Bank(the Fed) has been established with a mandate to achieve maximum employment andprice stability.
This is sometimes referred to as the Fed's "dual mandate." Most countries separate the monetary authority from any outsidepolitical influence that could undermine its mandate or cloud its objectivity.As a result, many central banks, including the Federal Reserve, are operated as independent agencies.
When a country's economy is growing at such a fast pacethat inflation increases to worrisome levels, the central bank will enact restrictive monetary policy to tighten the money supply, effectively reducing the amount of money in circulation and lowering the rate at which new money enters the system. Raising the prevailing risk-free interest rate will make money more expensive and increase borrowing costs, reducing the demand for cash and loans.
During and after the Great Recession, the Fed made use of quantitative easing as a means to spur the economy.
The Fedcan also increase the level of reserves commercial and retail banks must keep on hand, limiting their ability to generate new loans. Sellinggovernment bonds from its balance sheet to the public in the open market also reduces themoney incirculation. Economists of the Monetarist school adhere to the virtues of monetary policy.
When a nation's economy slides into a recession, these same policy tools can be operated in reverse, constituting a loose or expansionary monetary policy. In this case, interest rates are lowered, reserve limits loosened, and bondsare purchased in exchange for newly created money. If these traditional measures fall short, central banks can undertake unconventional monetary policies such as quantitative easing (QE).
Monetary Policy Pros andCons
Advantages of Monetary Policy
- Targeting an interest rate controls inflation: A small amount of inflation is healthy for a growing economy as it encourages investment in the future and allows workers to expect higher wages.Inflationoccurs when the general price levels of all goods and services in an economy increase. By raising the target interest rate, investment becomes more expensive and works to sloweconomic growtha bit.
- Easy to implement: Central banks can act quickly to use monetary policy tools. Often, just signaling their intentions to the market can yield results.
- Central banks are independent and politically neutral: Even if monetary policy action is unpopular, it can be undertaken before or during elections without the fear of political repercussions.
- Weakening currency can boost exports: Increasing the money supply or lowering interest rates tends to devalue the local currency. Aweaker currencyon world markets can serve to boost exports as these products are effectively less expensive for foreigners to purchase. The opposite effect would happen for companies that are mainly importers, hurting their bottom line.
Disadvantages of Monetary Policy
- Effects have a time lag: Even if implemented quickly, the macro effects of monetary policy generally occur after some time has passed. The effects on an economy may take months or even years to materialize. Some economists believe money is "merely a veil,"and while serving to stimulate an economy in the short-run, it has no long-term effects except for raising the general level of prices without boosting real economic output.
- Technical limitations: Interest rates can only be lowered nominally to 0%, which limits the bank's use of this policy tool when interest rates are already low. Keeping rates very low for prolonged periods of time can lead to aliquidity trap. This tends to make monetary policy tools more effective during economic expansions than recessions.Some European central banks have recently experimented with anegative interest rate policy(NIRP), but the results won't be known for some time to come.
- Monetary tools are general and affect an entire country: Monetary policy tools such as interest rate levels have an economy-wide impact and do not account for the fact some areas in the country might not need thestimulus, while states with high unemployment might need the stimulus more. It is also general in the sense that monetary tools can't be directed to solve a specific problem or boost a specific industry or region.
- Risk of hyperinflation: When interest rates are set too low, over-borrowing at artificially cheap rates can occur. This can then cause aspeculative bubble, whereby prices increase too quickly and to absurdly high levels. Adding more money to the economy can also run the risk of causing out-of-control inflation due to the premise ofsupply and demand: if more money is available in circulation, the value of each unit of money will decrease given an unchanged level of demand, making things priced in that money nominally more expensive.
An Overview of Fiscal Policy
Fiscal policyrefers to the tax and spending policies of a nation's government. A tight, or restrictive fiscal policy includes raising taxes and cutting back on federal spending. A loose or expansionary fiscal policy is just the opposite and is used to encourage economic growth. Many fiscal policy tools are based on Keynesian economicsandhope toboostaggregate demand.
Fiscal Policy Pros and Cons
Advantages of Fiscal Policy
- Can direct spending to specific purposes: Unlike monetary policy tools, whichare general in nature, a government can direct spending towardspecific projects, sectors,or regions tostimulate the economywhere it is perceived to be needed most.
- Can use taxation to discourage negative externalities: Taxing polluters or those that overuse limited resources can help remove the negative effects they cause while generating government revenue.
- Short time lag: The effects of fiscal policy tools can be seen much quicker than the effects of monetary tools.
Disadvantages of Fiscal Policy
- May be politically motivated: Raising taxes can be unpopular and politically dangerous to implement.
- Tax incentives may be spent on imports: The effect of fiscal stimulus is muted when the money put into the economy through tax savingsor government spending is spent onimports, sending that money abroad instead of keeping it in the local economy.
- Can create budget deficits: A governmentbudget deficitis when it spends more money annually than it takes in. If spending is high and taxes are low for too long, such adeficitcan continue to widen to dangerous levels.
What Is the Difference Between Fiscal Policy and Monetary Policy?
Fiscal policy is policy enacted by the legislative branch of government. It deals with tax policy and government spending. Monetary policy is enacted by a government's central bank. It deals with changes in the money supply of a nation by adjusting interest rates, reserve requirements, and open market operations. Both policies are used to ensure that the economy runs smoothly; the policies seek to avoid recessions and depressions as well as to prevent the economy from overheating.
What Are the Main Tools of Monetary Policy?
The main tools of monetary policy are changes in interest rates, changes in reserve requirements (how much reserves banks need to keep on hand), and open market operations, which is the buying and selling of U.S. Treasuries and other securities.
What Are Examples of Fiscal Policy?
Fiscal policy involves two main tools: taxes and government spending. To spur the economy and prevent a recession, a government will reduce taxes in order to increase consumer spending. The fewer taxes paid, the more disposable income citizens have, and that income can be used to spend on the economy. A government will also increase its own spending, such as on public infrastructure, to prevent a recession.
The Bottom Line
Monetary and fiscal policy tools are used in concert to help keep economic growth stable with low inflation, low unemployment, and stable prices. Unfortunately, there is no silver bullet or generic strategy that can be implemented as both sets of policy tools carry with them their own pros and cons. Used effectively, however, the net benefit is positive to society, especially in stimulating demand following a crisis.
