Have you ever noticed that many news sources, financial journalists and economists throw the terms 'fiscal policy' and 'monetary policy' around without ever explaining them?
They always assume that you’ll know what they’re talking about and that the difference is clear.
But this simply isn’t the case for most people. So, to make things easier for you, we’re going to lay it all out on the table and show you the ingredients that make up fiscal and monetary policies.
What do monetary policies and fiscal policies do?
As a quick overview, these are the key tools that are used to influence economic activity – either helping to curb or encourage growth. Both fiscal and monetary policy can be used to help stabilise the economy in a time of crisis or stimulate growth if the economy becomes stagnant.
While they can be used individually, when used together the impact they can have on the economy, businesses and consumers can be extremely powerful.
As a general rule of thumb, monetary policy is managed by a central bank, whereas fiscal policy tends to be determined by government legislation.
*Note: Before we get into too much detail, it’s worth sharing two terms that are used in conjunction with these policies – 'expansionary' and 'contractionary'. While they are jargon, they do mean what they say. Expansion is to encourage growth, while contraction is reigning it in.
What is monetary policy, and how does it work?
The simplest definition of monetary policy is the action that a central bank takes to manage its money supply to achieve an economic goal.
Central banks have a variety of tools at their disposal. For example, they can reduce or increase interest rates, influence bank reserve requirements, and even control the number of government bonds that banks need to hold. All of these will impact how much banks can lend, which directly affects the money supply.
There are three main reasons that monetary policy is used:
- Controlling inflation
- Managing employment levels
- Maintain long term interest rates
But how does it work? Well, there are two main types of monetary policy – expansionary and contractionary – which work against each other to tip the balance one way of the other. For example, expansionary monetary policy works to lower unemployment and help avoid a recession by giving banks more money to lend and lowering interest rates. This makes loans cheaper and means that businesses and consumers tend to borrow more.
On the other hand, the contractionary policy will work to reduce inflation by restricting how much the banks can lend, leading to less borrowing and slower growth.
Most central banks have a target inflation goal – the Bank of England set the UK’s as 2% - and they will use both expansionary and contractionary monetary policies to try and match this target.
What is fiscal policy, and how does it work?
Fiscal policy is how the government influence the economy through spending and taxation. Unlike monetary policy, fiscal policy has one goal, which is to influence ‘healthy’ economic growth. This isn’t a set target and is more of a Goldilocks’, and the bears approach – not too fast and not too slow.
Unlike central banks, fiscal policy has two main tools that they can use – taxes and spending – but how they use these tools is the difference between expansionary and contractionary policy. However, these two tools are often linked to government policy and so can become a political discussion.
Expansionary policy is when the government either spends more, cuts taxes, or both, putting more money into consumers’ pocket and encouraging them to spend more, which in turn increases business demand and creates job opportunities.
The other side of the coin is contractionary fiscal policy, which is rarely used but will see increased taxes and reduces spending to slow economic growth and reduce inflation.
What is the difference between monetary and fiscal policies?
As mentioned above, there are quite a few and differences, which can be easier to understand when all laid out and directly compared to each other.
It’s worth pointing out that monetary policy is generally a lot faster to act, as it requires less discussion and can deliver an impact almost immediately. In contrast, fiscal policy can take time to agree on and for the effects to be felt within the economy.
That said, the financial markets can react to how fiscal policy is being used – for example, infinite quantitative easing during the coronavirus pandemic helped to provide some reassurance to investors, which saw the markets begin to stabilise.
Both monetary and fiscal policies have a direct impact on a country’s economy, although the tools and processes they use to achieve it are very different.
When implemented, the effects are felt both on a personal level – within household finances – and on a larger level, with commercial lending.
Do monetary and fiscal policies work together?
Yes, ideally, monetary and fiscal policies would work together, but that’s not always the case. Because government leaders determine the fiscal policy, and it often forms a part of their election portfolio, the use of fiscal policy becomes a political discussion.
It can even hinder monetary policy if not used in conjunction with it. When this happens, the economy becomes more reliant on central banks to increase their money supply and lower inflation.
However, when the two policies do work together, they can deliver significant effects at a much faster rate.
As there is a lag between a fiscal policy being put in place and the effects being felt, monetary policy can help to kick things off, with the full force of both policies coming into play later on. Acting in this way can help reassure financial markets and bolster the short to medium-term outlook.
With investing, your capital is at risk, so the value of your investments can go down as well as up, which means you could get back less than you initially invested.