The economy is the engine which drives the growth of a country to a prosperous future. A strong national economy would flourish the living conditions of the citizens and create an environment where opportunities to produce and thrive are abundant. The sense of economic security would give people the confidence to actualise their potential, which, in turn, would translate into contributions to the national economy and facilitation of collective prosperity. The fuel of this engine is money. As a country’s top administrative body, the government is responsible for cultivating the economy and deciding on how to handle the money-related economic operations. A government’s economic operations include the management of national revenue, national expenditure, and public investments as well as the facilitation and regulation of employment, business, financing, investments in the private markets.

What is Economic Policy?

Economic policy is a government’s plan on how to conduct economic operations in accordance with the demands of current national and global economic conditions. It delineates the parameters and factors to consider when deciding for taxation, spending, budgeting, money supply, and interest rate levels. These economic operations are divided into two main categories:

  • Fiscal Policy: taxation, spending, and budgeting
  • Monetary Policy: money supply and interest rates

Together, fiscal and monetary policies help the government to monitor and adapt the nation’s economy and money supply. Fiscal Policy is managed by relevant governmental departments, while the monetary policy is managed by the country’s central bank. They are designed as guides to achieve the national economic goals such as optimum rates of inflation (2-3%), Gross Domestic Product (GDP) growth (2-3%), and unemployment (4-5%).

What is Fiscal Policy?

The fiscal policy outlines how a government generates revenue by collecting taxes, spends the income on public expenses and investments, and creates a budget using revenue and expenditure projections. It is based on Keynesian economics theory which suggests that a country’s macroeconomic productivity can be influenced by its government’s decisions on taxation and spending. Governments achieve macroeconomic goals through taxes, spending and budgeting.

  • Taxes: the main income sources of government spending. They are applied to a wide range of items such as consumer products, employee salaries, housing, and trade activities.
  • Spending: how the income generated by taxes is used by the government when creating subsidies, welfare programmes, and public projects.
  • Budgeting: distribution plan of the spending activities and the government’s discretionary budget, mostly fixed at national welfare programmes such as social security and health care.

Types of Fiscal Policies

  • Expansionary Fiscal Policy: Adopted to stimulate economic growth by increasing spending and decreasing taxes.
  • Contractionary Fiscal Policy: Adopted to slow down the economic growth by decreasing spending and increasing taxes.
  • Discretionary Fiscal Policy: Adopted when the government decides to adopt an expansionary or a contractionary fiscal policy which wasn’t a part of the main fiscal policy.
  • Neutral Fiscal Policy: Adopted when the economy is neither expanding nor contracting, and the budget deficit caused by regular spending is maintained over time.

How Fiscal Policy Affects the Economy?

When the economy is stagnant, the government can decrease taxes and increase spending to stimulate the economy. Tax reduction would allow individuals to consume more, while increased spending by the government would boost the demand for products and services in the focused industries. Eventually, the companies would enjoy higher net profits, which they can use to increase production, employ more workers, and invest in expanding their businesses. However, once the economy is up and running again, keeping low taxes and high spending can lead to extreme inflation. Rising consumer demand would increase the prices of goods and services, while excessive money circulation would reduce the value of the currency. Thus, the government can decide to increase taxes and decrease spending to slow down growth and manage inflation. Furthermore, taxes and spending can be used to control for demand and growth in specific areas of the economy. For example, the government can focus the spending on a struggling industry by buying debts and initiating projects to stimulate demand. Furthermore, they can reduce corporate taxes to allow companies to maintain their employment and production levels.

What is Monetary Policy?

Monetary policy is created by a country’s central bank as a guide to governing the value of the national currency. The central bank controls the demand and supply with the purposes of achieving macroeconomic goals in conjunction with fiscal policy and maintaining exchange rates against foreign currencies. It manipulates the money supply by means of interest rate modifications, open market operations to buy and sell debts, and reserve requirements to regulate banks.

  • Interest Rate: the baseline commission percentage when lending to the other banks; sets the cost of purchasing the national currency as a product and determines minimum interest rate the banks charge/award to their clients.
  • Open Market Operations: debt transaction programmes with other banks; can be quantitative easing, injecting cash into the economy by printing money and buying debts, or quantitative tightening, removing cash from the economy by selling debts and saving the money.
  • Reserve Requirements: the number of funds which banks are required retain to ensure that clients would meet their liabilities; influences the amount of capital the banks can use to offer loans or buy assets.
  • Public Announcements: the press conferences conducted by the central banks are also influential over demand and supply as they intend to manage investor perception; allows the bank to control the demand and supply without making any actual policy changes.

Types of Monetary Policies

  • Expansionary Monetary Policy: Adopted to stimulate economic growth by enhancing money supply through interest rate cuts, quantitative easing, or lower reserve requirements.
  • Contractionary Monetary Policy: Adopted to slowdown economic growth by reducing money supply through interest rate hikes, quantitative tightening, or higher reserve requirements.
  • Unconventional Monetary Policy: Adopted during economic crises to control the chaos by using interest rates, open market operations, and reserve requirements at the same time.

How Monetary Policy Affects the Economy?

When the central bank aims to stimulate economic growth, they can increase the money supply and circulation by adopting an expansionary monetary policy. Increasing the money supply causes the currency to lose value as it becomes more accessible. An interest rate cut would allow businesses and individuals to loan at more convenient terms and continue spending. It would also render the returns on interest investments less profitable and encourage investors to direct their savings capitals into the economic activity. A quantitative easing (QE) programme would inject cash into the economy by printing new money to buy debts from other banks and provide them with more capital to lend to their clients. Also, lowering the reserve requirements of the banks would let them use more of their reserved capital to give loans or buy assets/debts.

However, if the economy has over-expanded, the central bank might aim to slow down the growth by adopting a contractionary monetary policy to decrease the money supply. Consequently, the currency would become less accessible and gain value. Hiking interest rates would make loans more costly and discourage businesses and individuals to take loans. Investors would be attracted to commit their circulating capital into interest investments. Quantitative Tightening (QT) can further remove cash from the economy by selling debts to other banks and saving the collected money. The central bank can also raise the reserve requirements of the banks, which would cause them to have less capital to lend and act more selective when choosing who to lend. 

Fiscal Policy vs Monetary Policy

Fiscal policy and monetary policy are economic tools to help a country reach its macroeconomic goals. Fiscal policies are managed by the governmental departments and aim to improve the economic output of the country, while monetary policies are managed by the central bank and aim to keep the inflation levels under control. Monetary policy has relatively more rapid and long-lasting effects than the fiscal policy. This is partly due to the fact that the semi-autonomous central bank meets more frequently to make interest rate decisions and can act independently from the government.

Both policies are influenced by the government’s political orientations and social perspectives. However, if both policies are under the control of a single policymaking body, one policy could be dominating over and/or more effective than the other policy. They can be used in conjunction to balance the economic conditions. Expansionary fiscal policy decisions can be balanced through contractionary monetary policy decisions and vice versa. However, their interactive effect on the economy would be based on the extent they share the same goals. If they are fully independent of each other, no interaction can be suggested.

Active and Passive Fiscal and Monetary Policies

  • Active Fiscal Policy: Tax and spending levels are changed according to political perspectives of the policymakers
  • Passive Fiscal Policy: Tax and spending levels are maintained or changed according to natural budgeting demands
  • Active Monetary Policy: Interest rate decisions aim to achieve the inflation target, regardless of the fiscal policy
  • Passive Monetary Policy: Interest rate decisions aim to balance fiscal policies, regardless of the inflation target

Supply Shocks

Supply Shock occurs when the supply rate of goods or a commodity increases or decreases suddenly and dramatically.

  • Negative Supply Shocks: decreased output and increasing prices (undersupply)
  • Positive Supply Shocks: increased output and decreasing prices (oversupply)

In both types of supply shocks, the economic order must be restored by bringing output and prices to the regular levels. Fiscal and monetary policymakers may coordinate and adopt opposite policy types to achieve balance. For example, during a negative supply shock, the government can adopt an expansionary fiscal policy by increasing spending to stimulate output, while the central bank adopts a contractionary monetary policy by cutting the interest rate to increase money supply and reduce the prices.

Demand Shocks

Demand Shock refers to the situations when the demand for a good or a commodity increases or decreases suddenly and dramatically.

  • Negative Demand Shock: decreased demand and decreasing prices
  • Positive Demand Shock: increased demand and increasing price

Demand shocks usually occur due to external factors, such as tax cuts or natural crises like pandemics or wars, which are not directly related to the industry. If the demand can’t be balanced by the supply quickly, it can lead to inflation or deflation. When a negative demand shock occurs, opposite fiscal and monetary policies would be adopted; the government would increase spending to create demand, and the central bank would increase the interest rate to increase prices. In times of positive demand shocks, however, two policies would be congruent; the government could raise the taxes to reduce demand, and the central bank could increase the money supply by buying debts to reduce prices.

Fiscal policy vs. Monetary polic main FAQs

  • Is fiscal policy or monetary policy better?

    Both fiscal policy and monetary policy have the goals of growing the economy while keeping inflation and unemployment low. In that respect neither one is better than the other. However, in practice it has been found that certain situations will respond better to one form of policy over the other. For example, in a recession there has been evidence that fiscal policy can be more effective in supporting an economic recovery than monetary policy. In that case lowered taxes and increased spending would be used. However, when lawmakers need to slow growth it is often monetary policy that is used since public opinion is typically strongly against higher taxes and decreased spending, even though this course can also help lower a countries budget deficit.

     
  • Is there a link between monetary policy and fiscal policy?

    Monetary policy is implemented by the central banks, while fiscal policy is implemented by government lawmakers. Based on this you might think there is no connection between the two, but you would be mistaken. In truth monetary and fiscal policies are far from independent. Anytime there is a change in monetary policy it impacts fiscal policy and vice versa. This means that tensions can arise in the economy when monetary policy and fiscal policy aren’t aligned. In order to avoid these tensions lawmakers and central banks do their best to align monetary policy with fiscal policy so that the two are working together towards the same goals.

     
  • What is the goal of fiscal and monetary policy?

    Both fiscal policy and monetary policy have the same goals. Those are three-fold. To encourage full employment, to keep inflation low (most countries target 2% inflation), and to support economic growth. Both also seek to maintain a stable economy that avoids the cyclical boom and bust that has been so common throughout history. Both fiscal and monetary policy were developed in the 20th century as the proper tools for stabilizing the economy and have undergone several changes in their implementation as economic theory and the actual problems faced by economies change with the times.

     

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