Fiscal policy relates to government spending and revenue collection. For example, when demand is low in the economy, the government can step in and increase its spending to stimulate demand. Or it can lower taxes to increase disposable income for people as well as corporations.
Monetary policy relates to the supply of money, which is controlled via factors such as interest rates and reserve requirements (CRR) for banks. For example, to control high inflation, policy-makers (usually an independent central bank) can raise interest rates thereby reducing money supply.
These methods are applicable in a market economy, but not in a fascist,communist or socialist economy. John Maynard Keynes was a key proponent of government action or intervention using these policy tools to stimulate an economy in recession.
Fiscal policy is the use of government expenditure and revenue collection to influence the economy.
Monetary policy is the process by which the monetary authority of a country controls the supply of money, often targeting a rate of interest to attain a set of objectives oriented towards the growth and stability of the economy.
Manipulating the level of aggregate demand in the economy to achieve economic objectives of price stability, full employment, and economic growth.
Manipulating the supply of money to influence outcomes like economic growth, inflation, exchange rates with other currencies and unemployment.
Government (e.g. U.S. Congress, Treasury Secretary)
Central Bank (e.g. U.S. Federal Reserve or European Central Bank)
Taxes; amount of government spending
Interest rates; reserve requirements; currency peg; discount window; quantitative easing; open market operations; signalling
Contents: Fiscal Policy vs Monetary Policy
1 Policy Tools
1.1 Fiscal policy
1.2 Monetary policy
2 Videos comparing fiscal and monetary policy
The supply-demand model
Both fiscal and monetary policy can be eitherexpansionary or contractionary. Policy measures taken to increase GDP and economic growth are called expansionary. Measures taken to rein in an "overheated" economy (usually when inflation is too high) are called contractionary measures.
The legislative and executive branches of government control fiscal policy. In the United States, this is the President's administration (mainly the Treasury Secretary) and the Congress that passes laws.
Policy-makers use fiscal tools to manipulate demandin the economy. For example:
Taxes: If demand is low, the government can decrease taxes. This increases disposable income, thereby stimulating demand.
Spending: If inflation is high, the government can reduce its spending thereby removing itself from competing for resources in the market (both goods and services). This is a contractionary policy that would lower prices. Conversely, when there is a recession and aggregate demand is flagging, increased government spending in infrastructure projects would lead to higher demand and employment.
Both tools affect the fiscal position of the government i.e. the budget deficit goes up whether the government increases spending or lowers taxes. This deficit is financed by debt; the government borrows money to cover the shortfall in its budget.
Procyclical and Countercyclical Fiscal Policy
In an article for VOX on the tax cuts vs. stimulus debate, Jeffrey Frankel, Economicsprofessor at Harvard University has said that sensible fiscal policy is countercyclical.
When an economy is in a boom, the government should run a surplus; other times, when in recession, it should run a deficit.
[There is] no reason to follow a pro-cyclical fiscal policy. A procyclical fiscal policy piles on the spending and tax cuts on top of booms, but reduces spending and raises taxes…