What Is The Difference Between Fiscal And Monetary Policy?

A photo of the Marriner S. Eccles Federal Reserve Board Building.

Fiscal policy refers to the government's decisions on spending and taxation in an effort to influence the economy. This policy affects how much money the government collects and spends, thus affecting economic activity. The government uses fiscal policy to achieve things like economic growth, reduction of unemployment, and control of inflation.

Monetary policy, on the other hand, is more about the regulation of the money supply and interest rates by a central bank. Through its various tools, monetary policy attempts to regulate inflation, employment, and financial stability. While fiscal policy typically involves government budget decisions, monetary policy operates through the banking system and financial markets.

Who Makes Fiscal Policy?

Fiscal policy, in democratic nations, is usually made through the legislature of a government. For example, the U.S. Congress has the power of making laws for establishing tax rates, approving government expenditure, and giving the authorization to borrow. Although the President submits a proposed budget, Congress debates and alters the proposed bill before enacting fiscal policy.

It starts when the President submits a budget proposal to Congress—usually in early February—in which he outlines the fiscal plans of the administration for the coming fiscal year. Congress considers and amends these proposals and then passes budget resolutions, which establishes the overall limits on spending. Appropriations bills specify how much money goes to each government program, and various committees of the House of Representatives and the Senate write these bills. When both of these bills pass through both Houses and get signed by the President, they become law, thereby implementing fiscal policy.

Who Makes Monetary Policy?

Monetary policy is the duty of the central bank. The United States has the Federal Reserve System, simply known as the "Fed." The Federal Open Market Committee, abbreviated as FOMC, is the Federal Reserve's primary decision-making body, and it consists of all the members of the Board of Governors and the presidents of some Federal Reserve Banks. Members meet several times annually for discussion and deciding on monetary policy moves.

Monetary policy tools include establishing the federal funds rate, which is the interest rate on overnight loans that banks make to one another. The Fed uses this rate to influence other interest rates in the economy—like for mortgages or other loans, for instance. Another tool is open market operations, where the Fed buys or sells government securities to adjust the money supply. The Fed also establishes reserve requirements, which specify how much cash banks must hold and not lend out; the reserve requirements indirectly influence the money supply and the capacity to lend.

The Effects of Fiscal and Monetary Policy

Fiscal policy immediately affects government debt and deficits. If spending exceeds revenues, then the government must borrow, adding to the national debt. This can reduce credit ratings, decrease future fiscal flexibility, or put pressure on the Fed to change interest rates. However, government spending can also stimulate economic growth, particularly during a recession, by increasing demand for goods and services and putting more money in the market.

Monetary policy impacts interest rates for borrowing costs paid by consumers and companies. A policy that makes interest rates low can cause further economic growth and development, but, if not managed right, it can lead to very high inflation. High interest rates are generally able to cool down an overheating economy, but it also has a simultaneous negative impact on investment and growth.

Some Challenges

Both fiscal and monetary policies carry serious disadvantages. Fiscal policy, due to the legislative process it has to pass through, tends to be sluggish, and its influence may not fall squarely and specifically on spending behavior. There are even cases of political motivation—policies for voters rather than the economy. Large deficits are particularly dangerous, especially if debt buildup becomes unserviceable.

Monetary policy, while perhaps more agile, is not free of constraints. When interest rates are near zero—a situation usually described as a "liquidity trap"—the central bank's scope to operate on the economy becomes limited. Then, there is the risk of asset bubbles if low rates cause speculative investment rather than productive ones.

Conclusion

Fiscal and monetary policies are both basic tools of economic management. They are designed by different hands with various but sometimes interrelated objectives. Understanding who makes these policies and how they work provides information on how governments are able to influence the economy. Their effectiveness, however, depends on factors like timing, coordination, and the broader economic context in which they are applied.