Monetary policy is the process a government, central bank, or monetary authority of a country uses to control
(i) the supply of money,
(ii) availability of money, and
(iii) cost of money or rate of interest to attain a set of objectives oriented towards the growth and stability of the economy.
Fiscal policy involves the Government changing the levels of Taxation and Government spending in order to influence Aggregate Demand (AD) and therefore the level of economic activity.
(AD is the total level of planned expenditure in an economy (AD = C + I + G + X – M)
Fiscal policy and Monetary Policy aims to stabilise economic growth, avoiding the boom and bust economic cycle.
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 ECB in Europe)
• 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.
• In recent decades, monetary policy has become more popular because
• Because where the Central Bank is independent of government, it can reduce political influence (e.g. desire to have a booming economy before a general election)
• Fiscal Policy can have more effect on the supply side of the wider economy. E.g. to reduce inflation, higher tax and lower public spending would not be popular and the government may be reluctant to pursue this. Also lower government spending could lead to reduced public services and the higher income tax could encourage a disincentive to work.
• Monetarists argue that 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)
• Targeting inflation is too narrow. In some countries (viz. USA and Europe), the Central Banks ignored the booms in housing markets and bank lending which were unsustainable. This inevitably led to the current economic depression world-wide.
• Liquidity Trap. In a recession, cutting interest rates may prove insufficient to boost demand because banks don’t want to lend, or have no money to lend, and consumers are too nervous to spend.
• 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 kick-start 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.