Monetary policy and fiscal policy represent two differing approaches by governments to manage their nation's economies. Fiscal policy uses the government's budget and its power to tax and spend as tools of economic management, while monetary policy involves the control of the nation's money supply by a central bank, such as the U.S. Federal Reserve. As a means of managing the economy, monetary policy has certain advantages over fiscal measures.
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Governments enact fiscal policy by increasing or reducing government spending, or by raising or cutting taxes. Fiscal policy affects the economy-wide demand for goods and services, according to Harvard economist Gregory Mankiw, author of "Principles of Economics." Central banks make monetary policy by trading in government bonds, setting short-term interest rates and regulating banking reserve requirements. Monetary policy's goals include a stable price system and sustainable economic growth.
One of the most important advantages of monetary policy over fiscal policy is its applicability in a strong or a weak economy. The Federal Reserve Bank of San Francisco notes that when inflation becomes a threat in a strong economy, central banks can enact contractionary measures to reduce the money supply and control inflationary pressures. In a weak economy, expansionary monetary policy can reduce interest rates and inject more money into the economy to stimulate lending and consumer spending.
While fiscal policy can be expansionary or contractionary, governments generally enact fiscal policy only to stimulate the economy during a downturn, the San Francisco Fed points out. For example, the government under President Franklin Roosevelt employed extensive fiscal measures to stimulate the U.S. economy during the Great Depression. In 2009, Congress enacted President Barack Obama's economic stimulus program, a package of spending increases and tax cuts, to stimulate the economy out of a recession triggered by the 2008 financial crisis.
Another advantage of monetary policy over fiscal policy is the ability of central bankers to respond immediately to economic problems. Monetary policy can respond more quickly to changing economic conditions, the San Francisco Fed says. In addition, because Federal Reserve policymakers meet regularly throughout the year, they can quickly undo previous actions if changes in the economy warrant doing so. Fiscal measures, meanwhile, take much longer to enact and implement.
Another benefit of monetary policy is that it faces less political pressure than fiscal policy does. Although the president appoints Federal Reserve board members, the board enjoys a high degree of independence. Meanwhile, members of Congress must consider re-election prospects and other political consequences when enacting fiscal policy. Political pressures may bias Congress against spending cuts or tax hikes. This reduces the flexibility of fiscal policy, rendering it largely an economic stimulus tool.
By increasing government purchases of goods and services, fiscal policy may overstimulate the economy and trigger inflation. Mankiw warns that fiscal policy may create a "crowding out" effect in which government spending leads to higher interest rates, reducing private sector investment. Ironically, excessive stimulation through fiscal policy may require contractionary monetary policy actions to counter the inflationary effects.
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