Readers Question: Explain the terms monetary policy and fiscal policy and compare the ways in which they influence the UK economy.
- Monetary policy involves influencing the supply and demand for money through interest rates and other monetary tools.
- Monetary policy is usually conducted by the Central Bank, e.g. UK – Bank of England, US – Federal Reserve.
- The target of Monetary policy is to achieve low inflation (and usually promote economic growth)
- The main tool of monetary policy is changing interest rates. For example, if the Central Bank feel the economy is growing too quickly and inflation is increasing, then they will increase interest rates to reduce demand in the economy.
- In some circumstances, Central Banks may use other tools than just interest rates. For example, in the great recession 2008-12, Central Banks in UK and US pursued quantitative easing. This involved increasing the money supply to increase demand.
UK interest rates cut in 2009 due to the global recession.
- Fiscal policy relates to the impact of government spending and tax on aggregate demand and the economy.
- Expansionary fiscal policy is an attempt to increase aggregate demand and will involve higher government spending and lower taxes.
- Expansionary fiscal policy will lead to a larger budget deficit.
- Deflationary fiscal policy is an attempt to reduce aggregate demand and will involve lower spending and higher taxes.
- This deflationary fiscal policy will help reduce a budget deficit.
In 2009/10, the UK pursued expansionary fiscal policy – cutting VAT. This led to a rise in government borrowing.
Similarities and differences between Fiscal and Monetary Policy
Both aim at creating a more stable economy characterised by low inflation and positive economic growth. Both fiscal and monetary policy are an attempt to reduce economic fluctuations and smooth out the economic cycle.
The main difference is that Monetary policy uses interest rates set by the Central Bank. Fiscal policy involves changing government spending and taxes to influence the level of aggregate demand.