Readers Question: What is the difference Between Monetary and Fiscal 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.
Fiscal Policy is carried out by the government and involves changing:
- Level of government spending
- Taxation
and hence this influences the level of government borrowing.
Which is More Effective Monetary or Fiscal Policy?
In recent decades, monetary policy has become more popular because
- Set by the Central Bank, it reduces political influence (e.g. 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 purse 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 spending, and higher government borrowing pushes up interest rates. (However, this analysis is disputed)
However, the recent Recession shows that Monetary Policy too can Have Many Limitations.
- Targeting inflation is too narrow. This meant Central banks ignored an unsustainable boom in 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.
- Even quantitative easing – creating money may be ineffective if banks just want to keep the extra money in their balance sheets.
- Government spending directly creates demand in the economy and can provide a kickstart 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.
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5 comments ↓
For those interested, I think one of the best running commentaries on what is happening in relation to the credit crunch (combined with some fresh and unconventional thinking on matters fiscal and monetary) is this: http://www.winterspeak.com/
Good article.
Part of Monetary policy, especially in the past, is control of the exchange rates and therefore value of the currency, which is worth noting.
This was of course before there were floating exchange rates. It’s much more difficult to do it nowadays, but a devalued pound has been the possibly beneficial consequence of the recession.
Surely increased government spending shifts demand rather than creates it? The money has to come from somewhere after all, and “thin air” is not one of the determinants of demand, at least last time I checked.
Both policies are useful and effective. But all depends on the demand and supply curve of the economy. If the demand curve is flat, where money policy is no longer efffective, then we need fiscal policy. Government must spend money to move the demand and the economy. On other side, if demand curve is elastic to interest rates, normally monetary policy works….
in principal all economic activity could be conducted through market transactions. how ever even in market economics much economic activity occurs within firms where administrative decisions rather than market prices are used to allocate resources
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