What are Fiscal and Monetary Policies? Key Differences and Examples

Policy-making is an art. Designing effective policies that can address the situation at hand is a sign of an efficient policymaker. The two key entities that are responsible for policymaking in an economy are
(a) The Government (for fiscal policies), and
(b) The Central Bank (for monetary policies).

The role of the government is to promote sustainable growth, reduce inequalities, and improve social welfare in the economy. The role of the Central Bank is to ensure that inflation is stable in the economy. However, both these policies are like two taps that release water into the economy. It is therefore extremely crucial to balance the taps as an uneven flow from one could have an adverse effect on the economy.

Let’s now understand fiscal and monetary policies in detail.

Fiscal policy refers to the actions taken by the government to maintain employment and output stability. Through its revenues and expenditures, the government frames policies to enhance economic growth. The fiscal policy can be expansionary or contractionary in nature.

An expansionary fiscal policy is one where the government reduces taxes or increases subsidies and welfare schemes and expenditures towards infrastructure projects with the aim of increasing economic growth. For example, building a highway, investing in clean energy projects, or providing subsidies to farmers are all examples of an expansionary fiscal policy.

On the other hand, a contractionary fiscal policy is one where the government increases taxes or reduces expenditures and subsidies to bring down economic growth. This phenomenon is seen during times of high boom, which could lead to high volatility in the market. This is termed a contractionary monetary policy.

Monetary policy refers to the actions taken by central banks to pursue objectives such as price stability, and economic growth. In the United States, the Federal Reserve (popularly known as The Fed) is the central bank of the economy. Just like the fiscal policy, the monetary policy can be expansionary or contractionary.

An expansionary monetary policy is when the central bank pursues policies to increase the money supply in an economy. The central bank does this by either reducing policy rates (which in turn reduces lending rates by commercial banks) or reducing the reserve ratios (the amount of money that retail commercial banks need to keep with the central bank). There are a few other ways by which the central bank can affect the money supply in the economy. However, the central point of an expansionary monetary policy is to increase the amount of money in the hands of the people to induce spending, which in turn leads to higher economic growth.

On the other hand, a contractionary monetary policy is one where the central bank pursues policies to reduce the money supply in the economy. The central bank does this by increasing policy rates (which in turn increases lending rates by commercial banks) or increasing the reserve ratios (the amount of money that retail commercial banks need to keep with the central bank). A contractionary monetary policy reduces the money supply in the economy which in turn reduces spending and lowers economic growth. A contractionary monetary policy is most effective during times of high inflation. The goal of the policy is to reduce inflation and maintain price stability.

Fiscal and monetary policies are two taps of the same pipe. It is therefore important that there is close coordination between the central bank of an economy and the government.

For instance, if the government is reducing taxes, and investing in infrastructure projects that would lead to higher economic growth in the economy, the central bank should complement this policy by reducing interest rates and reducing the reserve ratios which would yield higher economic growth and boost the fiscal policy by the government. In case the monetary policy takes a reverse stance as compared to the fiscal policy, it would result in conflicting results.

Designing effective policies first requires policymakers to understand the current state of the economy. Careful diagnosis of the problems and issues will lead to correct and effective policies that can provide a remedy. The effectiveness of a fiscal and monetary policy depends on a large variety of factors such as time lag between implementation and outcome, the cause of the problem, and the impact that the policies can have on the economy.

Consider the case of the Great Recession in 2008. The initial response under both Bush and Obama’s administrations was a fiscal stimulus – which was to increase the income of the economy through large-scale transfers. The Bush administration facilitated tax cuts, while the Obama administration facilitated increased spending. The Fed complemented the fiscal policy by reducing interest rates. However, as the recession deepened, the governments pulled back on spending with the fear that the economy would enter into high debt in the future. Thus, this was a clear scenario of The Fed and the U.S. Congress being at odds with each other.

Governments are usually concerned about the economy’s debt and deficit level which can have political consequences in the future. The Fed is concerned about inflation and price levels. Therefore, there could be times when both policies are moving in opposite directions.

Book cover of Principles of Economics Essentials You Always Wanted To Know - a handy guidebook to the world of economics.

This blog is written by Cledwyn Fernandes, author of Principles of Economics Essentials You Always Wanted To Know.  In the book, Cledwyn has dedicated a chapter to fiscal and monetary policies, wherein he goes into the details of how these policies impact the economy and the application of fiscal and monetary policies in different economic scenarios.

The book is an easy-to-understand guide on all the essential economics concepts related to the world of economics and is a part of Vibrant Publishers’ Self-Learning Management Series.

Find out more about the book here: 
Link to the book: Principles of Economics Essentials You Always Wanted To Know
Author: Cledwyn Fernandes 
Press Release: A Complete Guide To The  World Of Economics