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 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: 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.
