Fiscal Vs. Monetary Policy: What is the Difference?

You’ve probably read about fiscal vs. monetary policy discussions on many platforms, and you might wonder how they differ. Since most economists keep throwing these two terms around, it’s vital to learn their differences. So, how do they work in the economy?

Monetary policy refers to a central bank’s actions to fulfill macroeconomic policy goals, such as stable economic growth, price stability, and full employment. On the other hand, fiscal policy is the tax and spending policies set by the federal government.

Both monetary and fiscal policies can significantly impact a country’s economic activity, even though they mean different things. For example, both financial tools can help stabilize the economy during a crisis or enhance growth if the economy stagnates.

When used together, monetary and fiscal policies can strongly impact the economy and businesses. Unfortunately, it can also affect consumers. This guide explores the several differences between monetary vs. fiscal policy. You will learn the roles of each tool.

That said, let’s get started!

What is Monetary Policy and How it Works

Monetary policy deals mainly with interest rates and the supply of money in circulation. However, it is the central bank’s responsibility to manage the distribution of funds to fulfill its economic goals. Thankfully, they have many tools to help them achieve that.

For example, central banks can increase or lower interest rates, control government bonds, and influence banks’ reserve requirements. These factors can influence the amount of money financial institutions can lend, affecting the money supply directly.

Based on the example above, monetary policy mainly addresses interest rates and money supply in the economy. In a nutshell, here are the three primary objectives of monetary policy:

• To control inflation
• To manage employment levels
• To maintain long-term interest rates

Now, let’s look at how monetary policy works.

There are two primary types of monetary policy: expansionary and contractionary. The two tools work against one another to maintain balance in the economy. 

Expansionary Monetary Policy

The objective of this monetary policy is to increase the money supply in an economy by:

• Lowering interest rates
• Decreasing reserve requirements for banks
• Buying government securities by central banks

The expansionary monetary policy helps to lower unemployment rates and stimulates consumer spending and business activities. As a result, the actions will fuel economic growth to prevent a recession. The reduced interest rates will make loans cheaper.

With expansionary monetary policy at work, many consumers and businesses are likely to borrow more. Unfortunately, it can occasionally cause hyperinflation if not controlled.

Contractionary Monetary Policy

The primary goal of this monetary policy is to reduce the amount of money circulating in the economy. The government often implements it through the following actions.

• Increasing interest rates
• Selling the government bonds
• Increasing reserve requirements for banks

The government, through its central bank, uses the contractionary monetary policy to reduce inflation. The high interest rates restrict the amount of money banks can lend, making loans more expensive. As a result, it will reduce borrowing in the economy.

What is Fiscal Policy and How it Works

The fiscal policy generally addresses taxation and government spending in a country, determined through government legislation. Since the two tools are often linked to government policies, fiscal policy can become a political discussion.

The primary purpose of the fiscal policy is to facilitate ‘healthy’ economic growth in the country. It achieves that by either cutting taxes and increasing spending or by raising taxes and cutting spending. Either way can affect the country’s budget deficit.

For example, the government can cut taxes and increase spending to raise demand and economic growth. However, this will result in a higher budget deficit. The amount of money the government uses to increase spending is commonly known as a stimulus.

Conversely, the government can cut spending and increase tax rates to lower demand and reduce inflation. As a result, it leads to a lower budget deficit.

The Difference between Fiscal and Monetary Policy

Now that you understand what fiscal and monetary policies are and how they work, it’s also essential to learn their differences. That will help you understand the economy.

So, what is the difference between monetary and fiscal policy?

Monetary policy involves raising or lowering interest rates and influencing the supply of money in the economy. On the other hand, fiscal policy applies when a government changes tax rates and its spending to adjust aggregate demand in the economy.

Here are the other differences between fiscal policy vs. monetary policy on various bases. The table below summarizes all their differences.

Which Policy is More Effective: Fiscal or Monetary 

Monetary policy has been more popular than fiscal policy due to the following reasons:

• The central bank sets monetary policy, helping to reduce the political influence. For example, some politicians may lower interest rates to grow the economy before general elections. They can do that for their interest and benefit.

• Fiscal policy can bring more side effects to the broader economy. For instance, the government may not lower spending or increase taxes to lower inflation. Besides that, lower spending could cause reduced public services.

• Expansionary fiscal policy will likely result in crowding out. In other words, higher government spending can fail to increase private sector expenditure. Also, higher government borrowing might push up the interest rates.

• It is quicker and easier to implement monetary policy than fiscal policy. This is because a central bank can set interest rates each month. However, increasing government spending might take time because the government has to figure out where to spend money.

Final Words

Both monetary and fiscal policies play a significant role in controlling the economy. The fiscal policy involves tax and spending decisions made by the government. Conversely, monetary policy gets determined by the central bank, such as the Bank of Canada. It can boost consumer spending and make borrowing cheaper due to low interest rates.