Definition of fiscal and monetary policy

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Definition of fiscal and monetary policy
Loose monetary policy causes booms in asset prices. (economy image by Madera from Fotolia.com)

Fiscal and monetary policy are two distinct economic tools used by governments or national banks as part of a nation's overall economic strategy. Fiscal policy relates to the government's own account balance -- the money raised through tax revenue and other means against money spent by government. Monetary policy relates to measures to control the supply of money in the economy.

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Fiscal policy

Fiscal policy is the instrument whereby a government can produce effects in the economy through decisions on taxing and spending. When spending outstrips revenue over a defined period, a budgetary deficit occurs. When revenue exceeds spending, the result is a budget surplus. Fiscal policy can be used to stimulate economic growth. Cutting taxes, with the aim of encouraging employment and increasing productivity, is an example of fiscal policy at work.

Monetary policy

Monetary policy is the instrument whereby a government controls the supply of money and the cost of borrowing money through interest rate changes. Cutting interest rates -- the cost of money -- increases borrowing and the supply of money in the economy. Raising interest rates has the opposite effect. Importantly, changes in the cost of money affect its exchange value measured against other currencies. A change in the exchange value measured against the currencies of trading partners can stimulate or depress a country's export market.

Effectiveness of monetary policy

Monetary policy is a more effective tool for economic stimulus than fiscal policy under a floating exchange rate system, in other words, a system in which the currencies of trading countries can increase or decrease in value. For example, if a government attempts to stimulate economic growth by reducing the cost of money (cutting interest rates), the resulting effect on the exchange rate -- reducing it against other currencies -- will stimulate exports while making imports more expensive. This adds impetus to the intended economic stimulus.

Effectiveness of fiscal policy

Attempting to stimulate the economy, through fiscal policy, requires an increase in government spending and therefore an increase in the budget deficit. The resulting increase in interest rates -- the cost of money -- raises the cost of producing goods, causing higher prices and thereby making goods harder to export. This has a depressing effect on exports as opposed to imports, and thus works against economic stimulus. However, where a common market of countries trading with each other agrees on a fixed exchange rate (or, as in the case of the European Union, shares a common currency), fiscal policy is actually more effective at promoting economic growth than monetary policy. This is because, if using monetary policy to reduce the cost of money has no effect on the exchange rate, it does nothing to stimulate exports and discourages imports.

Responsible institutions

A combination of fiscal and monetary policy is generally used to steer the economy in a desired direction. Although governments direct fiscal policy, many countries delegate responsibility for monetary policy to central banks. This strategy prevents governments from manipulating interest rates for short-term political advantage and promotes stability in the money supply as well as in the price of goods. In the United Kingdom, monetary policy is the remit of the Bank of England; in the United States, this role is played by the Federal Reserve; in the European Community, the European Central Bank takes this position.

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