When discussing what shapes a nation’s economic growth and stability, monetary policy and fiscal policy may often come to mind. This is because these two types of policies wield significant influence over a nation's economic landscape and despite their differences, both play a substantial role in economic growth.
So what is the difference between monetary and fiscal policy and how do these two function? Here’s what might help you to understand monetary and fiscal policy:
Definition of Monetary Policy
In short, monetary policy encompasses the strategies and steps implemented by a central bank like the Federal Reserve or another monetary authority with the aim of regulating and influencing the money supply, interest rates, and the general financial landscape within a nation’s economy. In other words, its fundamental goals include ensuring price stability, fostering economic growth, and safeguarding financial stability.
Definition of Fiscal Policy
While monetary policy usually hails back to central banks, fiscal policy relates to governments. Accordingly, a fiscal policy refers to the strategic approaches and the use of government spending and taxation with the goal of shaping, enhancing, and stabilizing the economy. To do so, a fiscal policy targets an economy's overall spending level, overall spending composition, or both.
Key Differences Between Monetary Policy and Fiscal Policy
Both monetary and fiscal policy aim to influence the economy’s trajectory, however, there are key differences that should be kept in mind in order to get a better grasp of how the economy works. Here is a brief comparison between monetary and fiscal policies:
The responsible entities: one of the main differences between the types of policies is the parties involved in their making. Whereas monetary policy is executed by a central bank, fiscal policy is executed through a nation’s government.
Tools and methodology: the tools and approach used to set each policy differ. While monetary policy uses open market operations, adjustments, discount rates, and reserve requirements, fiscal policy uses government spending and changes in taxation. (Source:Investopedia)
An Overview of Monetary Policy
Since central banks are responsible for monetary policy, understanding monetary and fiscal policies and what they are may be a good idea to get a basic understanding of monetary policy.
Central banks are financial institutions that are responsible for the regulation and distribution of a nation or a group of nations’ money and credit. These bodies can range from the US Federal Reserve to the European Central Bank (ECB). Central banks also set interest rates among other things. To gain a more exhaustive understanding of central banks, read our “Central Banks of the World Explained” article. (Source:ECB Website)
How Does Monetary Policy Impact the Economy?
Since monetary policy directly shifts interest rates, this means that it can eventually influence inflation and economic growth. As a result, it can have direct impacts on the markets. This is because, usually, when interest rates are higher, tech-heavy stocks, for example, tend to suffer as investors aim for safe-haven assets instead.
In addition, when interest rates increase, financial institutions face the need to secure funds at higher borrowing costs and they become more compelled to raise the interest rates they charge when offering loans to businesses and individuals. As a result, it can lead to higher borrowing expenses for firms and households.
On the flip side, lower interest rates, for example, allow financial institutions to gain access to funds at more affordable borrowing costs. Consequently, they can pass on this advantage by lowering the interest rates they charge when providing loans to businesses and individuals. This results in reduced borrowing costs for firms and households.
What Are the Tools Used in Monetary Policy in the US?
In the world’s biggest economy, the three main tools used by the Federal Reserve to set monetary policy are open market operations, discount rates, and reserve requirements.
Open market operations: Open market operations refer to the daily transactions the Fed engages in. These include the purchase and sale of U.S. government bonds and aim to either inject money into the economy or withdraw money from circulation.
Discount rate: The discount rate refers to the interest rates the Fed charges commercial banks for short-term loans. Accordingly, the Fed can focus on adjustments to the discount rate with the aim of influencing short-term interest rates throughout the entire economy.
Reserve requirements: The Fed can directly change the quantity of money generated through bank lending by establishing the reserve ratio (the percentage of deposits that banks must hold in reserve).
An Overview of Fiscal Policy
Just as much as monetary policy plays an integral role in the economy, fiscal policy can also be extremely substantial. It can also affect economic growth and inflation rates.
How Does Fiscal Policy Influence Economic Growth and Inflation?
The government's fiscal policies can shift the trajectory of the economy through adjustments to tax levels, changes in the types of taxes imposed, modifications in the extent and nature of spending, and decisions regarding borrowing.
The effects of these policy measures can be significant on various aspects of the economy, including aggregate demand, resource allocation, income distribution, and economic activity levels.
Moreover, fiscal policy can directly impact inflation rates. While higher inflation rates can initially benefit public finances by boosting government revenues, the implications of inflationary shocks depend on many factors. These factors can range from magnitude and type of shock to fiscal policy response, institutional budgetary factors, and monetary policy reaction. That is to say that the fiscal policy response, in particular, can influence the inflation outlook based on the scale and composition of the stimulus.
What Are the Tools Used in Fiscal Policy?
The government employs several tools to set fiscal policy, and two of the main ones are taxes and spending.
Taxes: Taxes play a detrimental role in the economy due to the fact that they can affect how much money the government and individuals spend. As such, to stimulate consumer spending, the government can reduce taxes, providing families with extra cash to spend on goods and services, thereby boosting the overall economy.
Spending: Spending serves as a fiscal policy instrument aimed at channeling government funds into particular sectors that require an economic stimulus. Those receiving these funds usually have additional resources to allocate. In addition, similar to taxes, the government anticipates that this money will be spent on various goods and services. (Source:CME)
Interaction and Coordination Between Monetary and Fiscal Policy
It is believed that fiscal and monetary policies are most effective when combined. On the one hand, monetary policy can ensure liquidity and favorable financial conditions for investment and spending. On the other hand, fiscal policy uses taxation and spending policies to directly stimulate the economy.
As such, implementing fiscal and monetary policies together can help heal the economy from its downturns and promote growth through the coordination between central banks and governments.
Criticisms and Challenges of Monetary and Fiscal Policies
While fiscal and monetary policies can be great tools to promote economic health, they can have some setbacks of their own. Those who critique these policies focus on the following limitations of monetary and fiscal policies:
Central banks like the Federal Reserve have limited leverage on how far they can influence the economy through monetary policy.
Economists can be torn between which monetary or fiscal policy works best for the benefit of the economy.
Fiscal policy can be delayed due to the fact that it can take the government some time to approve and implement it.
Adjusting tax rates through fiscal policy is not a task that can be carried out arbitrarily or frequently due to practical limitations.
Sometimes fiscal and monetary policies can clash as one party's interests may stunt the growth of the others.
What Are the Latest Monetary and Fiscal Policies in Some of the Biggest Economies?
In times of economic uncertainty and turmoil, governments and central banks usually adopt measures to tackle these economic hurdles. For example, the European Commission revealed in June 2023 that it intends to rewrite its fiscal rules with a focus on taxation and government spending. In other words, Europe intended to make debt levels more sustainable in the face of rising inflation, economic crisis, and recessions, and the energy crisis brought about by the war in Ukraine.
In the world’s biggest economy, the Federal Reserve had to adopt what’s called a hawkish hiking policy to fight the aforementioned economic challenges. That is to say that the US central bank hiked interest rates multiple times throughout 2023 in order to deal with record-high inflation rates and a possible US debt ceiling.
At the same time, the US government was facing a possible default and as a result, the US Senate Republicans and the Democratic Party, two parties that usually oppose each other, had to come to an agreement to raise the US debt ceiling. This, in turn, helped avoid a default that could’ve sent ripples across the various global economies.
All in all, understanding how monetary and fiscal policies work is substantial to grasping the overall economy. While the two economic policies certainly have their benefits, they also have their drawbacks. To see how these two come into play when it comes to economic growth, traders may want to keep any news or substantial events in mind.