As we know, monetary policy and fiscal policy are the two most well-known systems utilized to exert an effect on the economic activity of a nation. Nevertheless, in this article, we will clarify more about both of them, including their definitions, tools, and pros and cons.
List of Contents
What Exactly Is Monetary Policy?
Monetary policy refers to the actions and statements of a central bank that govern the money supply. Central banks use it to prevent inflation, reduce unemployment, and encourage reasonable long-term interest rates. Significantly, it improves productivity to create economic growth. Moreover, monetary policy limits liquidity to keep inflation within range. In addition, interest rates, bank reserve requirements, and the number of government bonds that banks must keep are all used by central banks. All of these tools have an impact on how much money banks can lend. The number of loans has an impact on the money supply.
Credit, cash, cheques, and money market mutual funds are also part of the money supply. However, credit is the most essential of these types of money. Loans, bonds, and mortgages are all forms of credit. In a recession, central banks may provide banks with more money to battle rising unemployment. Banks, in turn, cut interest rates. As a result, it allows businesses to hire more workers. This is an illustration of expansionary monetary policy.
Monetary Policy Tools
Generally, the Central Bank, the Federal Reserve in the United States, is in charge of monetary policy. The government selects the Fed chairman, and a congressional committee oversees the Fed. However, the institution is mainly autonomous and free to take whatever actions are necessary to accomplish its dual goal of stable pricing and low unemployment. Monetary policy tools are as follows:
1. Reserve Requirement
Banks are mandated to retain a specific percentage of their deposits in reserve to ensure that they always have enough cash to meet depositor withdrawal requests. Nonetheless, not all depositors are likely to withdraw their funds simultaneously. As a result, the CRR is typically around 10%. It implies that banks are free to lend the remaining 90%. The Fed can control the amount of lending in the economy and the money supply by changing the CRR requirement for banks.
2. Interest Rates
The cost of borrowing, or the price of money, is represented by the interest rate. The central bank can make borrowing money easier or harder by changing interest rates. When money is cheap, people borrow more, and there is more economic activity. Businesses, for instance, discover that projects that are not viable when borrowing money at 5% become viable when the rate is only 2%. Lower interest rates further disincentivize saving and encourage people to spend their money rather than keep it, as the return on savings is so low.
3. Open Market Operations
The Fed can generate money out of thin air and inject it into the economy by purchasing government bonds. This increases government debt, expands the money supply, and devalues the currency. Finally, it results in inflation. However, inflation benefits asset prices such as real estate and stocks.
4. Currency Pairing
Weak economies can choose to peg their currency to a stronger one. This approach is typically utilized in times of high inflation when other control methods are ineffective.
Monetary Policy Pros and Cons
Pros
- Interest rate targeting controls inflation.
- Central banks are independent and politically neutral.
- Weakening the currency may increase exports.
Cons
- The hyperinflation can occur.
- Monetary tools affect an entire country.
- It has technical limitations.
- The time lag of effects can occur.
Pros Clarified
- Interest rate targeting controls inflation.
A little bit of inflation benefits a rising economy because it drives future investment and allows people to expect increased pay. Inflation happens when the prices of an economy’s goods and services rise. Raising the target interest rate makes investment more expensive, slowing economic development slightly.
- Central banks are independent and politically neutral.
Even if monetary policy action is controversial, it can be implemented before or during elections without the risk of political consequences.
- Weakening the currency may increase exports.
Increases in the money supply or reductions in interest rates tend to depreciate the local currency. A lower currency on global markets can enhance exports by making these products more affordable to international buyers. Companies that primarily import would suffer a negative impact on their financial line.
Cons Clarified
- The hyperinflation can occur.
Interest rates can overborrow at unnaturally low rates when they are excessively low. This can lead to a speculative bubble, where prices rise too quickly and to impossibly high levels. Adding more money to the economy also risks causing out-of-control inflation because of the 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. As a result, it makes things priced in that money nominally more expensive.
- Monetary tools affect an entire country.
Monetary policy measures such as interest rate levels have an economy-wide influence. Moreover, it is also broad because monetary tools cannot be aimed at a specific problem.
- It has technical limitations.
Interest rates can only be cut nominally to 0%, limiting the bank’s ability to utilize this policy tool when interest rates are already low. Maintaining extremely low-interest rates for extended periods can result in a liquidity trap. Monetary policy tools are more successful during economic expansions than during recessions as a result. Some European central banks have lately experimented with negative interest rate policies (NIRP), although the outcomes will not be understood for some time.
- The time lag of effects can occur.
The macro consequences of monetary policy often take time to manifest. Some economists believe that money is merely a curtain. Thus, while it can stimulate an economy in the short run, it has no long-term benefits other than rising general prices without increasing real economic activity.
What Exactly Is Fiscal Policy?
The word “Fiscal Policy” refers to the activities taken by the government to influence an economy through purchasing goods and services from businesses and collecting taxes.
Governments, for instance, can decrease taxes and increase spending to stimulate the economy if necessary. Traditionally, they spend on infrastructure projects that generate jobs, money, and social services. Alternatively, the government can cut spending while raising taxes if the economy is performing well. Businesses create enough jobs during these times for officials to minimize their reliance on private-sector goods and services.
Fiscal Policy Tools
Generally, fiscal policy is controlled by the legislative and executive arms of government. In the United States, the President’s administration and Congress pass laws relevant to this policy. Policymakers use fiscal tools to affect economic demand. The examples are as follows:
1. Spending
If inflation is high, the government can limit expenditure. Thus, this policy can avoid competing for resources in the market, both goods, and services. Significantly, when a recession and aggregate demand are weak, more government spending on infrastructure projects leads to increased demand and employment.
2. Taxes
When demand is low, the government can lower taxes. This raises disposable income, encouraging demand.
Nevertheless, both tools have an impact on the government’s fiscal position. The budget deficit rises whether the government raises spending or decreases taxes. This deficit is financed by debt. The government borrows money to meet the budget shortfall.
Fiscal Policy Pros and Cons
Pros
- Time lag is short.
- Taxation can be used to discourage negative externalities.
- It can direct spending to specific purposes.
Cons
- Tax incentives may be spent on imports.
- It can create budget deficits.
- It may be politically motivated.
Pros Clarified
- Time lag is short.
The consequences of fiscal policy tools are far more visible than the effects of monetary policy tools.
- Taxation can be used to discourage negative externalities.
Polluters and people who abuse limited resources might be taxed to help mitigate the negative consequences they produce while also producing government revenue.
- It can direct spending to specific purposes.
In contrast to monetary policy tools, which are broad in scope, a government can focus expenditure toward specific projects, sectors, or regions to stimulate the economy where it is seen to be most needed.
Cons Clarified
- Tax incentives may be spent on imports.
When the money placed into the economy through tax savings or government spending is spent on imports, the benefit of fiscal stimulus is diminished instead of remaining in the local economy.
- It can create budget deficits.
A government budget deficit occurs when annual spending exceeds annual revenue. If spending is high and taxes are low for an extended period, this deficit can continue to grow to harmful proportions.
- It may be politically motivated.
Tax increases are often unpopular and politically risky to impose.
Conclusion
Fiscal and monetary policy both play an important role in economic management. Significantly, both have direct and indirect effects on personal and household finances. Fiscal policy involves government-set tax and expenditure decisions that affect individuals’ tax bills through government programs. However, the central bank sets monetary policy, promoting consumer spending by lowering interest rates on everything from credit cards to mortgages.
FAQs
Monetary policy refers to the actions taken by a central bank, such as the Federal Reserve in the United States, to impact the supply of money and credit in the economy. Typically, monetary policy aims to foster price stability and sustainable economic growth.
The employment of government spending and taxation to impact the economy is fiscal policy. Fiscal policy can be used to encourage economic growth during a recession or to control economic development during inflationary periods.
While both policies aim to achieve macroeconomic goals, monetary policy is administered by the central bank and focuses on managing the money supply and interest rates, while fiscal policy focuses on government spending and taxation.
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Read more: Economies
Source: The balance, Investopedia