Fiscal Policy vs. Monetary Policy: Pros & Cons
By ADAM HAYES
Updated Mar 26, 2020
TABLE
OF CONTENTS
- An Overview
of Monetary Policy - Monetary
Policy Pros and Cons - Pros
and Cons of Fiscal Policy - The Bottom
Line
When it comes to
influencing macroeconomic outcomes, governments have typically relied on one of
two primary courses of action: monetary policy or fiscal policy.
Monetary policy
involves the management of the money supply and interest rates by central banks. To stimulate a faltering
economy, the central bank will cut interest rates, making it less expensive to
borrow while increasing the money supply. If the economy is growing too
rapidly, the central bank can implement a tight monetary policy by
raising interest rates and removing money from circulation.
Fiscal policy, on the other hand, determines
the way in which the central government earns money through taxation and how it
spends money. To assist the economy, a government will cut tax rates while increasing its own spending;
to cool down an overheating economy, it will raise taxes and cut back
on spending. There is much debate as to whether monetary policy or fiscal
policy is the better economic tool, and each policy has pros and cons to
consider.
KEY TAKEAWAYS
- Central banks use monetary
policy tools to keep economic growth in check and stimulate economies out
of periods of recession. - While central banks can be
effective, there could be negative long-term consequences that stem from
short-term fixes enacted in the present. - Fiscal policy are the tools
used by governments to change levels of taxation and spending to influence
the economy. - Fiscal policy can be swayed by
politics and placating voters, which can lead to poor decisions that are
not informed by data or economic theory. - If
monetary policy is not coordinated with fiscal policy enacted by governments,
it can undermine efforts as well.
An Overview of Monetary Policy
Monetary
policy refers to the actions taken by a country’s central bank to achieve
its macroeconomic policy objectives. Some
central banks are tasked with targeting a particular level of inflation. In the
United States, the Federal Reserve Bank (the Fed) has been established
with a mandate to achieve maximum employment and price stability. This is
sometimes referred to as the Fed’s “dual mandate.” Most
countries separate the monetary authority from any outside political
influence that could undermine its mandate or cloud its objectivity. As a
result, many central banks, including the Federal Reserve, are operated as independent
agencies.
When a country’s
economy is growing at such a fast pace that inflation increases to worrisome levels,
the central bank will enact restrictive monetary policy to tighten the money
supply, effectively reducing the amount of money in circulation and lowering
the rate at which new money enters the system. Raising the prevailing risk-free
interest rate will make money more expensive and increase borrowing costs,
reducing the demand for cash and loans. The Fed can also increase the
level of reserves commercial and retail banks must keep on hand, limiting their
ability to generate new loans. Selling government bonds from its balance
sheet to the public in the open market also reduces the money
in circulation. Economists of the Monetarist school adhere to the virtues
of monetary policy.
When a nation’s
economy slides into a recession, these same policy tools can be
operated in reverse, constituting a loose or expansionary monetary policy. In
this case, interest rates are lowered, reserve limits loosened, and
bonds are purchased in exchange for newly created money. If these
traditional measures fall short, central banks can undertake unconventional
monetary policies such as quantitative easing (QE).
Monetary Policy Pros and Cons
Pros
- Interest
Rate Targeting Controls Inflation
A small amount of inflation is healthy for a growing economy as
it encourages investment in the future and allows workers to expect higher
wages. Inflation occurs when the general price
levels of all goods and services in an economy increases. By raising the target
interest rate, investment becomes more expensive and works to slow economic growth a bit.
- Can Be
Implemented Fairly Easily
Central banks can act quickly to use monetary policy tools.
Often, just signaling their intentions to the market can yield results.
- Central
Banks Are Independent and Politically Neutral
Even if monetary policy action is unpopular, it can be
undertaken before or during elections without the fear of political
repercussions.
- Weakening
the Currency Can Boost Exports
Increasing the money supply or lowering interest rates tends to
devalue the local currency. A weaker currency on world markets can
serve to boost exports as these products are effectively less expensive for
foreigners to purchase. The opposite effect would happen for companies that are
mainly importers, hurting their bottom line.
Cons
- Effects Have
a Time Lag
Even if implemented quickly, the macro effects of monetary
policy generally occur after some time has passed. The effects on an economy
may take months or even years to materialize. Some economists believe money is
“merely a veil,” and while serving to stimulate an economy in
the short-run, it has no long-term effects except for raising the general level
of prices without boosting real economic output.
- Technical
Limitations
Interest rates can only be lowered nominally to 0%, which limits
the bank’s use of this policy tool when interest rates are already low. Keeping
rates very low for prolonged periods of time can lead to a liquidity trap. This tends to make monetary
policy tools more effective during economic expansions than
recessions. Some European central banks have recently experimented with
a negative interest rate policy (NIRP), but
the results won’t be known for some time to come.
- Monetary
Tools Are General and Affect an Entire Country
Monetary policy tools such as interest rate levels have an economy-wide
impact and do not account for the fact some areas in the country might not need
the stimulus, while states with high unemployment
might need the stimulus more. It is also general in the sense that monetary
tools can’t be directed to solve a specific problem or boost a specific
industry or region.
- The Risk of
Hyperinflation
When interest rates are set too low, over-borrowing at
artificially cheap rates can occur. This can then cause a speculative bubble, whereby prices increase
too quickly and to absurdly high levels. Adding more money to the economy can
also run the risk of causing out-of-control inflation due to the premise
of supply and demand: if more money is available
in circulation, the value of each unit of money will decrease given an
unchanged level of demand, making things priced in that money nominally more
expensive.
Pros and Cons of Fiscal Policy
Fiscal
policy refers to the tax and spending policies of a nation’s government. A
tight, or restrictive fiscal policy includes raising taxes and cutting back on
federal spending. A loose or expansionary fiscal policy is just the opposite
and is used to encourage economic growth. Many fiscal policy tools are based on
Keynesian economics and hope to boost aggregate demand.
Pros
- Can Direct
Spending To Specific Purposes
Unlike monetary policy tools, which are general in nature,
a government can direct spending toward specific projects, sectors or
regions to stimulate the economy where it is perceived
to be needed to most.
- Can Use
Taxation to Discourage Negative Externalities
Taxing polluters or those that overuse limited resources can
help remove the negative effects they cause while generating government
revenue.
- Short Time
Lag
The effects of fiscal policy tools can be seen much quicker than
the effects of monetary tools.
Cons
- May Be
Politically Motivated
Raising taxes is unpopular and can be politically dangerous to
implement.
- Tax
Incentives May Be Spent on Imports
The effect of fiscal stimulus is muted when the money put into
the economy through tax savings or government spending is spent on imports,
sending that money abroad instead of keeping it in the local economy.
- Can Create
Budget Deficits
A government budget deficit is when it spends more
money annually than it takes in. If spending is high and taxes are low for too
long, such a deficit can continue to widen to
dangerous levels.
The Bottom Line
Monetary and fiscal policy tools are used
in concert to help keep economic growth stable with low inflation, low
unemployment, and stable prices. Unfortunately, there is no silver bullet or
generic strategy that can be implemented as both sets of policy tools carry
with them their own pros and cons. Used effectively however, the net benefit is
positive to society, especially in stimulating demand following a crisis.