Monetary policy vs. fiscal policy: Two main tools used to maintain a stable and balanced economy (2024)

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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 are lags 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, created 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 US economy.

Monetary policy vs. fiscal policy: At a glance

Although monetary and fiscal policy are both designed to achieve economic stability, the officials responsible for them approach that goal on different fronts. 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.

• Monetary policy involves manipulating interest rates and the money supply and is the job of the Federal Open Market Committee (FOMC).
• Fiscal policy, determining how the existing supply of money will be spent, is the responsibility of the US Congress and the president, who use tax policy and spending legislation to achieve economic stability.

What is monetary policy?

Monetary policy, which can broadly be described as either expansionary or contractionary, is set by the Fed, a non-governmental body established by Congress in 1913.

To set monetary policy the FOMC, which usually meets eight times a year, controls the money supply by buying (or selling) securities on the open market, changing reserve requirements for federal banks, and raising or lowering the interest rate the Fed charges banks that borrow from it, known as the discount rate.

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.

Government fiscal policy, which relies on government spending and tax policies, attempts to expand or contract the economy to achieve the same goals as those of Fed monetary policy, just through different means.

In the case of monetary policy, targeted interest rates, for example, can put downward pressure on inflation or provide a needed boost during a recession. It helps that the Fed is by design neutral, unencumbered by the political machinations of Congress. Neutral or not, however, the impact of monetary policy is broad. It affects the entire economy, and focused implementation is almost impossible.

Finally, when the Fed cuts interest rates, the demand for dollars to invest in US markets is reduced. The resulting weaker currency makes goods produced in the US 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.

Example of monetary policy

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.

What is contractionary monetary policy?

Contractionary monetary policy is a macroeconomic tool that a central bank — in the US, that's theFederal Reserve— 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 ofexpansionary 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 US, for example, generally considers the averageannual inflation rateof 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.

A well-known example in which contractionary monetary policy was used to tame inflation was in the late 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 theUS dollarfrom the gold standard. To combat it, the Federal Reserve 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 arecessionand 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.

What is expansionary monetary policy?

Expansionary monetary policy is a macroeconomic tool that a central bank — like theFederal Reservein the US — 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 toa 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.

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.

When the government wants to expand the economy, instead of increasing the money supply, it spends more, taxes less, and effectively increases aggregate 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.

Fiscal policy can be used to efficiently reduce unemployment and poverty, a big plus, but also easily result in budget deficits. In fact, the contributions to deficit spending that result from fiscal policy are the primary reason the US annual deficit for 2021 was $2.77 trillion. However, that deficit and the $3.13 trillion deficit in 2020, are mostly the result of government spending to counteract the impact of the pandemic.

What are the 3 types of fiscal policy?

Fiscal policy is generally put into one of three categories, depending on its goal:

• Neutral policyis when the government's fiscal policy isn't intended to influence the economy. Policies may still be enacted, but new expenditures may be completely balanced by increased revenue.
• Expansionary policyis when the government increases spending or decreases taxes to stimulate growth. Expansionary policy may be an attempt to avoid or end a recession and prevent high unemployment.
• Contractionary policyis when the government decreases spending or increases taxes to prevent unsustainable growth. Contractionary policy may be put in place to slow inflation, decrease government debt, and try to maintain a healthy unemployment rate.

Example of fiscal policy

Both monetary and fiscal policy helped provide relief during the pandemic. On the fiscal policy side, the CARES Act and the American Rescue Plan Act are prime examples.

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.

Monetary policy and fiscal policy are forceful mechanisms to influence and stabilize the economy. The main problem with both is the lag, either between idea and implementation or between implementation and results.