Monetary policy vs. fiscal policy – Explained by Paul Haarman
Policymakers who frame economic policies rely on two main courses of action driven by the fiscal policy or monetary policy. Although we normally speak about these terms in the same breath, and many people even use these terms interchangeably, these are as much different as chalk and cheese. This article explains the difference between monetary policy and fiscal policy.
Paul Haarman explains what monetary Policy is
While both the policies are useful for achieving the objectives of macroeconomics, the monetary policy is about the actions taken by the central bank of any country for achieving macroeconomic objectives. It involves the supply of money to the market by the central banks and interest rates fixed by them. To drive the country’s economy in a particular direction, the government entrusts the central bank to keep inflation within a target level. For example, the US government has mandated the Federal Reserve Bank, commonly known as the Fed, to achieve price stability and maximum employment.
When the economy is faltering, the central bank will make all efforts to stimulate it by lowering interest rates, increasing the money supply, and effectively making it easy for people to borrow money. On the other hand, Paul Haarman cites that central banks are responsible for controlling the pace of the economy if it tends to grow too rapidly. In such instances, the central banks would tighten the monetary policy by reducing money from circulation and raising interest rates. A fast-paced economy leads to increased inflation that can become worrisome. A timely intervention by the central bank can help to put the economy back on track.
By raising the interest rate, The Fed aims at discouraging people from borrowing money that reduces the demand for loans and cash. To limit the ability of banks to generate new loans, the Fed can increase the level of reserves that retail and commercial banks can maintain.
What is fiscal policy?
Fiscal policy relates to the earnings of the government and is completely different from the monetary policy. The fiscal policy determines the manner in which the central government earns money by imposing taxes and the manner of spending money. One of the steps that governments take to stimulate the economy is by cutting tax rates and at the same time increasing its own spending. To cool down an overheated economy, the government will take some actions that are just opposite to the actions taken to stimulate the economy. The first step that government would take is to reduce spending and at the same time raise the taxes.
Although the government uses both monetary policy and fiscal policy to drive the economy and ensure prosperity, there is continuing debate about which of the two is a better economic tool. Since each of the tools has its own pros and cons, it is up to the government to study the economic situation and use the policy that appears to be most appropriate for the moment and in the long term, says Paul Haarman.
Achieving long-term economic benefits is more important than short-term fixes.