Monetary and Fiscal Policy: Tools of Economic Management

October 3, 2023
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Economic management refers to using economic policies and tools to achieve certain goals. A sound economic management helps to:

  • increase economic growth and create jobs;
  • reduce poverty and inequality;
  • promote low inflation;
  • maintain a healthy balance of payments;
  • aggregate demand;
  • protect the environment.

The government uses monetary and fiscal policy to achieve these goals.

Understanding monetary policy

Monetary policy is the process by which central banks regulate the money supply and interest rates in the economy. Monetary policy allows us to achieve these primary objectives.

Price Stability

Central banks strive to maintain low and stable levels of inflation. This objective holds significant importance, as elevated inflation rates diminish the ability of consumers and businesses to get purchasing power and pose challenges for long-term financial planning.

Maximum Employment

Banks are dedicated to generating employment opportunities. It is crucial as it contributes to elevating the overall quality of life for members of society by providing more job opportunities and enhancing economic prosperity.

Financial Stability

The stability of the financial system is based on banks. It is extremely important, as financial crises can unleash devastating repercussions on the entire economy, underscoring the need for a resilient and secure financial framework.

Monetary policy uses such tools to achieve the above-mentioned objectives:

  • Open market operations. Open market operations are the buying and selling of government securities in the open market. When the bank buys government securities, it injects money into the economy. These are the most important monetary policy tools because they are very precise and can be used quickly.
  • Discount rate. The discount rate is the interest rate at which commercial banks can borrow money from the central bank. It can lower the discount rate to make it cheaper for commercial banks to borrow money.
  • Reserve requirements. Reserve requirements are the minimum amount of money that commercial banks must hold in reserve. Banks can increase reserve requirements to reduce the amount of money that commercial banks have available to lend, which can slow inflation. 

The dual mandate of the Federal Reserve

The Federal Reserve operates under a dual mandate, signifying its responsibility for pursuing two key economic objectives: ensuring price stability and maximizing employment.

The first one entails maintaining low and steady inflation rates. This objective holds significance due to the adverse effects of high inflation, which can erode the buying power of both consumers and businesses, thereby complicating long-term financial planning.

The second one signifies that the economy is functioning at its utmost capacity. This goal is paramount, as it contributes to enhancing the overall quality of life for all members of society by fostering increased job opportunities and bolstering economic prosperity.

Fiscal policy in economic management

Fiscal policy refers to using government taxation and spending to influence the economy. Governments can increase spending to stimulate growth or cut taxes to increase disposable income and spending. Governments can also decrease spending or raise taxes to slow inflation. There are four main objectives of fiscal policy. 

Economic Growth

Fiscal policy serves as a tool for promoting growth through increased government investments in infrastructure, education, and research and development. These expenditures not only foster job creation but stimulate private-sector investments as well.

Price Stability

It is curbed by government spending or implementing tax hikes. So, fiscal policy can preserve stability and mitigate inflationary pressures.

Full Employment

Fiscal policy plays a role in promoting full employment by augmenting government spending on employment-generating programs. Such fiscal initiatives both reduce unemployment rates and encourage greater labor force participation.

Income Redistribution

Fiscal policy aids in income redistribution from affluent segments to less privileged ones through progressive tax income implementation and the provision of government benefits to those in need. 

Among the most common fiscal policy tools are:

  • Government spending. Governments increase spending on infrastructure, education, research and development, and other programs to create jobs. 
  • Taxes. Governments can cut taxes to increase disposable income and spending. Governments can also raise taxes to reduce disposable income and spending, which can slow inflation.
  • Transfer payments. Governments provide transfer payments, such as social security benefits and welfare payments, to the poor and unemployed. Transfer payments help to reduce poverty and inequality.

Expansionary or contractionary: types of monetary and fiscal policy

Contractionary policy is an economic strategy employed by governments and central banks to reduce the rate of inflation and cool down an overheating economy. The primary goal of contractionary policy is to slow down economic growth and curb rising prices when they are considered excessive or when the economy is operating beyond its sustainable capacity.

Expansionary policy is the opposite of contractionary policy. It is used to stimulate economic growth and combat economic downturns. The primary goal of expansionary policy is to aggregate demand and encourage spending, investment, and job creation.

Difference between fiscal and monetary policy

Fiscal policy and monetary policy are two key tools that governments and central banks use to manage economic stability and growth. The main difference between them is that fiscal policy is implemented by the government, while monetary policy is implemented by the central bank. Fiscal policy is also more direct in its impact on the economy, while monetary policy can take longer to have an effect.

But keep in mind that fiscal and monetary policy are complementary tools. For example, if the economy is in recession, the government can increase spending and cut taxes to stimulate economic growth. The central bank can also lower interest rates to make it cheaper for businesses to borrow money and invest.

Monetary policy vs. fiscal policy: exploring interaction

The interaction between these policies is a crucial aspect of macroeconomic management. These two policy tools influence economic conditions but operate through different mechanisms and have different goals.

The interaction between them can either reinforce or offset each other's effects on the economy:

  1. Reinforcement. When they work in the same direction, their effects are cumulative. For example, during an economic recession, the central bank may lower interest rates to stimulate borrowing and spending, while the government may increase public spending on infrastructure projects. Together, these actions have a more potent impact on reviving the economy.
  2. Offsetting. Sometimes policies may work in opposite directions. For instance, if the government implements an expansive fiscal policy to boost the economy, the central bank might raise interest rates to counteract the potential inflationary pressures resulting from increased demand. It creates a balancing act, as one policy counters the other.

Let's recall the financial crisis of 2008. During this time, the Federal Reserve and the U.S. government interacted to combat the economic downturn. The Federal Reserve lowered interest rates to near zero and engaged in a program called quantitative easing to inject money into the financial system. These actions aimed to encourage borrowing, investment, and lending. The U.S. government, under President Obama, passed the American Recovery and Reinvestment Act (ARRA) in 2009. This fiscal stimulus package involved increased spending on infrastructure projects, tax cuts, and various social programs. By keeping interest rates low and providing liquidity to the banking system, the Federal Reserve supported the government's efforts to stimulate the economy through increased public spending. Together, these policies played a significant role in helping the U.S. economy recover from the recession.