A:

Monetary policy and fiscal policy refer to the two most widely recognized tools used to influence a nation's economic activity. Monetary policy is primarily concerned with the management of interest rates and the total supply of money in circulation and is generally carried out by central banks such as the U.S. Federal Reserve. Fiscal policy is the collective term for the taxing and spending actions of governments. In the United States, the national fiscal policy is determined by the executive and legislative branches of the government. (See Who sets fiscal policy, the president or congress?)

Monetary Policy

Central banks have typically used monetary policy to either stimulate an economy or to check its growth. The theory is that, by incentivizing individuals and businesses to borrow and spend, monetary policy can spur economic activity. Conversely, by restricting spending and incentivizing savings, monetary policy can act as a brake on inflation and other issues associated with an overheated economy.

The Federal Reserve, also known as the "Fed," has frequently used three different policy tools to influence the economy: opening market operations, changing reserve requirements for banks and setting the discount rate. Open market operations are carried out on a daily basis where the Fed buys and sells U.S. government bonds to either inject money into the economy or pull money out of circulation. By setting the reserve ratio, or the percentage of deposits that banks are required to keep in reserve, the Fed directly influences the amount of money created when banks make loans. The Fed can also target changes in the discount rate (the interest rate it charges on loans it makes to financial institutions), which is intended to impact short-term interest rates across the entire economy.

Fiscal Policy

Generally speaking, the aim of most government fiscal policies is to target the total level of spending, the total composition of spending, or both in an economy. The two most widely used means of affecting fiscal policy are changes in government spending policies or in government tax policies.

If a government believes there is not enough business activity in an economy, it can increase the amount of money it spends, often referred to as "stimulus" spending. If there are not enough tax receipts to pay for the spending increases, governments borrow money by issuing debt securities such as government bonds and, in the process, accumulate debt; this is referred to as deficit spending. (For details, see What is the role of deficit spending in fiscal policy?)

By increasing taxes, governments pull money out of the economy and slow business activity. But typically, fiscal policy is used when the government seeks to stimulate the economy. It might lower taxes or offer tax rebates, in an effort to encourage economic growth. Influencing economic outcomes via fiscal policy is one of the core tenets of Keynesian economics.

When a government spends money or changes tax policy, it must choose where to spend or what to tax. In doing so, government fiscal policy can target specific communities, industries, investments, or commodities to either favor or discourage production – and sometimes, its actions based on considerations that are not entirely economic. For this reason, the numerous fiscal policy tools are often hotly debated among economists and political observers.

Which is More Effective: Monetary or Fiscal Policy?

In terms of improving the real economy, expansionary fiscal policy is more effective. In terms of the financial economy, expansionary monetary policy is the better choice. Both types work through different channels and impact individuals and corporations in different ways.

Fiscal policy affects consumers positively for the most part, as it leads to increased employment and income. Essentially, it is targeting aggregate demand. Companies also benefit as they see increased revenues.

However, if the economy is near full capacity, expansionary fiscal policy risks sparking inflation. This inflation eats away at the margins of certain corporations in competitive industries that may not be able to easily pass on costs to customers; it also eats away at the funds of people on a fixed income. Fiscal policy can also have the effect of creating asset bubbles if the market and incentives become too distorted.

Monetary policy has less impact on the real economy. Case in point: the Great Depression, during which the Federal Reserve was particularly aggressive on a historical scale. Its actions prevented deflation and economic collapse but did not generate significant economic growth to reverse the lost output and jobs.

Expansionary monetary policy can have limited effects on growth by increasing asset prices and lowering the costs of borrowing, making companies more profitable. In addition, it has the psychological benefits of taking worse-case economic scenarios off the table. As with fiscal policy, extended periods of low borrowing costs can create asset bubbles that are only apparent in hindsight.

Another crucial difference between the two is that fiscal policy can be targeted, while monetary policy is more of a blunt tool in terms of expanding and contracting the money supply to influence inflation and growth.

Learn more about how the economy is controlled with A Look at Fiscal and Monetary Policy.

RELATED FAQS
  1. What are some examples of expansionary fiscal policy?

    Learn about expansionary fiscal policy – tax cuts and government spending – that are used by governments to boost spending ... Read Answer >>
  2. How does expansionary economic policy impact the stock market?

    Find out how expansionary economic policy affects the stock market; it is bullish for stocks whether it is monetary or fiscal ... Read Answer >>
  3. Who sets fiscal policy, the president or congress?

    Discover how fiscal policy is set in the United States, including how all three branches of government can affect a given ... Read Answer >>
  4. What is the role of deficit spending in fiscal policy?

    Read about the role deficit spending can play in a government's fiscal policy, and learn why economists are torn about the ... Read Answer >>
  5. What strategies can be used to achieve the goals of contractionary policy?

    Read about the difference between contractionary monetary policy and contractionary fiscal policy, the goals of each, and ... Read Answer >>
Related Articles
  1. Insights

    Fiscal Policy vs. Monetary Policy: Pros & Cons

    When it comes to influencing macroeconomic outcomes, governments have typically relied on one of two courses of action: monetary policy or fiscal policy.
  2. Insights

    Not Crazy: Unconventional Monetary Policy

    Unconventional monetary policy, such as quantitative easing, can be used to jump-start economic growth and spur demand.
  3. Insights

    The Federal Reserve: Too Powerful?

    The Federal Reserve needs its power in order to make the tough decisions that politicians can't.
  4. Personal Finance

    How the Federal Reserve Affects Your Mortgage

    The Federal Reserve can impact the cost of funds for banks and consequently for mortgage borrowers when maintaining economic stability.
  5. Investing

    How The U.S. Government Formulates Monetary Policy

    Learn about the tools the Fed uses to influence interest rates and general economic conditions.
  6. Insights

    The Federal Reserve

    As an investor, it's important to understand exactly what the Fed does and how it influences the economy.
  7. Taxes

    The Fundamentals Of Abenomics

    Abenomics is Japanese Prime Minister Shinzo Abe's aggressive, three-pillared economic policy.
  8. Trading

    Why Negative Interest Rates Are Not Working

    Find out why negative interest rate policies are failing because bond buyers do not want a negative yield and saturated borrowers want to pay off debts.
  9. Insights

    Top 4 Central Banks Dominating the World Economy

    Central banks play an integral role in market economies by maintaining the stability and credibility of national currencies used in those economies.
RELATED TERMS
  1. Policy Mix

    The combination of fiscal and monetary policy a nation's policymakers ...
  2. Monetary Policy

    Monetary policy is the actions of a central bank, currency board ...
  3. Expansionary Policy

    A macroeconomic policy that seeks to expand the money supply ...
  4. Open Market Operations - OMO

    Open market operations refer to the buying and selling of government ...
  5. Fiscal Neutrality

    Fiscal neutrality occurs when taxes and government spending are ...
  6. Monetary Theory

    Monetary theory is a set of ideas about how changes in the money ...
Hot Definitions
  1. Compound Annual Growth Rate - CAGR

    The Compound Annual Growth Rate (CAGR) is the mean annual growth rate of an investment over a specified period of time longer ...
  2. Net Present Value - NPV

    Net Present Value (NPV) is the difference between the present value of cash inflows and the present value of cash outflows ...
  3. Price-Earnings Ratio - P/E Ratio

    The Price-to-Earnings Ratio or P/E ratio is a ratio for valuing a company that measures its current share price relative ...
  4. Internal Rate of Return - IRR

    Internal Rate of Return (IRR) is a metric used in capital budgeting to estimate the profitability of potential investments.
  5. Limit Order

    An order placed with a brokerage to buy or sell a set number of shares at a specified price or better.
  6. Current Ratio

    The current ratio is a liquidity ratio that measures a company's ability to pay short-term and long-term obligations.
Trading Center