Fiscal vs Monetary Policy Guide
Fiscal and monetary policies are two means through which the economy of a nation can be controlled.
There is always need to control the economy of a nation so as to avoid an economic collapse.
These two policies are made and implemented by two different organs. This gives them their varying powers, or pros and cons.
Apart from the drafting and implementing bodies, there is also the general means by which they work.
These help distinguish between them.
But more importantly, they seek to reach their goals in different ways.
A country’s fiscal policy is drafted and implemented by the government.
The main aim is to address the government’s spending as well as taxation.
With taxation, the government can decide to increase taxes.
When this happens, it will collect more revenue. With an increase in taxes, the general cost of living becomes high.
Consumer goods become more expensive and the most affordable items quickly become more costly.
This is the approach taken by the government to mitigate an uncontrollable growth of the economy.
On the other hand, the government might decide to lower tax and increase its own spending.
This will typically happen when the economy is experiencing a downturn.
In the event of a recession, increased government spending becomes an attractive force which stimulates economic growth.
At the same time, there will be lowered taxes to encourage others to take action which will spur growth. Lower taxes have the effect of reducing the price of commodities.
This makes it easier for people to buy the necessary products for their use.
A monetary policy also serves the economy of the nation, though differently. Instead of targeting taxation and government spending, this policy targets interest rates and the supply of money in circulation.
When interest rates are increased, it becomes more difficult to borrow money. This has the effect of stifling the growth of the economy.
Commercial banks will charge more for loans and only the rich will be able to afford them.
Startups and SMBs usually suffer when such action is taken.
These businesses will not be able to grow and as life becomes expensive, their profits reduce.
If this situation prevails for a long time, they may start shutting down.
Whenever interest rates are increased, it is often for the purposes of regulating growth.
An economy may be growing too fast to the point of requiring to be constrained.
In such a situation, businesses will not suffer much, only that their profit margins may reduce.
The other way the monetary policy is used to accomplish the same purpose is the control of the money in circulation.
The more the money in circulation, the easier it becomes to acquire it.
When it’s easy to get money, then spending it is not a problem.
This reflects a situation where making transactions is easy. Meaning, the cost of living is not too high.
TYPES OF FISCAL POLICY
There are two major types of fiscal policy which can be implemented by a government.
These are used depending on the situation at hand.
Since there can only be two situations, either extreme growth or recession, the suitable one will be picked to regulate the economy.
These two are:
Expansionary Fiscal Policy
The expansionary fiscal policy is the type used when the economy is in a downturn. When there is a slump on the economy, there is need for growth.
The expansionary fiscal policy will be implemented by the government to get the economy out of the danger zone.
As the name suggests, it is aimed at causing an expansion.
Some of the things this policy may do include lowering the tax payable for different goods.
This will especially target food or the things which have a direct impact on the cost of food.
An example of this is oil. Oil is a major determinant of the prices of food because it affects transport. If oil prices are high, then transportation costs will be high.
And if transportation costs are high, then moving food from the farms to the market will be expensive.
This cost will be passed on to the consumer and it may be too high for affordable living.
The government may also decide to increase its spending.
This may target specific areas of the economy, those which can have a quick effect on other sectors.
When the government spends more, it typically encourages economic growth.
Contractionary Fiscal Policy
The opposite of the expansionary fiscal policy is the contractionary policy. This is implemented when the economy is growing too fast and there is need for reducing the growth.
This policy will be used to contract the economy in the shortest time possible.
As you will learn in the section about the pros and cons of these policies, the desired effects of a fiscal policy are realized quickly.
As such, a government is able to quickly take remedial action whenever things are going wrong. Or threatening to go wrong.
A move like the increase in tax will take effect quickly enough to reduce unwanted growth. One problem with fiscal policy comes from the body which implements it.
Since it is determined by legislation, things can take a political direction.
When this happens, it may take some time before the right action is taken.
ADVANTAGES OF USING FISCAL POLICY
The fiscal policy has some strengths attached to it. This is why presidential campaigns include the candidate’s discussion on things like taxes.
This is because he has to show how he intends to improve life.
Some advantages of using the fiscal policy are:
They are specific and can stimulate specific growth.
The nature of fiscal policy is that it is very specific in its targets.
When a fiscal policy is being developed, the writers must be aware of the specific areas they intend to target with the legislation.
This is because the policy, once implemented, will only have effect on the areas of interest.
Other areas will normally be affected indirectly.
Unless the policy is written to target all areas of the economy, there will usually be areas which will not be touched by the policy.
This specific nature of the fiscal policy has great advantages and provides a lot of control to the government.
Take for instance a situation where the economy has fallen due to a housing bubble.
This will likely have an effect on other sectors like banking since they are the mortgage providers.
When a government decides to remedy the situation, it will create legislation that specifically targets these two industries and any other directly related to it.
This saves a lot of time as there won’t be need to focus on anything outside the problem area.
At the same time, this policy will be easy to implement because there are only a few factors being monitored.
There may also be no need for a big multi-agency team to work on the implementation.
Just a small team put together by the government will do.
Higher taxes can greatly reduce negative impacts on life.
Fiscal policies can be used for purposes other than those which directly impact an economy.
However, it will still be for the benefit of the economy in one way or another.
Consider the below example.
Most of the countries in the world have agreed to combat global warming.
For this to happen, there must be very deliberate efforts taken to ensure certain economic activities are heavily controlled, greatly reduced or totally stopped.
An example is logging.
Trees are known to take carbon dioxide and give out oxygen.
Too much carbon dioxide in the atmosphere is one of the leading causes of global warming.
This problem is having far-reaching effects all over the world.
It causes the melting of the ice caps in the Northern hemisphere resulting in the rise of sea levels. It is also the cause of heat waves and forest fires. The change in climate is also responsible for frequent storms and their increased intensity.
Coal burning has a a similar impact on the environment. The smoke produced is destructive to the environment.
When a government decides to act against such activities, it doesn’t have to tell those companies to close down.
All it has to do is draft a tax policy and publish it. It may have some grace period by which it will take effect.
At the commencement date, these businesses will have to pay higher taxes as specified.
The money collected from these businesses may then be used to plant fast-growing tree seedlings so as to work against the effects of the pollution going on.
Fiscal policies take effect fast.
This is probably one of the best things about fiscal policies.
They are a real solution when you want one quickly. This is built on the way they function.
Targeting tax and government spending is usually something which can make a visible impact in a week’s time, if not less.
This provides the advantage of knowing that there is always a way out of even the worst situations.
This does not mean that a government can sit pretty and fail to monitor the situation for signs of economic trouble.
Actually, the government should always be on the lookout for signs that things are not going right.
Still, at times, problems arise faster than they can be resolved. Also remember that fiscal policies come from the government.
As such, it may take some time before the discussions are complete and an agreed-upon policy is presented.
The delay will most often result from the political debates raging around the policy being drafted.
DISADVANTAGES OF USING FISCAL POLICY
Having advantages always means there are disadvantages too.
The same applies to the fiscal policy. Here are some of the common disadvantages.
Can create or worsen budget deficits.
Fiscal policies may come with a heavy price tag if implemented in an economic environment which is not well balanced.
An example would be when the government has recently been unable to reach its target in revenue collection.
Still required to carry out its obligations, the government may choose to spend more than it is receiving. The extra money needed will come from local and foreign loans.
Increased spending by a government which doesn’t have the money in the first place can be dangerous.
If this situation prevails for a couple of years, then the final deficit can become too big to be quickly dealt with.
Tax incentives may not benefit the local economy.
Where the implemented policy causes some savings on taxes so as to spur growth, this intention may not be realized.
The reason is that as much as you can lower taxation, you cannot really tell people what to do with their savings.
Private business may decide to import more raw materials for their manufacturing processes. They have definitely embraced the tax reduction but then opted to do what is in their best interest.
Whereas the government hoped for the savings to be used to expand the local economy, individuals and businesses may be thinking otherwise.
If the money is used to increase imports of raw materials, then the transactions done only send the money out of the country.
When money is not revolving around locally, there is a reduced circulation.
With little money in circulation, the economy suffers. This means that people will still not be able to make purchases.
The raw material importer will go ahead and manufacture more products but there will be no-one to buy.
His business will thus suffer just as it had before the fiscal policy came into effect.
At the end of the day, very little change will be experienced.
Often suffers from political influence.
The biggest hurdle a fiscal policy will have to pass is not realizing the benefit it seeks to bring. It is the political fighting that will rage around it.
Being a tool in the hands of the sitting government, the opposition will be readily available to throw accusations and condemnations.
As if that is not enough, there will also be some among the government who will not agree with the policy as it is.
These may cause a bigger problem as they will essentially be on the side of the opposition.
Although politicians will normally be aware that the people are suffering, they will often engage in politics.
This will always create a delay in the drafting, publishing and implementation of the policy.
ADVANTAGES OF USING MONETARY POLICY
The monetary policy is the other tool available for making changes in the country’s economy.
Controlled by the central bank, this policy has its own way of dealing with the economy. Instead of touching on taxes, it goes for lending rates and money circulation.
Here are some benefits from using it.
Controlling interest rates controls inflation.
Interest rates and inflation are closely connected. Inflation is the rate at which the price for goods and services rises. Interest rate is the percentage of money charged for every loan taken.
You can look at it as the cost of borrowing.
When the Central Bank increases or reduces the interest rate, inflation will soon show the impact.
For example, the inflation rate may be rising steadily such that it needs to be dealt with. The Central Bank will then come up with a policy of dealing with it through the interest rate.
A high inflation rate means higher prices of essential goods and services. If goods and services are expensive, then most people are not able to afford them. This points to a high cost of living.
This therefore means that the higher the inflation, the more expensive life is.
And if life is expensive, then economic growth is minimal.
What does the Central Bank do?
When the interest rate is lowered, banks will be able to issue loans to more people.
Money will be more readily available. Businesses will be able to expand.
Farmers will be able to get farm supplies more easily. And with money being available, then it is readily spent.
With more money, people will be able to afford what they need—even want.
With needs being met, the cost of life goes down. And with the cost of life going down, inflation reduces.
The independence of the Central Bank keeps politics away.
The Central Bank is usually independent and functions without political influences. It is a politically-neutral body.
As such, implementing a policy will not take unnecessarily long as there are no politicians seeking to win the masses through a regulation. Not being open to politicians also keeps the Central Bank professional.
This is what will ensure that whatever policy the Central Bank makes, it is based on knowledge and research. Being an independently-run body means that it is possible that many economists are working there.
Being experts in economy matters, these can be trusted to point the nation in the right direction.
This is very different from what happens with the fiscal policy.
Can boost exports by undervaluing the local currency.
The kind of action taken by the Central Bank can have the effect of lowering the value of the local currency. This will happen as a result of boosting the circulation of money.
Alternatively, the decision taken may be to reduce the interest rates. Lower interest rates mean that many people can take loans.
As such, there will be free and easy availability of money. With more money freely-flowing, the value of the currency will most likely drop.
In the international market, when a currency is of a lower value, the products coming from that country are cheaper to buy.
Therefore, if there are similar products from a country with a strong currency and another with a weaker one, the weaker currency will make the products attractive for purchase.
The businesses which export products will experience a surge in sales.
Unfortunately, the opposite effect will be experienced by those who import goods.
The weaker currency will mean they have to spend more to buy the material they need.
DISADVANTAGES OF USING MONETARY POLICY
The monetary policy also has disadvantages.
The opponents of these policies will advocate against them on the basis of these disadvantages. Some are:
Are general in nature and affect all areas of the economy.
Unlike a fiscal policy which can target a specific sector of the economy, monetary policies are general.
Once implemented, they affect everyone; those suffering and need help as well as those already doing well, having no problem with the economic status.
When an interest rate is increased for example, everyone in the nation will experience it.
As long as you intend to borrow money, you will have to bear the heavier burden.
This will be the case even in a section of the country where the economy is experiencing slow growth.
At the same time, parts of the country may need more economic stimulus than others.
In this case, the monetary policy will not be able to help out. The implementation will put everyone at the same level.
Consider a situation whereby state A has 30% unemployment, state B has 10% and state C has 2%.
In an attempt to help business which can expand to states A and B to create employment, interest rates may be reduced.
Considering other business factors such as taxation in individual states, reducing interest rates may not help at all.
The overall cost of doing business in state A may be prohibitive.
Unless this factor is looked at, businesses may still find it challenging to set up shop in that state.
As such, the move which may have worked for state B, fails to make an impact in state A.
Risk of hyperinflation.
When more money is released into the economy, there is a risk of inflation getting out of control. This can come about due to the over-supply of money when the demand for it remains the same.
This causes the value of the money to go down.
Products and services will become more expensive as you need more money to cover for the difference.
For example, the value of $1 may reduce by half. If there was a meal you used to buy at $5, this money now becomes worth $2.5. You will then be required to have $10 so as to reach the value of $5.
A similar situation can result from interest rates being reduced too low. This has the effect of making people borrow more money. With more money in their hands, the value of the money can easily reduce.
With money being of low value, manufacturers will spend more money to buy raw materials and pay their workers. These costs add to the cost of production.
This makes the final product high yet the money in people’s hands is of little value.
Takes time to have an impact.
Monetary policies take some time for their impact to be felt in the economy at the national level. This duration may be anything from months to a few years.
This can be a disappointment for the people who desire to see the changes sooner than later.
It has been argued that monetary policies have no real long-term effect other than raising the prices of commodities.
The expected economic boost, which is what everyone looks forward to, may not be realized.
This argument downplays the role the policy can play in shaping the economy of a nation.
All in all, between these two policies, fiscal and monetary, the best results come from a balanced use of both.
Coming from different sources, they can both be used to control the economy so as to avoid either an over-expansion of the economy or a recession.