What are the Differences Between Fiscal and Monetary Policies in Managing Economic Growth?
Jean-Baptiste WAUTIER
Wautier Family Office | Lecturer at ScPo Paris | Contributor to Les Echos & Project Syndicate | Private Investor | WEF Speaker | Philanthropist
Economic statistics matter. They are the metric by which we measure our progress as a society. If that seems a stretch, consider the following.
Economic growth might seem like an abstract concept sometimes. However, it is a vital indicator of a nation’s prosperity and stability. It tells us about the increase in the production of goods and services over time. If that increase is sustainable and built on solid foundations, it can lead to higher income levels, improved living standards, and enhanced economic opportunities for citizens.
In an environment where those things exist, desirable outcomes like reduced poverty, fulfilling and productive employment, and social cohesion are achievable.
Fiscal and monetary policy are the two primary tools available to governments and policymakers to facilitate and nurture economic growth, particularly in the context of globalization.
Understanding these tools and, perhaps more importantly, the differences between them is essential for comprehending how economic growth is managed. These policies interact complexly but are distinct in their objectives and impacts.
This piece will delve into the specifics of fiscal and monetary policies, examining their roles and impacts on economic growth. By clearly defining and exploring these concepts, the aim is to provide a comprehensive understanding of how these critical tools are employed to foster sustainable economic growth and, by extension, to encourage the positive externalities that can result from that growth.
Defining Fiscal Policy
Fiscal policy refers to the government’s strategies for influencing the economy through spending and taxation decisions. It involves allocating government budgets and implementing tax policies designed to manage economic activity.
Fiscal policy’s primary goals are to stimulate economic growth and reduce unemployment. These are often central concerns for voters in liberal democracies, so aligning them with the choices of their elected representatives makes sense.
The government aims to influence overall economic demand by adjusting spending and taxation levels. Increased government spending and tax cuts can boost aggregate demand during economic downturns, encouraging production and investment. This, in turn, helps to reduce unemployment by creating jobs and funding public projects and services. Conversely, reducing government spending or increasing taxes can cool down the economy, reduce excess demand, and stabilize prices during periods of excessive inflation.
Several fiscal policy tools, including government budgets, tax policies, and public expenditures, can be adopted to attain the desired results.
Defining Monetary Policy
Monetary policy has less visible effects. While a government spending announcement delivered as part of an annual budget or tax cuts might be immediately evident to citizens, the role of monetary policy is more subtle.
Monetary policy involves regulating the money supply and interest rates by a nation’s central bank or a bloc of nations (e.g., the European Union). It is a crucial mechanism for managing the economy that influences the availability and cost of money.
In most Western democracies, monetary policy’s goals are to control inflation and achieve full employment. Central banks can influence economic activity by adjusting the money supply and interest rates.
Controlling inflation is essential to prevent purchasing power erosion and maintain economic confidence. Achieving full employment ensures that the labor market is robust, with minimal unemployment, supporting the economic health of the host economy overall.
The central bank employs several tools to implement monetary policy effectively:
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Key Differences Between Fiscal and Monetary Policy
The most fundamental difference between fiscal and monetary policy is who makes the decisions.
Fiscal policy is crafted and implemented by elected representatives who form the government of the day. Political processes and negotiations influence policy.
In contrast, monetary policy is managed by a country’s central bank. Central banks are intended to operate independently of the government to ensure objective and non-political management of the economy. This independence is crucial for maintaining credibility and avoiding political interference in monetary decisions. Some argue that central bank independence is eroded at different times, with political imperatives influencing central bank decision-making.
A further difference may be found when analyzing the different tools utilized to influence the economy. Fiscal policy primarily involves government spending and taxation. Adjusting spending on public services and social programs and modifying tax rates gives the government levers that it can use to directly influence economic activity and aggregate demand.
On the other hand, monetary policy focuses on regulating the money supply and controlling interest rates. Central banks use tools such as setting benchmark interest rates, adjusting reserve requirements for commercial banks, and conducting open market operations. These mechanisms share a common feature: they influence the cost and availability of money, impacting borrowing and lending decisions from private sector market participants.
Another key difference is speed and flexibility. Fiscal policy changes often require legislative approval, making the process slower and subject to political debate and negotiation. This can delay the implementation of fiscal measures. However, once enacted, fiscal policy tends to affect the economy more immediately. Government spending on infrastructure projects or social programs can quickly stimulate demand and create jobs. Similarly, changes in tax policy can immediately affect disposable income and consumption patterns.
In contrast, monetary policy can be adjusted more quickly but typically has more delayed observable effects. Central banks can promptly respond to economic changes and emerging issues by altering interest rates or conducting market operations. However, changes in interest rates or the money supply can take time to permeate the economy. This is sometimes referred to as the “transmission mechanism.” For example, altering interest rates influences borrowing and lending behaviors, subsequently impacting investment and consumption over extended periods.
Fiscal and Monetary Policy in Practice
Classical economic theories and their evolution provide an instrumental foundation for understanding the fiscal and monetary tools we use today. Classical economics, as represented by Adam Smith’s ideas and later developed by economists such as David Ricardo and John Stuart Mill, emphasized the importance of free markets, limited government intervention, and balanced budgets.
However, the Great Depression of the 1930s challenged these classical views and led to the development of the ideas of John Maynard Keynes. He argued for active government intervention to manage economic cycles, particularly during recessions. Keynesian theory posited that fiscal policy, through increased government spending and lower taxes, could stimulate demand and pull economies out of depression. This marked a significant shift in economic thought and laid the groundwork for modern fiscal policy.
A fiscal deficit occurs when a government’s expenditures exceed its revenues. Many economies run budget deficits. The rationale behind running deficits is often to stimulate economic growth, especially during periods of economic downturn or stagnation. Governments increase spending on infrastructure, social programs, and other public services to boost demand and create jobs. Simultaneously, tax cuts are implemented to increase disposable income and encourage consumption.
The post-World War II era saw a significant expansion of government involvement in the economy. This trend continued through the latter half of the 20th century and into the 21st century. Deficits are now a common feature of economic management. But no action is without consequence. While these policies have supported economic growth, they have also led to substantial public debt in many countries.
Pro-cyclical monetary policies align with the economic cycle. For example, lowering interest rates during economic downturns stimulates borrowing and spending, while raising rates during periods of growth helps control inflation. Reduced interest rates make borrowing cheaper, encouraging businesses to invest and consumers to spend. This monetary stimulus complements fiscal measures to amplify their impact on economic activity.
Current Economic Challenges
An earlier section alluded to the concept that no action is without consequence. One clear and obvious consequence of the current fiscal and monetary policy experiment that has been run across the Western world is a mountain of debt. Most Western democracies now face the challenge of how to address unsustainable debt levels amid a return to more normalized interest rates.
The government revenue consumed by servicing the interest bill on national debt is growing at incredible rates. Each dollar consumed for this purpose cannot be directed towards other priorities like healthcare and services.
On the fiscal side of the ledger, governments must first recognize this reality and then educate their citizens on the imperative to reduce deficits to avoid losing the option to invest revenue in desirable programs. On the monetary side of the ledger, central banks must assert their independence to manage inflation and stabilize the economy effectively. Central banks need autonomy to make unbiased decisions, be free from political influence, maintain credibility, and implement measures that promote long-term economic health.
Evolving Roles and Responsibilities
It is tempting to think of institutions such as central banks as fixed and unchanging. However, this cannot be true because it is based on the incorrect assumption that our societies and economies are static. Institutions are built to serve the societies and economies that they exist within. Therefore, central banks must evolve to reflect the world in which they operate and the citizens they serve.
The most obvious way to achieve this is to correct the “accountability deficit” at these institutions. Central banks are run primarily by technocrats and economists. They are unelected. But in that framework, accountability is lacking. Steps need to be taken to make the decision-makers for these economy-shaping decisions accountable for their actions.
It is also well past time to broach the topic that the world’s most powerful central banker, Jerome Powell, has identified, but it is currently being ignored. He referred to the need for an “adult conversation” about the debt levels being borne by nations and their taxpayers. The current fiscal path has the West in a situation where the national debt is growing faster than the economy. The conversation about how to correct this needs to begin immediately, and it must end with a viable pathway to a sustainable fiscal future where future generations aren’t forced to pay the bill that this one has incurred.
Cohesion Between Fiscal and Monetary Policy
The potential for true cohesion between fiscal and monetary policies lies in their coordinated implementation to achieve overarching economic goals. When these policies are aligned, they can complement each other, enhancing their effectiveness.
Effective management of economic growth requires a delicate balance between fiscal and monetary policies. During a recession, accommodative monetary policy can bolster expansionary fiscal policy, resulting in a more robust economic recovery. Conversely, in times of inflationary pressure, restrictive fiscal measures paired with tighter monetary policy can help cool down an overheating economy. However, the inverse is also true. At a time of rising inflation and strained household budgets, contractionary monetary policy to address that problem can be undermined by populist spending and taxation measures that increase the money supply in the economy.
There are notable instances where coordinated fiscal and monetary policies have successfully managed economic challenges. During the 2008 financial crisis, the United States implemented significant budgetary stimulus through the American Recovery and Reinvestment Act. The Federal Reserve simultaneously pursued an aggressive monetary policy, including lowering interest rates and implementing quantitative easing.
Key Takeaways
Understanding fiscal and monetary policy distinctions is essential for effective economic management. Fiscal policy, set by governments, utilizes spending and taxation to influence demand directly. Monetary policy, controlled by central banks, manages the money supply and interest rates to stabilize the economy. Each policy plays a crucial role in achieving economic goals that range from stimulating growth and reducing unemployment to managing inflation.
Fiscal policy often involves more extended implementation due to legislative processes, while monetary policy can be adjusted more swiftly to address immediate economic conditions. Once implemented, fiscal policy tends to have a more immediate impact, while monetary policy takes more time to transmit through the economy. Both policies require careful coordination to achieve optimal outcomes, and one can undermine the effectiveness of the other if it is done ineffectively.
Understanding these principles and their implications is equally crucial for policymakers, economists, and citizens alike if we are to be partners in shaping stable, prosperous economies that effectively serve the needs of their citizens.