Download comparison of monetary and fiscal policies

COMPARISON OF
MONETARY AND FISCAL
POLICIES
OUTLINES
Introduction
Definition of fiscal policy
Definition of monetary policy
Policy Tools
Fiscal policy
Monetary policy
Which is More Effective Monetary or Fiscal Policy?
Comparison
Similarities
Differences
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INTRODUCTION
Economic policy-makers are said to have two kinds of tools to influence a country's
economy: fiscal and monetary.
Definition of Fiscal policy: It relates to government spending and revenue collection. For
example, when demand is low in the economy, the government can step in and increase its
spending to stimulate demand. Or it can lower taxes to increase disposable income for
people as well as corporations.
Definition of Monetary policy: it relates to the supply of money, which is controlled via
factors such as interest rates and reserve requirements (CRR) for banks. For example, to
control high inflation, policy-makers (usually an independent central bank) can raise
interest rates thereby reducing money supply.
These methods are applicable in a market economy, but not in a fascist, communist or
socialist economy. John Maynard Keynes was a key proponent of government action or
intervention using these policy tools to stimulate an economy in recession.
POLICY TOOLS
Both fiscal and monetary policy can be either expansionary or contractionary. Policy
measures taken to increase GDP and economic growth are called expansionary. Measures
taken to rein in an "overheated" economy (usually when inflation is too high) are called
contractionary measures.
Fiscal policy
The legislative and executive branches of government control fiscal policy. In the United
States, this is the President's administration (mainly the Treasury Secretary) and the
Congress that passes laws.
Policy-makers use fiscal tools to manipulate demand in the economy. For example:
 Taxes: If demand is low, the government can decrease taxes. This increases
disposable income, thereby stimulating demand.
 Spending: If inflation is high, the government can reduce its spending thereby
removing itself from competing for resources in the market (both goods and
services). This is a contractionary policy that would lower prices. Conversely, when
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there is a recession and aggregate demand is flagging, increased government
spending in infrastructure projects would lead to higher demand and employment.
Both tools affect the fiscal position of the government i.e. the budget deficit goes up
whether the government increases spending or lowers taxes. This deficit is financed by
debt; the government borrows money to cover the shortfall in its budget.
Procyclical and Countercyclical Fiscal Policy
In an article for VOX on the tax cuts vs. stimulus debate, Jeffrey Frankel, Economics
professor at Harvard University has said that sensible fiscal policy is countercyclical.
When an economy is in a boom, the government should run a surplus; other times, when in
recession, it should run a deficit.
[There is] no reason to follow a pro-cyclical fiscal policy. A procyclical fiscal policy piles on the
spending and tax cuts on top of booms, but reduces spending and raises taxes in response to
downturns. Budgetary profligacy during expansion; austerity in recessions. Procyclical fiscal
policy is destabilising, because it worsens the dangers of overheating, inflation, and asset
bubbles during the booms and exacerbates the losses in output and employment during the
recessions. In other words, a procyclical fiscal policy magnifies the severity of the business
cycle.
Monetary policy
Monetary policy is controlled by the Central Bank. In the U.S., this is the Federal Reserve.
The Fed chairman is appointed by the government and there is an oversight committee in
Congress for the Fed. But the organization is largely independent and is free to take any
measures to meet its dual mandate: stable prices and low unemployment.
Examples of monetary policy tools include:
 Interest Rates: Interest rate is the cost of borrowing or, essentially, the price of
money. By manipulating interest rates, the central bank can make it easier or
harder to borrow money. When money is cheap, there is more borrowing and more
economic activity. For example, businesses find that projects that are not viable if
they have to borrow money at 5% are viable when the rate is only 2%. Lower rates
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also disincentivize saving and induce people to spend their money rather than save
it because they get so little return on their savings.
 Reserve requirement: Banks are required to hold a certain percentage (cash reserve
ratio, or CRR) of their deposits in reserve in order to ensure that they always have
enough cash to meet withdrawal requests of their depositors. Not all depositors are
likely to withdraw their money simultaneously. So the CRR is usually around 10%,
which means banks are free to lend the remaining 90%. By changing the CRR
requirement for banks, the Fed can control the amount of lending in the economy,
and therefore the money supply.
 Currency peg: Weak economies can decide to peg their currency against a stronger
currency. This tool is usually used in cases of runaway inflation when other means
to control it are not working.
 Open market operations: The Fed can create money out of thin air and inject it into
the economy by buying government bonds (e.g. treasuries). This raises the level of
government debt, increases the money supply and devalues the currency causing
inflation. However, the resulting inflation supports asset prices such as real estate
and stocks.
WHICH IS MORE EFFECTIVE MONETARY OR FISCAL POLICY?

In recent decades, monetary policy has become more popular because:

Monetary policy is set by the Central Bank, and therefore reduces political influence
(e.g. politicians may cut interest rates in desire to have a booming economy before a
general election)

Fiscal Policy can have more supply side effects on the wider economy. E.g. to reduce
inflation – higher tax and lower spending would not be popular and the government
may be reluctant to purse this. Also lower spending could lead to reduced public
services and the higher income tax could create disincentives to work.

Monetarists argue expansionary fiscal policy (larger budget deficit) is likely to cause
crowding out – higher government spending reduces private sector spending, and
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higher government borrowing pushes up interest rates. (However, this analysis is
disputed)

Expansionary fiscal policy (e.g. more government spending) may lead to special interest
groups pushing for spending which isn’t really helpful and then proves difficult to reduce
when recession is over.

Monetary policy is quicker to implement. Interest rates can be set every month. A
decision to increase government spending may take time to decide where to spend the
money.

However, the recent recession shows that Monetary Policy too can have many
limitations.

Targeting inflation is too narrow. This meant Central banks ignored an unsustainable
boom in housing market and bank lending.

Liquidity Trap. In a recession, cutting interest rates may prove insufficient to boost
demand because banks don’t want to lend and consumers are too nervous to spend.
Interest rates were cut from 5% to 0.5% in March 2009, but this didn’t solve recession in
UK.

Even quantitative easing – creating money may be ineffective if banks just want to keep
the extra money in their balance sheets.

Government spending directly creates demand in the economy and can provide a kickstart to get the economy out of recession. Thus in a deep recession, relying on monetary
policy alone, may be insufficient to restore equilibrium in the economy.

In a liquidity trap, expansionary fiscal policy will not cause crowding out because the
government is making use of surplus saving to inject demand into the economy.

In a deep recession, expansionary fiscal policy may be important for confidence – if
monetary policy has proved to be a failure.
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COMPARISON
Fiscal Policy
Fiscal
Monetary Policy
policy
of
Monetary policy is the process by which the
and
monetary authority of a country controls the
revenue collection to influence
supply of money, often targeting a rate of
the economy.
interest to attain a set of objectives oriented
government
Definition
is
the
use
expenditure
towards the growth and stability of the
economy.
Manipulating
level
of
Manipulating the supply of money to influence
in
the
outcomes like economic growth, inflation,
economy to achieve economic
exchange rates with other currencies and
objectives of price stability, full
unemployment.
aggregate
Principle
employment,
the
demand
and
economic
growth.
Policy-
Government (e.g. U.S. Congress,
Central Bank (e.g. U.S. Federal Reserve or
maker
Treasury Secretary)
European Central Bank)
Taxes; amount of government
Interest rates; reserve requirements; currency
spending
peg; discount window; quantitative easing;
Policy
Tools
open market operations; signalling
Similarities
They are both used to pursue policies of higher economic growth or controlling inflation.
Both policies could be applied for contractionary and expansionary economic purposes
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Both policies have common macroeconomic objectives such as stable economic growth.
Differences between Monetary and Fiscal Policies
S/N
Monetary
1
Monetary
Fiscal
policy
involves Fiscal policy involves the
changing the interest rate government
and influencing the money rates
supply.
changing
tax
levels
of
spending
to
and
government
influence aggregate demand
in the economy.
2
Monetary policy is usually Fiscal Policy is carried out by
carried out by the Central the government and involves
Bank / Monetary authorities changing:
and involves:
Level
of
government
Setting base interest rates spending
(e.g. Bank of England in UK
and Federal Reserve in US)
3
Better
tool
during
economic boom
4
tool
during
economic recession
Monetary policy has
macroeconomic
Better
key
policy
Fiscal
policy
has
macroeconomic
policy
objectives such as price
objectives
stability
economic growth and full
control
and
inflation
such
key
as
employment
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CONCLUSION
Economists and politicians rarely agree on the best policy tools even if they agree on the
desired outcome. For example, after the 2008 recession, Republicans and Democrats in
Congress had different prescriptions for stimulating the economy. Republicans wanted to
lower taxes but not increase government spending while Democrats wanted to use both
policy measures.
References

Fiscal Policy vs Monetary Policy - Dr. F. Steb Hipple, East Tennessee State University

http://en.wikipedia.org/wiki/Fiscal_policy

http://en.wikipedia.org/wiki/Monetary_policy
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