Fiscal Policy vs. Monetary Policy: Pros and Cons

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 stimulate the economy, a government will cut tax rates while increasing its own spending; while 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.

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

An Overview 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.

Fiscal Policy Pros and Cons

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.