Fiscal policy and monetary policy are macroeconomic tools used for managing the economy or to be more specific, to resolve macroeconomic problems such as recession, inflation, high unemployment rates, or an ongoing economic crisis. To understand better how these tools help in stabilizing an economy, it is important to understand their specific purposes, definitions, and differences.
Fiscal Policy vs. Monetary Policy: What is the Difference?
There are three options available to the government during periods of economic instability. One is a no-policy-approach that involves waiting for the economy to correct itself. Take note that the fundamental principle of classical economics is that the economy is self-regulating and it is capable of achieving the natural level of real GDP.
A no-policy-approach can have a positive impact. For example, during a recession characterized by high unemployment rates, it is possible for wages to go down due to the overabundance of human resource in the labor market. When wages go down, the cost of production will also go down. Eventually, aggregate supply will increase due to inputs from massive inexpensive labor.
But the economy is not always self-regulating. One of the fundamental principles of Keynesian economics is that the economy cannot regulate itself and as such, the government needs to intervene. Hence, from a Keynesian perspective, the government has two more options to choose from during periods of economic instability. These are fiscal policy and monetary policy.
The primary difference between fiscal policy and monetary policy is that the former revolves around government expenditures or stimulus and taxation policies while the latter centers around the mediating roles of the central bank to control the money supply and interest rates.
Keynesian economics argues that the government can influence aggregate demand and the level of economic activity through rates or levels of taxes and public spending. These measures are fundamental to fiscal policy and there are two of the several factors affecting demand.
For example, during a recession, increase government spending to fund public projects or increase employment in government agencies would lead to an increase in aggregate demand. Meanwhile, decreasing taxes will increase the disposable income of the consumers, thus leading also to an increase in aggregate demand.
Monetary policy is another collective measure employed by a government and course through a central bank to influence aggregate demand and economic activity. The specific goals of monetary policy are to maintain GDP stability, achieve or maintain low unemployment, and to maintain exchange rates with other foreign currencies.
During a recession, the central bank can increase the money supply through the reserve requirement, discount rate, or open market operation. Successfully increasing the money supply would lead to a decrease in interest rates that in turn, would allow banks to loan out money that would encourage businesses to expand their operations. Business expansions will eventually increase aggregate demand.
Fiscal Policy and Monetary Policy in a Nutshell
Take note that increasing the aggregate demand during a period of recession encourages businesses to hire more employees and expand their operations to increase their supplies and thus, respond to the increase in demand. Hence, increasing the aggregate demand through government intervention, particularly through fiscal policy and monetary policy, stimulates economic activity.
It is also important to highlight the fact that fiscal policy and monetary policy are macroeconomic tools used for managing the economy in general. What this means is that both are not only used to respond to recession and expand the economy but also to contract the economy, thus maintaining economic stability.
As a summary, the difference between fiscal policy and monetary policy centers on the specific measures observe by the government. Essentially, fiscal policy is about taxation and government expenditures while monetary policy is simply about controlling the money supply. All of these measures are intended to either expand the economy during periods of recession or contract the economy to maintain stability.