fiscal policy vs monetary policy essay

• What is monetary policy? 
• What is fiscal policy? 
• Key differences
• How they work together 
• Impact on economic growth 

Monetary Policy vs. Fiscal Policy: Understanding the Differences

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• Monetary policy seeks to control the economy by manipulating the money supply and interest rates.
• Fiscal policy is designed to achieve the same end using targeted taxes and spending.
• The Achilles' heel of both types of policy is the lag between implementation and results.

In 1992, when presidential campaign advisor James Carville famously told Bill Clinton's staff, "It's the economy, stupid!" he was stressing the importance of what matters most to a majority of voters.

The two most widely recognized tools to influence the economy, and keep constituents happy, are monetary policy, controlled by the Federal Reserve , and fiscal policy, which falls under the auspices of Congress and the president. Both play important roles in maintaining a stable and balanced U.S. economy. 

What is monetary policy? 

Definition and objectives .

Monetary policy, which can broadly be described as either expansionary or contractionary, is set by central banks. In the case of the U.S., the Federal Reserve is the central bank. 

Monetary policy is designed to influence economic conditions by increasing (or decreasing) the size of the money supply and pushing interest rates lower or higher. 

By increasing the money supply, the Fed's action can lower interest rates, make borrowing easier, boost gross domestic product, reduce unemployment, and provide a lift to the stock market. When inflation or hyperinflation threaten to overheat the economy, the Fed tightens (decreases) the money supply to avoid inflation or even hyperinflation.

Expansionary monetary policy is a macroeconomic tool that a central bank — like the Federal Reserve in the U.S. — uses to stimulate economic growth. A bank usually implements it during a contractionary phase of the business cycle — when the gross domestic product (GDP) in a nation starts to decline.

A decline in GDP can have a variety of undesirable effects, including:

• Business bankruptcies and failures
• Unemployment
• A fall in the stock market
• A decline in the national currency's value

All these effects, if unchecked, can eventually lead to a recession or depression . 

The overall goal of any expansionary policy is to encourage spending and borrowing. The theory is that when there's more money available to individuals and businesses at lower costs, it will result in the increased purchase of goods and services, stimulating growth.

Contractionary monetary policy is a macroeconomic tool that a central bank uses to reduce inflation. 

The goal is to slow the pace of the economy by reducing the money supply, or the amount of cash and readily cashable funds circulating throughout the nation. It is the opposite of expansionary monetary policy. 

Governments and central banks gauge when an economy is overheating by looking at the rate of inflation. It's natural for a rise in demand to spark some increase in the prices for goods and services. The U.S., for example, generally considers the average annual inflation rate of 2% to 3% as normal. 

But if inflation is rising above its target growth rate, it acts as a warning — and becomes the key catalyst for implementing a contractionary monetary policy. 

Tools of monetary policy 

The Federal Reserve, the U.S. central bank, has several monetary policy levers it can use to influence the economy. The Federal Open Market Committee (FOMC) is a committee made up of 12 individual voting members. This committee sets the target range for the federal funds rate , the interest rate banks must pay when borrowing money from each other (or lending to one another). 

If the fed funds rate increases, it places upward pressure on broader interest rates, and if this rate goes lower, it puts downward pressure on these broader rates. 

In addition to setting the target range for the fed funds rate, the FOMC can help keep the effective rate for this rate within the aforementioned range by buying or selling securities. By purchasing securities, the committee can help place downward pressure on interest rates, and by selling them, it can achieve the opposite. 

A separate body, the Federal Reserve Board, which consists of seven members nominated by the president and ratified by the senate, is responsible for setting reserve requirements and the discount rate. 

By lowering reserve requirements, the board can give individual banks the ability to lend more money, placing upward pressure on the money supply. Alternatively, by making these requirements stricter, the board reduces banks' ability to lend, placing contractionary pressure on the money supply. 

Examples of monetary policy actions 

An example of contractionary monetary policy materialized during the 1970s. From 1972 to 1973, inflation jumped from 3.4% to 8.7%.

There were many reasons for this dramatic price rise, such as wage control and untying the U.S. dollar from the gold standard. To combat it, the Fed increased the fed funds rate from 6% in January to 11% in August. This reduced inflation to around 5.7%.

However, in August, the OPEC energy crisis hit, which caused oil prices to skyrocket.

Inflation reached 12.3% in 1974 and the fed funds rate hit a high of 13%.

Even though prices were rising, economic growth was still low, which led to a paradoxical period of stagflation. The country plunged into a recession and the Fed reduced rates to try and improve the situation. However, prices remained stubbornly high.

Eventually, the Federal Reserve increased interest rates to 20% in 1980, when the inflation rate was posting 14%. This move finally reversed the price trend. Inflation eventually dropped to 3.8% in 1982.

A great example of expansionary monetary policy materialized in the aftermath of the Great Financial Crisis, when the Fed engaged in a phase of unprecedented monetary stimulus called quantitative easing, where it purchased trillions of dollars worth of assets in an effort to stimulate the economy. 

As a result, the federal funds rate was close to zero between 2009 and 2015. While some market observers warned that these aggressive purchases of assets might cause inflation, the inflation that some worried about failed to materialize. 

Another situation that provides examples of both expansionary and contractionary monetary policy is the global coronavirus pandemic that was first declared in 2020. 

During the coronavirus pandemic, the Fed's ability to control a wildly swinging economy through monetary policies was severely tested. First, it reduced short-term interest rates to zero. When that proved insufficient, the FOMC began buying $120 billion worth of bonds and mortgage-backed securities every month. 

These measures were designed to keep interest rates low and increase the money supply to help shore up the economy, which had contracted by as much as 19.2%. The moves by the Fed helped limit the duration of the recession to just the two-month period between February and April 2020.

The next step in monetary policy was to begin pulling back the unprecedented stimulus to get inflation in check. The Fed did so by starting a process known as tapering, in which it gradually slows the pace at which it buys securities.

The FOMC took further action, hiking the benchmark federal funds rate repeatedly between 2022 and 2023, increasing it by over 500 points to its highest level in over 20 years. 

What is fiscal policy? 

Like monetary policy, fiscal policy is either expansionary or contractionary, depending on whether the goal is to boost the economy or tamp down inflation. When the federal government sets fiscal policy it uses different tools than the FOMC does to achieve the same economic stability. This allows fiscal policy to have a much more targeted effect on the economy. 

Fiscal policy is determined by Congress and the president, who work together to enact legislation. 

Tools of fiscal policy 

When the government wants to expand the economy, instead of increasing the money supply, it spends more, taxes less, and effectively increases aggregate (total) demand within the economy. When it wants to pull back, it implements a policy to cut spending, raise taxes, or do both. 

Importantly, the government can target spending, something increasing the money supply doesn't do. It can target the poor, individual industries, geographic areas, and more. Since government is inherently political, there is always a danger money will go to the loudest, most influential voices, or, even worse, be spent on the wrong things.

Using taxes to control the money supply allows for the same targeting as spending, but is also subject to the same political influences. As with spending programs, there are also dangers of misused incentives.

The time lag between implementation and results is shorter with targeted fiscal policy, but the legislative process creates its own delay on the implementation side, according to Professor Robert R. Johnson of the Heider College of Business at Creighton University. "The economy may benefit from increased fiscal spending or lower tax rates currently, but by the time lawmakers are able to pass appropriate legislation, the economy may have turned and may not need fiscal stimulus," Johnson says. "The Federal Reserve can pivot much more easily with respect to monetary policy than Congress can with fiscal policy." 

Examples of fiscal policy actions 

The government can cut taxes if it wants to stimulate economic growth. For example, the U.S. went into recession in 2000, and in 2001, lawmakers enacted the Economic Growth and Tax Relief Reconciliation Act of 2001 in an effort to stimulate growth. 

This legislation cut federal income tax rates, increased the amount that could be contributed to 401(k) plans and individual retirement accounts (IRAs), reduced the federal estate tax, and cut federal capital gains taxes. 

In 2003, government officials enacted the Jobs and Growth Tax Relief Reconciliation Act of 2003, further reducing capital gains and dividend taxes. 

It is worth noting that the federal government also increased expenditure during the 2000s, to a point where these gains outpaced inflation by 62%, according to a Heritage Foundation report . 

While this created substantial budget deficits and caused the national debt to grow, it put money directly into the economy, which helped stimulate expansion. 

Other examples of fiscal policy are the CARES Act and the American Rescue Plan Act. The CARES Act, signed into law in 2020, provided more than $2 trillion in stimulus, directed at small businesses and individuals in the form of forgivable loans and direct relief checks, tax law changes to allow penalty-free withdrawals from retirement accounts, and other measures.

The $1.9 trillion American Rescue Plan Act of 2021 provided more stimulus, including money to mount a national vaccination program and safely reopen schools, additional direct relief checks, an extension to unemployment benefits and stipends, emergency rent aid, increased child tax credits, and additional community funding.

Key differences between monetary policy and fiscal policy 

Authority and implementation .

Monetary and fiscal policy are controlled by different sets of government officials. People who work for the Fed are responsible for monetary policy, while lawmakers are in charge of fiscal policy. 

Although monetary and fiscal policy are both designed to achieve economic stability, the officials responsible for them approach that goal in different ways. The primary difference between fiscal and monetary policy is found in the meaning of the names of the two policies. Monetary refers to the supply of money, or the amount there is to spend. Fiscal implies the budget, or how the money will be spent. 

Time frame and flexibility 

Monetary policy and fiscal policy both have their time constraints. For example, the FOMC can increase (or decrease) the federal funds rate target range during its policy meetings, which happen eight times per year. It can engage in open-market operations (buying and selling of assets) to help ensure the Fed funds rate is within this range, but it usually makes these transactions gradually. 

The relatively small FOMC can implement monetary policy quickly compared to the ability of Congress and the president to pass complex legislation. The downside, according Johnson, is the lag between implementation and results. 

"The Federal Reserve has a dual mandate of price stability and maximum sustainable employment," says Johnson. "It is difficult, if not impossible, to determine how long it takes for Fed actions to work their way through to the final goals." 

Finally, when the Fed cuts interest rates, the demand for dollars to invest in U.S. markets is reduced. The resulting weaker currency makes goods produced in the U.S. cheaper and easier to export. On the other hand, without the watchful eye of the FOMC, inflation and even hyperinflation can result from an overheated economy. As with all things monetary, balance is key.

Note: The time lag between implementation of government policy and results is called a response lag. Other types including recognition lag, decision lag, and implementation lag define delays that can create inefficiencies related to Fed and government economic policies.

Impact on the economy 

Monetary and fiscal policy are both capable of having a significant impact on the economy. The Fed can either stimulate (or help dampen) economic activity through monetary policy. By increasing the fed funds rate, it can place upward pressure on a broad range of interest rates and make it more expensive for consumers and businesses to borrow money. This can help cool down robust business activity in order to help contain inflation. 

Fiscal policy can also have a significant impact on the economy. An increase in government expenditure, for example, is one of the fastest ways to stimulate activity, as it puts money directly into the hands of government employees and contractors, who can in turn use it for consumption, which is a major component of GDP and has a significant influence on the job market. 

Cutting taxes for businesses can reduce their expenses, making it easier for them to hire employees and purchase new equipment. 

How monetary and fiscal policies work together 

Complementary roles .

Monetary and fiscal policy are most effective when used together. When expansionary policies are needed, the former can be used to boost the money supply and cut interest rates, making it easier for individuals and companies to borrow money. At the same time, fiscal policy can put money right into their pockets either by cutting taxes or bolstering government expenditure. 

When the government is looking to bring inflation under control, monetary policy can help shrink the money supply and increase interest rates, making it more costly for individuals and businesses to borrow money, while fiscal policy can reduce the after-tax income of individuals and businesses in order to reduce spending. 

Potential conflicts 

Certain nations (for example, the U.S.) have a long history of generating budget deficits. Even if the Fed ratchets up the fed funds rate in order to push interest rates higher, and starts selling assets in order to reduce the money supply, lawmakers may very well continue to spend more than they bring in with tax revenue, a situation that is inherently inflationary. 

Impact of monetary and fiscal policies on economic growth 

Influence on inflation .

Expansionary monetary and fiscal policy can place upward pressure on prices by increasing the money supply and providing both individuals and businesses with higher after-tax income. 

In contrast, contractionary monetary and fiscal policy can help dampen increases in the price level by reducing the size of the money supply and reducing the after-tax income of consumers and corporations. 

Influence on employment 

Expansionary monetary and fiscal policy can help create jobs by bolstering consumption and giving businesses more money after taxes, therefore making it easier for them to take on additional workers. Contractionary monetary and fiscal policy can do the opposite. 

Influence on interest rates 

Expansionary monetary policy can easily help reduce interest rates by lowering the federal funds rate. In contrast, contractionary monetary policy can help increase interest rates by increasing this benchmark rate. 

Monetary policy vs. fiscal policy FAQs 

Monetary policy is designed to influence the economy through the money supply and interest rates, while fiscal policy involves taxation and government expenditure. 

It depends on the time frame you are using. In the short term, monetary policy is more effective, whereas fiscal policy is better at creating long-term, structural changes in the economy. 

Monetary policies impact changes in the price level (inflation) directly by influencing the size of the money supply and interest rates. Fiscal policy affects inflation indirectly through government expenditure and taxation. 

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Here’s the Difference between Fiscal Policy and Monetary Policy

Thinkstock/Askold Romanov

Learning the difference between fiscal policy and monetary policy is essential to understanding who does what when it comes to the federal government and the Federal Reserve. The short answer is that Congress and the administration conduct fiscal policy, while the Fed conducts monetary policy.

Both types of policy can have a significant effect on our everyday lives, but the lines between them can seem blurry to the average consumer. Let’s sort it out.

Monetary Policy Is the Federal Reserve’s Role

The word “monetary” means having to do with money. And monetary policy is the wheelhouse of a central bank.

Monetary policy refers to actions that central banks take to pursue objectives such as price stability, maximum employment and stable economic growth. When we say pursue, we’re talking on a big scale—a macroeconomic scale.

In the United States, the Federal Reserve is the central bank. (It’s often called the Fed, for short.) The U.S. Congress has established maximum employment and price stability as the macroeconomic objectives for the Fed to work toward. This is often referred to as the Federal Reserve's dual mandate .

How does the Federal Reserve conduct monetary policy? It can do so by influencing the supply of money in the economy, as well as influencing interest rates in markets, explained St. Louis Fed economist David Wheelock in a recent podcast.

To influence the money supply and interest rates, the Fed has various tools. Some key ones include:

• Open market operations
• The discount rate
• Reserve requirements
• Interest on reserve balances

Fiscal Policy Is the Federal Government’s Role

The word “fiscal” relates to public treasury or revenues. Fiscal policy is a broad term used to refer to the tax and spending policies of the federal government.

“Fiscal policy refers to government spending and taxing decisions,” Wheelock said. “Economics textbooks and various economic models usually think of fiscal policy in terms of the size of the government budget deficit, the difference between what the government spends and its revenue.”

As stated by the Federal Reserve Board of Governors , fiscal policy decisions are determined by Congress and the administration; the Fed does not play a role in determining fiscal policy.

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An Example of Both: The Response to the Financial Crisis

Like driving a car, both monetary and fiscal policy provide ways to accelerate or pump the brakes on the economy. The financial crisis that took place from 2007 to 2009—and the Great Recession that followed—drew a multipronged response from both the Federal Reserve and the U.S. government.

Monetary Policy

Remember those tools we mentioned? The first, open market operations, refers to the Fed’s ability to buy and sell government securities in the open market. Purchasing securities—known as “easing” or “expansionary” monetary policy—increases the amount of reserve funds that banks have available to lend, which puts downward pressure on the federal funds rate .

Expansionary monetary policy took place as part of the Fed’s response to the financial crisis. As the crisis emerged, the Fed implemented a series of programs to provide short-term liquidity while purchasing large amounts of U.S. Treasury and mortgage-backed securities to put downward pressure on longer-term interest rates and ease overall financial conditions.

Fiscal Policy

Meanwhile, the U.S. Treasury and the executive and legislative branches of the federal government took swift action as well. A deluge of new programs—the Economic Stimulus Act, the Housing and Economic Recovery Act, the Emergency Economic Stabilization Act and others—were enacted, pumping billions of dollars into the economy to not only prevent further crisis, but also stimulate spending from businesses and consumers.

The actions of the Federal Reserve and the federal government ultimately had the same intended purpose: to lessen the crisis and to promote a stable economy and financial system. But they illustrate the differences between monetary policy and fiscal policy.

Fed Independence: Why Boundaries Matter

If monetary policy and fiscal policy can work toward similar goals, why worry about keeping those policies separate? The answer lies within one of the Fed’s most important and timeless tenets—independence.

For the Fed, achieving its dual mandate of price stability and maximum sustainable employment requires a longer-term perspective, given the time lag between monetary policy actions and results, the Federal Reserve Board explains . Wheelock noted it’s important that the Fed be shielded from short-term political pressures.

With very rare exceptions, he said, there’s never been coordination between monetary and fiscal policy. “The Fed makes its own decisions with regard to the economy. It takes into consideration all kinds of information, including the stance of government’s fiscal policy.”

“But, basically,” he continued, “the Fed is looking at indicators of expected inflation, the state of the business cycle, whether we’re at full employment or whether there are a lot of unemployed resources, and it tries to look at all sorts of factors when it sets monetary policy. So in that sense there’s no direct coordination.”

Additional Resources

• Podcast: Monetary Policy Minutes: What Is Monetary Policy?
• Open Vault: A Look at the Fed’s Dual Mandate
• In Plain English: How Monetary Policy Works

Laura Hopper is the St. Louis Fed's employee ambassador coordinator. She works in the External Engagement and Corporate Communications Division.

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This blog explains everyday economics and the Fed, while also spotlighting St. Louis Fed people and programs. Views expressed are not necessarily those of the St. Louis Fed or Federal Reserve System.

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Difference between monetary and fiscal policy

Readers Question: What is the difference between monetary and fiscal policy?

• Monetary policy involves changing the interest rate and influencing the money supply.
• Fiscal policy involves the government changing tax rates and levels of government spending to influence aggregate demand in the economy.

They are both used to pursue policies of higher economic growth or controlling inflation.

Monetary policy

Monetary policy is usually carried out by the Central Bank/Monetary authorities and involves:

• Setting base interest rates (e.g. Bank of England in UK and Federal Reserve in the US)
• Influencing the supply of money. E.g. Policy of quantitative easing to increase the supply of money.

How monetary policy works

• The Central Bank may have an inflation target of 2%. If they feel inflation is going to go above the inflation target, due to economic growth being too quick, then they will increase interest rates.
• Higher interest rates increase borrowing costs and reduce consumer spending and investment, leading to lower aggregate demand and lower inflation.
• If the economy went into recession, the Central Bank would cut interest rates.
• See also: Cutting interest rates

• Fiscal policy

Fiscal policy is carried out by the government and involves changing:

• Level of government spending
• Levels of taxation
• To increase demand and economic growth, the government will cut tax and increase spending (leading to a higher budget deficit)
• To reduce demand and reduce inflation, the government can increase tax rates and cut spending (leading to a smaller budget deficit)

Example of expansionary fiscal policy

In a recession, the government may decide to increase borrowing and spend more on infrastructure spending. The idea is that this increase in government spending creates an injection of money into the economy and helps to create jobs. There may also be a multiplier effect , where the initial injection into the economy causes a further round of higher spending. This increase in aggregate demand can help the economy to get out of recession.

This shows that in 2009/10 the UK ran a budget deficit of 10% of GDP. This was caused by the recession and also the government’s attempt to provide a fiscal stimulus (VAT tax cut) to try and get the economy out of recession.

See more at: Expansionary fiscal policy

If the government felt inflation was a problem, they could pursue deflationary fiscal policy (higher tax and lower spending) to reduce the rate of economic growth.

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 the 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 pursue 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 expenditure, and 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 the 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. During the period 2000-2007, inflation was low but central banks ignored an unsustainable boom in the 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 the UK.
• Even quantitative easing – creating money may be ineffective if banks just want to keep the extra money on their balance sheets.
• Government spending directly creates demand in the economy and can provide a kick-start 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.
• Policies for reducing unemployment
• UK Monetary Policy
• Criticisms of fiscal policy

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An Overview of Monetary Policy

• Monetary Policy Pros and Cons

An Overview of Fiscal Policy

Fiscal policy pros and cons, the bottom line.

• Monetary Policy
• Federal Reserve

Fiscal Policy vs. Monetary Policy: Pros and Cons

Adam Hayes, Ph.D., CFA, is a financial writer with 15+ years Wall Street experience as a derivatives trader. Besides his extensive derivative trading expertise, Adam is an expert in economics and behavioral finance. Adam received his master's in economics from The New School for Social Research and his Ph.D. from the University of Wisconsin-Madison in sociology. He is a CFA charterholder as well as holding FINRA Series 7, 55 & 63 licenses. He currently researches and teaches economic sociology and the social studies of finance at the Hebrew University in Jerusalem.

Amanda Bellucco-Chatham is an editor, writer, and fact-checker with years of experience researching personal finance topics. Specialties include general financial planning, career development, lending, retirement, tax preparation, and credit.

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Rudy Sulgan / Getty Images

When it comes to influencing macroeconomic outcomes, governments have typically relied on one of two primary courses of action: fiscal policy or monetary 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, on the other hand, determines the way in which the central government earns money through taxation and how it spends money. To stimulate the economy, a government will cut tax rates while increasing its own spending; while 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.

Key Takeaways

• Central banks use monetary policy tools to keep economic growth in check and stimulate economies out of periods of recession.
• While central banks can be effective, there could be negative long-term consequences that stem from short-term fixes enacted in the present.
• Fiscal policy refers to the tools used by governments to change levels of taxation and spending to influence the economy.
• Fiscal policy can be swayed by politics and placating voters, which can lead to poor decisions that are not informed by data or economic theory.
• If monetary policy is not coordinated with a fiscal policy enacted by governments, it can undermine efforts as well.

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).

During and after the Great Recession, the Fed made use of quantitative easing as a means to spur the economy.

Monetary Policy Pros and Cons

Advantages of monetary policy.

• Targeting an interest rate 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 increase. By raising the target interest rate, investment becomes more expensive and works to slow  economic growth  a bit.
• Easy to implement: Central banks can act quickly to use monetary policy tools. Often, just signaling their intentions to the market can yield results.
• 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.
• Weakening 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.

Disadvantages of Monetary Policy

• 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.
• 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. 
• 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.
• 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. 

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 .

Advantages of Fiscal Policy

• 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 most.
• 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.
• Short time lag: The effects of fiscal policy tools can be seen much quicker than the effects of monetary tools.

Disadvantages of Fiscal Policy

• May be politically motivated: Raising taxes can be unpopular and politically dangerous to implement.
• 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. 
• Can create budget deficits: A government  budget deficit  is when it spends more money annually than it takes in. If spending is high and taxes are low for too long, such a  deficit  can continue to widen to dangerous levels.

What Is the Difference Between Fiscal Policy and Monetary Policy?

Fiscal policy is policy enacted by the legislative branch of government. It deals with tax policy and government spending. Monetary policy is enacted by a government's central bank. It deals with changes in the money supply of a nation by adjusting interest rates, reserve requirements, and open market operations. Both policies are used to ensure that the economy runs smoothly since the policies seek to avoid recessions and depressions as well as to prevent the economy from overheating.

What Are the Main Tools of Monetary Policy?

The main tools of monetary policy are changes in interest rates, changes in reserve requirements (how much reserves banks need to keep on hand), and open market operations, which is the buying and selling of U.S. Treasuries and other securities.

What Are Examples of Fiscal Policy?

Fiscal policy involves two main tools: taxes and government spending. To spur the economy and prevent a recession, a government will reduce taxes in order to increase consumer spending. The fewer taxes paid, the more disposable income citizens have, and that income can be used to spend on the economy. A government will also increase its own spending, such as on public infrastructure, to prevent a recession.

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.

Federal Reserve Bank of Chicago. “ The Federal Reserve's Dual Mandate .”

European Central Bank. “ Independence .”

Board of Governors of the Federal Reserve System. “ What Does It Mean That the Federal Reserve Is 'Independent Within the Government'? ”

International Monetary Fund. “ What Is Keynesian Economics? ”

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Fiscal Policy vs. Monetary Policy

Economic policy-makers are said to have two kinds of tools to influence a country's economy: fiscal and monetary .

Fiscal policy 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.

Monetary policy 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 during a recession .

Comparison chart

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 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 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.

Videos Comparing Fiscal and Monetary Policy

For a general overview, see this Khan Academy video .

To learn about the different monetary and fiscal policy tools, watch the video below.

For a more in-depth technical discussion watch this video , which explains the effects of fiscal and monetary policy measures using the IS/LM model .

Responsibility

Fiscal policy is managed by the government, both at the state and federal levels. Monetary policy is the domain of the central bank. In many developed Western countries — including the U.S. and UK — central banks are independent from (albeit with some oversight from) the government.

In September 2016, The Economist made a case for shifting reliance from monetary to fiscal policy given the low interest rate environment in the developed world:

To live safely in a low-rate world, it is time to move beyond a reliance on central banks. Structural reforms to increase underlying growth rates have a vital role. But their effects materialise only slowly and economies need succour now. The most urgent priority is to enlist fiscal policy. The main tool for fighting recessions has to shift from central banks to governments.

To anyone who remembers the 1960s and 1970s, that idea will seem both familiar and worrying. Back then governments took it for granted that it was their responsibility to pep up demand. The problem was that politicians were good at cutting taxes and increasing spending to boost the economy, but hopeless at reversing course when such a boost was no longer needed. Fiscal stimulus became synonymous with an ever-bigger state. The task today is to find a form of fiscal policy that can revive the economy in the bad times without entrenching government in the good.

Libertarian economists believe that government action leads to inefficient outcomes for the economy because the government ends up picking winners and losers, whether intentionally or through unintended consequences. For example, after the 9/11 attacks the Federal Reserve cut interest rates and kept them artificially low for too long. This led to the housing bubble and the subsequent financial crisis in 2008.

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.

As noted in the excerpt above, one criticism of fiscal policy is that politicians find it hard to reverse course when the policy measures, e.g. lower taxes or higher spending, are no longer necessary for the economy. This can lead to an ever-larger state.

• Fiscal Policy vs Monetary Policy - Dr. F. Steb Hipple, East Tennessee State University
• How to live in a low-interest-rate world - The Economist
• Fiscal policy - Wikipedia
• Monetary policy - Wikipedia

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What’s the difference between fiscal and monetary policy?

Professor, Monash University

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Mark Crosby does not work for, consult, own shares in or receive funding from any company or organisation that would benefit from this article, and has disclosed no relevant affiliations beyond their academic appointment.

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This article is part two of The Conversation’s “ Business Basics ” series where we ask leading experts to discuss key concepts in business, economics and finance.

How governments should manage their budgets, and how interest rates should be set, are two of the most important questions in economics.

Ideally, both work hand in hand to ensure the best outcomes for the economy as a whole. But they are enacted by different branches of government, and fall into different buckets within economics.

Budgeting – the way governments tax and spend – falls within the domain of fiscal policy . In contrast, the management of credit and interest rates falls into the domain of monetary policy.

With the recent federal budget handed down amid an ongoing battle to tackle inflation, both topics have dominated recent news coverage, so it’s important to understand the difference.

Read more: At a glance: the 2024 federal budget split four ways

• Fiscal policy

Paying tax is an unavoidable fact of life, but is needed to support spending on government services such as hospitals, roads, schools and defence. Taxation and spending decisions are made on different scales at every level of government, and form the basis of a government’s fiscal policy.

Traditionally, fiscal policy was seen as a very simple equation.

Governments should spend only as much as they earn through taxation, and only take on a small amount of debt for things like longer-term infrastructure projects.

But when economic growth falls, tax revenues also fall, forcing governments to cut spending to balance their budgets. Such spending cuts come at precisely the wrong time and are only likely to further worsen economic growth.

Noticing this pattern, economist John Maynard Keynes was the first to question this traditional wisdom, arguing that fiscal policy should be “countercyclical”.

According to Keynes, when economic growth falls, government spending should increase, only falling back as the economic recovery plays out.

Under a Keynesian approach, it’s therefore wholly appropriate for governments to issue debt to fund spending increases as the economy weakens.

The problem with this view of fiscal policy is that some governments have arguably abused their licence to spend, relying on ever-increasing levels of debt.

Greece famously suffered a spectacular debt crisis after the global financial crisis in 2008, but other European countries such as France, Italy, Portugal and Spain also have high and problematic levels of debt.

Chronically high debt can lead to higher interest payments on this debt, which in turn can limit a government’s ability to spend to support its economy.

• Monetary policy

Monetary policy affects the economy via a different lever.

By changing the relative cost of borrowing money, changes in interest rates affect the aggregate level of spending in the economy.

This in turn can impact inflation – increases in the general level of prices.

Cuts in interest rates will tend to stimulate demand and push prices up, while rate increases reduce demand and push prices down.

Interest rates are typically set by a country’s central bank, whose primary role is to keep inflation low.

Our own central bank – the Reserve Bank of Australia, sets rates to meet an official inflation target of between 2% and 3%.

A combined Keynesian approach

Alongside Keynes’ writing on fiscal policy, he and other economists argued that interest rates should be reduced as an economy heads into recession, to support borrowing and spending by businesses and consumers.

Coupled with higher government spending, keeping interest rates lower in a recession should theoretically speed up economic recovery.

The merits of a Keynesian approach were borne out clearly in Australia in both the 2008 global financial crisis and the COVID pandemic.

Most recently, the pandemic saw the Reserve Bank cut interest rates to almost zero. Simultaneously, the government supported the economy with a wide range of spending programs, including big boosts to welfare payments and a generous JobKeeper program to mothball Australia’s workforce.

As a result, unemployment quickly returned to low levels and economic growth recovered following the lifting of restrictions.

Helping people pay their bills while taming spending is hard

Emergence from the pandemic left us with a different problem. Inflation surged and remained stubbornly above the Reserve Bank’s target range, forcing the bank to repeatedly raise rates to try to tame it.

At the same time, the government has been trying to support Australians through a cost-of-living crisis.

Now, critics of the government have argued that further spending to support Australians could unintentionally put further pressure on inflation and force the Reserve Bank to keep interest rates higher for longer.

Such challenges reflect the fact that our understanding of best practice for fiscal and monetary policy is constantly evolving.

Problems with burgeoning state debt have prompted debate on the former, and whether there should be limits on governments’ ability to issue debt.

These could include limits to public debt, or new oversight authorities to monitor levels of public spending.

And on monetary policy, a recent review of the Reserve Bank considered requiring a “dual mandate” that would force it to give equal consideration to employment and to inflation goals, as is currently required of the US Federal Reserve.

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Monetary policy vs. fiscal policy: Which is more effective at stimulating the economy?

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Rochester economist Narayana Kocherlakota explains the difference between the two—and why fiscal policy comes out ahead.

When the country experiences an economic shock that leads to an increase in the unemployment rate and a decline in living standards, the debate begins anew. Politicians, pundits, and the general public grapple with how best to promote economic recovery. Is it, for example, by lowering interest rates or by issuing stimulus checks?

The debate ultimately boils down to a single question: Which is more effective at stimulating a sluggish economy—monetary policy or fiscal policy?

According to Narayana Kocherlakota , there’s a textbook answer, and it’s the wrong one.

Kocherlakota is the Lionel W. McKenzie Professor of Economics at the University of Rochester and a former president of the Federal Reserve Bank of Minneapolis. During a recession, he explains, the longstanding consensus has been to rely on monetary policy by lowering interest rates. Once that approach stops working, there’s typically a switch to fiscal policy, such as issuing stimulus checks. As he points out, once rates get too low, they can’t be cut any further.

In a National Bureau of Economic Research working paper called “ Stabilization with Fiscal Policy ,” Kocherlakota argues that, contrary to the long-standing consensus view, monetary policy is ineffective at stabilizing the economy during periods of shock. Instead, he presents a model showing that fiscal policy—in the form of stimulus checks for all adults—is actually a more reliable tool.

Why is that the case? His reasoning goes like this: During bad economic times, the demand for goods drops because consumers are worried about their financial futures. The goal, then, is to restore that demand. Lower interest rates do stimulate current demand—people find borrowing to be more attractive than saving—but, according to Kocherlakota, lower interest rates create a drag on future demand.

As he explains, “When interest rates are cut, savers earn less income from their financial assets. That means that, in the future, they have less money to spend, which creates a drag on overall future demand. This future drag means that monetary policy is relatively ineffective at fostering fast economic recoveries.”

In contrast, Kocherlakota’s model shows that a fiscal policy approach—such as issuing lump-sum transfers to all consumers—is likely to increase current demand and future demand. The key, according to Kocherlakota, is that the higher transfers won’t increase the country’s tax burden from debt.

“Some economists worry a lot about the government’s going deeper into debt because they believe that the government will have to collect taxes later to pay for it,” says Kocherlakota, the Lionel W. McKenzie Professor of Economics. “But this concern seems out of date, because it ignores how low interest rates have been over the past three decades. The government can readily afford to pay off the costs of additional borrowing simply by issuing more debt.”  

Q&A: A closer look at monetary and fiscal policy

Kocherlakota’s findings are best appreciated with a little context. He offers that context by answering some basic questions about monetary and fiscal policy and how they work to support the US economy.

What is monetary policy?

• If it has to do with interest rates, it’s monetary policy. Monetary policy is made by the Federal Reserve.

Kocherlakota: Monetary policy generally refers to the raising and lowering of interest rates by the Federal Reserve, which is the central bank of the United States. In doing so, the Fed targets what’s called the federal funds rate, which is the overnight interest rate that banks use to borrow and lend to each other.

What happens when the Fed changes the federal funds rate?

• It effects the interest rates that lenders charge to consumers and the interest rates savers can earn on their investments

Kocherlakota: The federal funds rate is very short term. What matters is what that change signals about the Fed’s actions in the future.

For instance, lenders—as well as all investors—are looking at all financial markets at the same time. Longer term interest rates—like a three-year interest rate—would be affected by how they think the Fed is going to move that overnight rate over the next three years. If they think the rates will go up a lot in the next six months, three-year interest rates will reflect that information. Why do I pick three years? Because that’s a car loan or a layaway plan for furniture. These are the interest rates that start to filter into consumer spending. That’s monetary policy in action.

How do lower interest rates affect savings and investments?

• Lower interest rates can reduce future earnings from savings accounts and investment portfolios.

Kocherlakota: All these interest rates are interlinked because a bank has the opportunity to save with the Federal Reserve—it serves as a type of bank account—and that affects the interest rate that a bank is willing to pay to depositors or to savers in CD accounts. The higher the interest that the Fed is paying to banks, then the higher interest that banks will end up paying to you and me in our CD account and in commercial deposits—and vice versa. Everything is linked through the mechanisms of people looking for profits in markets. So, if banks think that the Fed is going to be raising rates, they’re going to be willing to buy government bonds or longer-term government bonds.

What are the limitations of monetary policy?

• Interest rates can only be cut so much.

Kocherlakota: Once interest rates get close to zero, as we’ve seen in the last two recessions here in the US, then the central bank’s ammunition becomes very limited. At that point, the Federal Reserve no longer has the power to cut interest rates to stimulate the economy, and that’s when governments are typically willing to turn to fiscal policy.

What is fiscal policy?

• Fiscal policy refers to changes in tax rates and public spending. Congress sets fiscal policy, with a lot of input from the executive branch.

Fiscal policy is a much broader category than monetary policy. All taxing and spending decisions made by Congress fall into the category of fiscal policy. Those decisions have implications for how much the US borrows, which flows into the deficit and the debt. If Congress raises taxes on the super-rich, that’s fiscal policy. When the government distributes stimulus payments to Americans’ bank accounts, that’s another example of fiscal policy. It can also be a tax or a tariff on a small range of products.

Can fiscal policy and monetary policy be at odds with each other?

• That can happen when the Fed lowers interest rates, while Congress is concerned about adding to the national debt.

Kocherlakota: Yes. We saw fiscal and monetary policy at odds in the wake of the Great Recession. The initial response—both in 2008 under the Bush administration and then in 2009 under the Obama administration—was fiscal stimulus. The Bush administration facilitated tax cuts through Congress and the Obama administration increased spending. But the recession proved deeper and more protracted than most economists expected. In response to that persistence, the Federal Reserve kept interest rates extraordinarily low, and called desperately for more fiscal stimulus. Instead, Congress cut back on spending. What we saw was Congress and the Fed moving in opposite directions—and an example of politics playing its role in fiscal policy. Why did Congress cut spending? Because as elected officials they were very concerned about the perceived fear among voters that increased spending would run up the deficit and lead to higher debt.

What are the limitations of fiscal policy?

• Increased government spending can add to the national debt, but the implications aren’t clear cut.

Kocherlakota: The issue of the debt and deficit is very complicated, but to boil it down, in 1973, Robert Barro, then a professor here at Rochester (now at Harvard), wrote a paper called “Are Government Bonds Net Wealth?” He called into question the long-term consequences of handing out money in order to increase consumer demand. Barro pointed out that the government is going to have to pay that back at some point. The question he posed, then, is how will those expectations of future taxes offset the effects of stimulus payments today? Do these factors exactly offset each other? Almost certainly not. But then how much do the expectations of future taxes influence—or undercut—an attempt to provide stimulus?

This has been a very active debate among academics.  But my own work points out that, if interest rates are low enough, the government won’t have to raise taxes in the future.  In this kind of low-interest world, recipients of government stimulus payments (like those made in April 2020 and April 2021) should not expect to pay higher taxes in the future.

What Is the Difference Between Fiscal Policy and Monetary Policy?

Written by True Tamplin, BSc, CEPF®

Reviewed by subject matter experts.

Updated on March 29, 2023

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Table of contents, monetary policy: defined.

Monetary policy is the process by which a nation's central bank controls the supply of money.

This can be done in a number of ways, but most commonly it is done through interest rates . The central bank can raise or lower interest rates to try and stimulate or slow down the economy.

The Federal Reserve decides whether or not to expand or contract the economy based on a variety of metrics, including gross domestic product (GDP), unemployment, and inflation .

The goal of stimulating the economy is to improve GDP. Meanwhile, more restrictive monetary policy is intended to slow the economy in order to manage inflation in the present or future.

Fiscal Policy: Defined

The fiscal policy describes the taxation and spending by the government. With this, it is possible to influence the economy through increases or decreases in taxes and/or expenditures of money by the government.

It can also be used to try and maintain a balanced budget for the country.

Some common examples of fiscal policies include: increasing federal income tax rates, increasing government spending on public programs, increasing/decreasing taxes for certain types of income (i.e., capital gains), and decreasing government transfer payments (welfare).

Monetary vs Fiscal Authorities

The Federal Reserve is considered to be the monetary authority whereas the President & Congress are responsible for making fiscal policy decisions through tax & spending measures.

The 2 policies are yoked together: Monetary policy can only be effective if it is aligned with the government's fiscal policy objectives.

For instance, if the Federal Reserve wants to increase spending in the economy, it would need the President & Congress to agree to cut taxes or increase government spending.

On the other hand, if the Federal Reserve wants to decrease spending in the economy, it would need the President & Congress to agree to increase taxes or decrease government spending.

The Difference Between Monetary and Fiscal Policy

While the monetary and fiscal policy is related, they are two different ways of managing the economy.

Monetary policy is focused on controlling the money supply while fiscal policy is focused on controlling taxation and spending by the government.

Monetary policy works most effectively when it is aligned with fiscal policy objectives. However, officials must be careful about using fiscal policy to influence monetary authorities because this can result in runaway inflation.

For instance, if a nation's central bank wants to stimulate the economy by lowering interest rates further, the President & Congress can decide to spend more.

But if this leads to runaway inflation, the central bank will need to raise rates again, which could lead to a recession or even a depression.

On a similar note, fiscal policy has been less effective since the Great Recession of 2008 because many governments have failed to implement policies that align with expansionary monetary policy.

For example, some countries have raised taxes or cut spending as the central bank has been trying to stimulate the economy. In other cases, some countries have simply failed to implement any fiscal stimulus at all as rates have been kept low by the central bank.

Why It's Important to Understand Fiscal and Monetary Policies

It is important for citizens and policy-makers alike to understand the difference between monetary and fiscal policy because they can have a significant impact on economic growth and stability.

For citizens, it is important to be able to hold their government accountable for effective fiscal policymaking. And for policy-makers, it is important to be able to use both policies in an appropriate way to manage the economy.

The Bottom Line

Fiscal and monetary policies are related but different ways of managing the economy.

Monetary policy focuses on controlling the money supply while fiscal policy focuses on controlling taxation and spending by the government. These policies are yoked together, with each having to be effective for the other to be effective as well.

Finally, it is important for citizens and policy-makers to understand how these policies work together to manage the economy.

Fiscal Policy vs Monetary Policy FAQs

What is the difference between fiscal policy and monetary policy.

Fiscal policy is a government's approach to taxation, spending, and budgeting that influences economic activity and overall macroeconomic conditions. Monetary policy is the management of money supply and interest rates by central banks to influence outcomes such as inflation, employment, and economic growth.

How is Fiscal Policy implemented?

Fiscal policy is typically implemented through changes in government spending and taxation levels; these decisions are made by the legislative branch of government, such as Congress or Parliament.

Who manages Monetary Policy?

Monetary policy is managed by central banks, such as the Federal Reserve in the United States.

What is the goal of Fiscal Policy?

The primary purpose of fiscal policy is to promote economic growth and stability in an economy by influencing aggregate demand and employment levels.

How does Monetary Policy influence economic conditions?

Monetary policy is used to influence the cost and availability of money and credit, thus affecting economic activity such as inflation, employment levels, interest rates, exchange rates, business cycles, and investment activity.

About the Author

True Tamplin, BSc, CEPF®

True Tamplin is a published author, public speaker, CEO of UpDigital, and founder of Finance Strategists.

True is a Certified Educator in Personal Finance (CEPF®), author of The Handy Financial Ratios Guide , a member of the Society for Advancing Business Editing and Writing, contributes to his financial education site, Finance Strategists, and has spoken to various financial communities such as the CFA Institute, as well as university students like his Alma mater, Biola University , where he received a bachelor of science in business and data analytics.

To learn more about True, visit his personal website or view his author profiles on Amazon , Nasdaq and Forbes .

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How fiscal and monetary policy affect the economy.

If you’ve ever wondered how fiscal policy works or what the difference between fiscal and monetary policy is, you aren’t alone. In fact, the two – while interdependent in many ways – serve very different functions within the economy.

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It’s been said in the past that economics is an ivory tower type of profession with economists removed from the daily concerns of average people, and instead, engrossed in theoretical models and equations. Yet, if you were to ask economists about this – not only would they dispute this claim – you’d find that many of the core topics economists are exploring the same questions that citizens, policy makers, and tax payers alike are also asking themselves. Can fiscal policy increase economic growth? How much impact do central banks and monetary policy really have on society? What is fiscal policy’s effect on businesses?

Balancing Budgets and Printing Money: The Difference Between Fiscal and Monetary Policy

Nobel Laureate Finn Kydland was awarded the prize in 2004 for his contributions to dynamic macroeconomics and has done extensive research on the driving forces behind business cycles and the time consistency component to economic policy. He has published more than 50 papers, many of which have been focused on monetary policy.

“Monetary policy mainly consists of controlling the speed with which new money is created and, in the long run at least, the rate of inflation is determined by how quickly the money stock is increased,” says Kydland. “Fiscal policy has to do directly with the government budget. The government needs to spend a certain amount for goods and services. They also have to pay interest on their outstanding debt. And they need to get the money from somewhere, just like you and me, they need to balance the budget. We cannot spend more than we take in in wages. The main way they get revenue is through various forms of taxes. They can make up for potential shortfall by borrowing.”

“The conduct of all of that, that’s what we call fiscal policy,” he continues. “Now, both types of policy are such that decision makers’ view about what the policy is going to be in the future affects what they do today. So, for example, in the monetary arena, if you think that the central bank is going to speed up the extent to which they create money, today prices would start going up. Prices wouldn’t wait until the actual speedup takes place as long as that’s what people believe.”

If a country increases the speed in which they print money, they run the risk of hyperinflation. Hyperinflation is when the prices of goods and services rise drastically while the actual value of a currency decreases. This happened in Germany in the 1920s and in several Latin Americans countries in the 1980s. Hyperinflation is also behind the currency instability of Venezuela that began in 2016. According to Bloomberg , Venezuela’s now four year bout of hyperinflation is one of the longest in the world.

I would argue that by and large, it’s fiscal policy that’s really important for real economic sustainable growth.

“In the case of fiscal policy, tax policy in particular, the forward-looking, growth-promoting decisions about innovative activity and creating new capital, new factories, new machines, office buildings and so on – they’re very expensive activities as they take place,” says Kydland. “The returns come over after they’re finished, and here’s where fiscal policy can be quite important because these returns, two, three, five, ten years into the future, it’s after tax returns that matter. So in some sense, I would argue that by and large, unless there is an emergency or something, it’s fiscal policy that’s really important for real economic sustainable growth.”

50 Years of Learnings

Fellow Nobel Laureates Thomas Sargent and Christopher Sims, who were co-awarded the prize in 2011, agree about the practical importance of fiscal policy and discuss how fiscal policy can increase economic growth, and its limitations.

“Fiscal policy of certain kinds can have a more immediate impact,” says Sim. “If there’s lots of unused resources in the economy, the government can hire people and start building things quite promptly. There the delay is not so much in the effect of the action on the economy as it is in the political process for actually getting any fiscal policy changes implemented.”

“Fiscal policy has a huge ability to affect an economy because of its taxes and expenditures,” echoes Sargent. “The central bank’s a sideshow. This isn’t what you hear in the news, but to a first approximation, it’s a place to start. If you look at big events where governments have had huge effects on people, it’s through fiscal policy, it’s taxes. I probably shouldn’t say that, but it’s true.”

“Policy reacts to the state of the economy, so the interest rate moves because other things in the economy have changed,” says Sims. “But then when policy takes action, there’s a response in the economy. And in that sense, these relationships are reciprocal.”

If you look at big events where governments have had huge effects on people, it’s through fiscal policy, it’s taxes.

Economics Policies for Uncertain Times

Sims has built models using regulated methods that suggest that a tightening of monetary policy in ordinary times takes approximately one year to have its full effect on the level of business activity, and slightly longer than that to have its full effect on inflation. These types of methods and estimates are important when modeling for uncertain times, events like recessions or pandemics.

“One of our problems is when an economy goes into recession, we usually don’t know that this has happened until around six months at least after it’s actually happened because there’s a lack of data,” says Sims. “And so even fiscal policy, even if it’s applied quickly, tends to be a little late. That’s why we have recessions because if we knew when they were coming, we could take action to avoid them.”

“This is one reason why central banks think they need to anticipate changes in interest rates, changes in inflation, because they know that any action they take is going to have effects only slowly on the economy,” he continues. “If they wait until inflation is actually way below or way above their target, it’s going to take a long time to get back to target.”

While the effect fiscal and monetary policy have on businesses and the overall health of the economy is clear, a newer area being explored is the link between monetary policy and equality. Nobel Laureate Joseph Stiglitz doesn’t think there’s a silver bullet that can undo the inequalities that have been created and sustained for the last few decades, but he does see an opportunity for multiple policies, working cohesively, that could make a big difference. Progressive income taxes, expenditure programs, secure retirement and access to healthcare are a few of the areas where he believes we need better policies.

“Equality is really something that touches every aspect of policy. As inequality has become one of the dominant problems in our society, we have to use that lens of how policy affects inequality,” says Stiglitz. “For instance, monetary policy, it used to be nobody in a central bank talked about inequality. But today we realize that monetary policy has played a very big role in increasing inequality and wealth. And so central banks simply cannot ignore the impact that their policies have on inequality.”

Today we realize that monetary policy has played a very big role in increasing inequality and wealth. Central banks simply cannot ignore the impact that their policies have on inequality.

Kydland also sees the need for new commitments and policy implications to ensure that fiscal and monetary policy are used for long-term stability.

“There’s a need for a commitment mechanism, a way to commit the government to good policy over a reasonably long run,” says Kydland. “The best example we have of such a commitment mechanism is the idea of making a central bank independent of political pressure. It turns out, if you rank nations in terms of the independence of the central banks, monetary policy tends to be more benign under independent central banks.”

“In the arena of fiscal policy, it’s much harder. There’s nothing analogous to a central bank conducting fiscal policy,” he says. “It’s governed by voting. How you commit to good future fiscal policy is something I regard as especially serious these days.”

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Learn more about these Laureates

What makes good policy?

Finn E. Kydland

Nobel Laureate, 2004

What are the effects of fiscal & monetary policy changes on economic growth?

Thomas J. Sargent

Nobel Laureate, 2011

How can we solve monetary conflicts?

Christopher A. Sims

Can economics solve income inequality?

Joseph E. Stiglitz

Nobel Laureate, 2001

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Fiscal Policy and Monetary Policy Essay

Fiscal policy is one of the principles that are employed by a government to generate revenue thus prevent the decline in economy. It relies on taxation and spending. The government prevents the decline in economy by regulating interest rates and circulation of market.

Decline in economy may be due to imbalance between the government revenue and the way that money is spent. When the economy is balanced there is no need of having a fiscal policy. This means that the expenditure of that government is sustained by the revenues collected by the government.

According to Blanchard (2000), the economy is most likely to decline when the rate of unemployment increases because the government is not able to collect adequate taxes from employees’ salaries. To rectify this problem the government should persuade investors to come and do business in that country because by doing so the government will benefit from the taxations that will be imposed on employees and imported goods.

In addition to that, the foreigners will bring more foreign currency which will be exchanged with the local currency thus the demand for local currency will hike and therefore increase the value of the local currency. Thus, sectors like tourism generate more income when most tourists are people from other countries.

There are several ways through which the government can obtain money for running its daily routines. These options are the backbone of monetary policy, in which the government tries to control the supply of money hence boosting the economy. The first option is to issue treasury bonds that allow individuals to lend their money to the government for some time. The individuals will on the other hand reap the benefits of retrieving the profits that accumulate at the end of each month while the initial amount is left untouched (Mishkin, 2004).

The shortest time that a treasury bond can last is sixty days but the period can still be extended. Actually treasury bonds are preferred by most investors because they provide low risk investment. The government has to ensure the money obtained from creditors is used for the intended purposes only or else incur more losses beyond recovery.

Secondly, the government can sell some of its properties to generate revenue. This includes possessions such as vehicles, houses and land. The sale of these properties is done through public auctions where several people who are interested in buying the same property are requested to quote their respective price tag. The bidder who quotes the highest price is allowed to walk away with the property. The money obtained from the sale of government properties is then injected into the economy through various sectors.

Selling of these properties does not only generate income for the government but also reduces government spending. For instance a government may decide to trim the motorcade of its cabinet ministers in order to save on fuel consumption. Every cabinet minister is allocated a few vehicles that do not consume more fuel.

Additionally land owned by the government may be sold to a potential real estate investor to help in solving the problem of inadequate housing instead of leaving it idle. Most people prefer to buy properties that are owned by the government because they are considered to be relatively cheap as opposed to those sold by individuals (Heijra & Van der, 2002).

The government can also introduce seignrioage. This is done by printing more currency hence the currency goes round within the market. In developed countries people who own gold are allowed to trade their gold certificates with currency. They are allowed to hold the currency for some time and at the end they are given their gold ounces back. But the effectiveness of this method is determined by the stability on the worth of the mineral.

Thirdly, the government can subsidize taxes on commodities which will make their costs go down. But Warsh (2006) argues that this policy should only be applied to locally produced goods and services otherwise if traders who import commodities that are also available locally are exempted from taxation the local industries will be eliminated from the market.

This will cause most of the local companies to close thus many people will be without jobs which will on the other hand reduce government income which is deducted from their salaries. Governments should therefore be cautious about this issue. In contrary if taxes were increased the commodity prices will shoot hence people will withhold their money or choose alternatives for those items

The government can also use the money that is usually kept for extra expenses or emergencies. These funds are usually withdrawn when the economy has shown signs of decline. This money shields the government from failing to accomplish its missions due to lack of money and depending on the volume of this money the government may not obtain money from creditors.

Manfred (2006) explains that although the above mentioned monetary policies are effective governments should find ways of solving the underlying problems which causes most economies to decline. Issues like unemployment can be minimized by encouraging more people to establish medium enterprises and thus more people will be working hence the source of government money will be stable. This is because individuals will be paying for business licenses and income tax.

Government corporations that are not competent should be privatized more foreign trade should be promoted in order to generate more foreign currency. This can be done by maintaining peace which will attract more investors. Both tourists and foreign investors fear to visit countries that are prone to wars.

In essence, governments should establish bodies that monitor the expenses of government agencies to ensure they are valid. This is because a lot of government money is squandered by individuals due to lack of proper mechanisms of vetting expenses. It is therefore important for governments to fight impunity. Fiscal policy and monetary policy help a government to stabilize its economy through a controlled supply of factors of production

Blanchard, O. (2000) .Macroeconomics . New Jersey: Prentice Hall.

Heijdra, B.J. & Van Der. (2002). Foundations of Modern Macroeconomics . Oxford: Oxford University Press.

Manfred, G. (2006). Macroeconomics . New Jersey: Pearson Education Limited.

Mishkin, F.S. (2004). The economics of Money, Banking, and Financial Markets . Boston: Addison-Wesley.

Warsh, D. (2006). Knowledge and the Wealth of Nations: A Story of Economic Discovery New York: Norton.

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IvyPanda. (2018, July 20). Fiscal Policy and Monetary Policy. https://ivypanda.com/essays/fiscal-policy-and-monetary-policy/

"Fiscal Policy and Monetary Policy." IvyPanda , 20 July 2018, ivypanda.com/essays/fiscal-policy-and-monetary-policy/.

IvyPanda . (2018) 'Fiscal Policy and Monetary Policy'. 20 July.

IvyPanda . 2018. "Fiscal Policy and Monetary Policy." July 20, 2018. https://ivypanda.com/essays/fiscal-policy-and-monetary-policy/.

1. IvyPanda . "Fiscal Policy and Monetary Policy." July 20, 2018. https://ivypanda.com/essays/fiscal-policy-and-monetary-policy/.

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IvyPanda . "Fiscal Policy and Monetary Policy." July 20, 2018. https://ivypanda.com/essays/fiscal-policy-and-monetary-policy/.

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Monetary and Fiscal Policy, Essay Example

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Monetary policy refers to the actions of the central bank to achieve macroeconomic objectives such as price stability, full employment, and stable economic growth. In the U.S. monetary policy is usually carried out by the U.S. Federal Reserve System, usually called the Fed. Congress has delegated two major macroeconomic goals to the Fed which are maximum employment and price stability. Fed is an independent agency of the federal government to ensure freedom from undue political influence.

In order to achieve the objectives set under the monetary policy, Fed utilizes a variety of tools. One such tool is setting a target for federal funds rate, a key short-term interest rate. Fed’s influence over the federal funds rate also allow it to influence long-term interest rates and key asset prices. Another tool used by the Fed to conduct monetary policy is purchase of long-term securities. The purchase of long-term securities is primarily intended to influence long-term interest rates.

Fiscal policy refers to the revenue generation (taxation) and spending policies of the federal government. Fiscal policy is shaped by the U.S. Congress and the Administration.

Expansionary monetary policy refers to an increase in the supply of money in the economy and contractionary monetary policy refers to a decrease in the supply of money in the economy. The Fed can pursue an expansionary monetary policy in a number of ways. It may purchase securities in the open market. Similarly, lowering the federal discount rate would also lead to increasing borrowing activity in the economy. Fed can also lower the reserve requirement to increase money supply in the economy. Lower reserve requirement means banks can lend more. Expansionary monetary policy tends to increase bond prices because bond prices and interest rates have opposite relationship.

Contractionary monetary policy on the other hand requires opposite actions to what are taken to expand monetary policy. One way may be for the Fed sell securities in the market place, reducing the quantity of money in the economy. Similarly, Fed may increase federal discount rate which would discourage borrowing by making it more expensive. Fed may also increase the reserve requirement which means banks would have fewer funds to lend. Since contractionary policy increases interest rate, it causes decline in bond prices.

Expansionary fiscal policy is meant to increase the level of aggregate expenditures and demandto boost economic growth. It may be achieved through greater levels of government spending or a decrease in tax rates or both. Lower tax rates mean the business and consumers are left with higher disposable income to spend on consumption and investment activities. In addition to government spending and lower tax rates, expansionary fiscal policy also involves transfer payments such as social security and unemployment benefits. These transfer payments also left certain group of citizens with more income to spend. Similarly, contractionary fiscal policy is meant to prevent an overheating of the economy through reduced government spending, higher tax rates, or both. These measures discourage expenditures and aggregate demand and, thus, help reduce inflationary pressures as well as potential asset bubbles. The government may also scale back on transfer payments to reduce levels of expenditures and aggregate demand.

Works Cited

AMOSWEB. Expansionary Fiscal Policy . [online]. [Accessed 9 February 2014]. Available from World Wide Web: <http://www.amosweb.com/cgi-bin/awb_nav.pl?s=wpd&c=dsp&k=expansionary+fiscal+policy>

Board of governors of the federal reserve system. What is the difference between monetary policy and fiscal policy, and how are they related? [online]. [Accessed 9 February 2014]. Available from World Wide Web: <http://www.federalreserve.gov/faqs/money_12855.htm>

Moffatt, Mike. Expansionary Monetary Policy vs. Contractionary Monetary Policy . [online]. [Accessed 9 February 2014]. Available from World Wide Web: <http://economics.about.com/cs/money/a/policy.htm>

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Monetary vs. Fiscal Policy Effects: A Review of the Debate

This paper reviews empirical findings, econometric issues,and theoretical results bearing upon the "monetary vs. fiscal policy" debate that began with the 1963 Friedrnan-Meiselman study.The main substantive conclusions are not very dramatic.The clearest is that an open-market increase in the money stock has a stimulative effect on aggregate demand, a conclusion that in turn implies that a money-financed increase in government expenditures (or reduction in taxes) is more stimulative than it would be if bond financed.This conclusion is based on empirical results obtained from St. Louis-type estimates and large scale economebic models and is supported by theoretical analysis involving both Ricardian and non-Ricardian assumptions. In the case of pure fiscal policy actions -- i.e.,bond-financed tax cutsor bond-financed expenditure increases --theory suggests that the latter should be at least as stimulative as the former and probably to a positive extent; evidence is mixed but not obviously inconsistent with this prediction.With respect to the textbook issue concerning the relative effects of pure monetary and fiscal actions, the evidence seems to support the notion that a sequence of $k open-market purchases, one each period, will be much more stimulative than a single but unreversed $k/period bond-financed increase in expenditures. The importance of this last issue is debatable.

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Published Versions

McCallum, Bennett T. "Monetary vs. Fiscal Policy Effects: A Review of the Debate." The Monetary vs. Fiscal Policy Debate, edited by R. W. Hafer, pp . 9-29. Totowa, NJ: Rowman & Allanheld, Publishers, 1986.

McCallum, Bennett T. "Monetary Policy Without Monetary Aggregates," FRB Saint Louis - Review, 1994, v76(2), 216-218.

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