When it comes to influencing macroeconomic outcomes, governments have typically relied on one of two primary courses of action: monetary policy or fiscal 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 tight monetary policy by raising interest rates and removing money from circulation.
Fiscal policy determines the way in which the central government earns money through taxation and how it spends money. To assist the economy, a government will cut tax rates while increasing its own spending; to cool 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.
An Overview of Monetary Policy
Monetary policy refers 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 and price stability. This is sometimes referred to as the Fed's "dual mandate." Most countries separate the monetary authority from any outside political 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 pace that 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. The Fed can also increase the level of reserves commercial and retail banks must keep on hand, limiting their ability to generate new loans. Selling government bonds from its balance sheet to the public in the open market also reduces the money in circulation. 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 bonds are 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 and Cons
Pro: Interest Rate Targeting 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. Inflation occurs when the general price levels of all goods and services in an economy increases. By raising the target interest rate, investment becomes more expensive and works to slow economic growth a bit.
Con: The Risk of Hyperinflation
When interest rates are set too low, over-borrowing at artificially cheap rates can occur. This can then cause a speculative 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 of supply 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.
Pro: Can Be Implemented Fairly Easily
Central banks can act quickly to use monetary policy tools. Often, just signaling their intentions to the market can yield results.
Con: 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.
Pro: 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.
Con: 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 a liquidity trap. This tends to make monetary policy tools more effective during economic expansions than recessions. Some European central banks have recently experimented with a negative interest rate policy (NIRP), but the results won't be known for some time to come.
Pro: Weakening the Currency Can Boost Exports
Increasing the money supply or lowering interest rates tends to devalue the local currency. A weaker currency on 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.
Con: 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 the stimulus, 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.
Pros and Cons of Fiscal Policy
Fiscal policy refers 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 economics and hope to boost aggregate demand.
Pro: Can Direct Spending To Specific Purposes
Unlike monetary policy tools, which are general in nature, a government can direct spending toward specific projects, sectors or regions to stimulate the economy where it is perceived to be needed to most.
Con: Can Create Budget Deficits
Pro: 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.
Con: Tax Incentives May Be Spent on Imports
The effect of fiscal stimulus is muted when the money put into the economy through tax savings or government spending is spent on imports, sending that money abroad instead of keeping it in the local economy.
Pro: Short Time Lag
The effects of fiscal policy tools can be seen much quicker than the effects of monetary tools.
Con: May Be Politically Motivated
Raising taxes is unpopular and can be politically dangerous to implement.
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. (For related reading, see "Monetary Policy vs. Fiscal Policy: What's the Difference?")