Monetary Policy Versus Fiscal Policy
Governments have two main ways to influence their economies:
- Monetary policy is the actions taken by a country's central bank to regulate interest rates, control the supply of money and the amount of funds banks must hold rather than lend to their customers.
- Fiscal policy is the spending and taxation policies of the government that can influence how much money businesses and consumers have to spend.
In most developed world democracies, fiscal and monetary policies act separate from each other, as central banks are generally independent from the government. As a result, monetary policies can be affected fairly quickly, because only a handful of officials decide on what actions the central bank will take and those policies can be implemented almost immediately. Fiscal policies, by contrast, are decided upon by the country's legislatures, which are subject to a vote and then enactment by the chief executive.
What Is Monetary Policy?
In the U.S., for example, monetary policy is controlled by the Federal Reserve, which is mandated by Congress to promote "maximum employment, stable prices, and moderate long-term interest rates." A majority of the bigger central banks, such as the Bank of England and European Central Bank, largely have the same priorities and operate in the same fashion.
The Fed sets the federal funds rate, its benchmark interest rate. Banks pay this rate to hold on deposit at the Fed and to borrow and lend to each other overnight. This rate influences the general level of interest rates throughout the economy, both short- and long-term.
In addition, central banks control the amount of money in circulation by buying and selling government securities with private financial institutions and by mandating how much cash banks must hold in their vaults or on deposit at the central bank.
If the central bank wants to increase business activity in the economy, it can lower interest rates and allow banks to hold less money, making more and cheaper money available to lend to businesses and consumers. Conversely, if the central bank believes that the economy is growing too fast and is in danger of igniting inflation, it can make it more difficult or expensive to borrow money by raising interest rates and making less money available for borrowing. This can then reduce business and consumer spending and investment.
What Is Fiscal Policy?
Fiscal policy consists of the taxation and spending policies enacted by the government through its elected representatives. Governments can make it more difficult for businesses and consumers to spend and invest money by raising taxes. Conversely, they can make more money available by lowering taxes.
Governments can also try to stimulate economic activity by spending more money. Keynesian economic theory, for example, argues that governments should spend heavily on public infrastructure projects and unemployment benefits during economic downturns in order to stimulate economic growth. The theory then says to pull back on spending and raise taxes once the economy is expanding in order to avoid inflation.
Monetary and fiscal policies are the two main ways nations try to influence their economies. Monetary policy is set by the country's central bank, which generally acts independent of the government. It tries to control the level of interest rates and the amount of money circulating in the economy in order to stimulate or curtail economic activity. Fiscal policies consist of tax and spending policies that are set by the government; lower taxes and higher spending tend to stimulate economic activity, while higher taxes and lower spending tend to restrain it.