The Difference of Fiscal and Monetary Policy

Interest rates

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Monetary policy has been the most popular type of economic stimulus since the 2008 global financial crisis. Central banks lowered interest rates to encourage banks to lend and consumers to borrow. When those strategies failed, the central banks began quantitative easing programs that involved purchasing troubled assets or government bonds to increase the amount of cash in circulation and achieve the same outcomes.

Fiscal stimulus has been a lot less common with many governments cutting spending and raising taxes. While there is a lot of debate on the topic, there’s little doubt that spending cuts and higher taxes lead to slower economic growth. These efforts could be undermining monetary policy objectives by offsetting any improvements. Some economists believe that this is why the global economy has failed to recover meaningfully following the 2008 crisis.

In this article, we’ll take a look at the key differences between these approaches and how they can be combined with the most effective economic stimulus.

Limits of Monetary Policy

The goal of monetary policy is to control the supply of money to promote stable employment, prices, and economic growth. Since it cannot directly control the economy, there are limits to the power of monetary policy in achieving these objectives.

A liquidity trap occurs when a central bank’s efforts to inject liquidity into an economy fails to lower interest rates and stimulate economic growth. Often, this occurs when people start to hoard money rather than spending it on goods and services. These actions tend to push short-term interest rates toward zero as consumer prices remain stagnant. When this happens, central banks have few traditional monetary policy options left to combat the issue.

Deflation occurs when the rate of inflation falls below zero and increase the value of real money over time. Since prices are falling, consumers tend to hoard more cash and exacerbate the problem over time in what’s called a deflationary spiral. Deflation also increases the real value of debt and may lead to a recession in the economy as businesses and consumers struggle to repay debt and insist on saving cash and investing capital.

Fiscal Stimulus vs. Austerity

The goal of fiscal policy is to adjust government spending and tax rates to promote many of the same goals as monetary policy — a stable and growing economy. Like monetary policy, fiscal policy alone can’t control the direction of an economy.

Fiscal stimulus is the increase in government spending or transfers to stimulate economic growth. In most cases, this increase in spending increases the growth rate of public debt with the hope that economic improvements will help fill the gap. Governments acting to stimulate the economy may also decide to lower tax rates to put more cash in the pockets of businesses and consumers to encourage spending.

Austerity is the opposite process whereby a government cuts back on spending and increases taxes to reduce debt and improve its financial footing. Often, this results in a decrease in economic growth as consumers and businesses spend more money on taxes and rely less on government projects or jobs as a revenue source. These measures are often enacted by third-party creditors looking to ensure repayment of debt.

Conflicts in Policies

Fiscal policy occasionally runs contrary to monetary policy, especially during times of great economic uncertainty. After an economic downturn occurs, central banks often try to stimulate the economy by making capital more accessible to consumers and businesses. A fiscal policy might take a different approach by reining in government spending and increasing taxes, which can actually hurt business and consumer spending and offset any pro-growth effects.

Governments may take these actions to improve public finances or meet the demands of international banks and creditors. For instance, Greece was forced to undergo fiscal austerity by its European creditors, which ended up dramatically slowing its growth rates. This ran contrary to — and ultimately canceled out — the European Central Bank’s low-interest-rate policy that was attempting to stimulate growth in the Eurozone.

Most economists agree that a combination of pro-growth monetary and fiscal policy is needed to truly support growth.

The Bottom Line

Monetary policy and fiscal policy are the most popular tools for promoting a healthy economy over time. While these policies have the same objectives, they do not always operate on the same pathways. Monetary policy may be promoting economic growth through low interest rates, but the fiscal policy may be constricting growth through higher taxes and reduced public spending — and these efforts may end up canceling each other out.