Comparing Monetary and Fiscal Policy

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The Similarities Between Monetary and Fiscal Policy

Close-up of a financial paper
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Macroeconomists generally point out that both monetary policy — using money supply and interest rates to affect aggregate demand in an economy — and fiscal policy — using the levels of government spending and taxation to affect aggregate demand in an economy- are similar in that they can both be used to try to stimulate an economy in recession and rein in an economy that is overheating.  The two types of policies are not entirely interchangeable, however, and it's important to understand the subtleties of how they differ in order to analyze what type of policy is appropriate in a given economic situation.

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Effects on Interest Rates

Fiscal policy and monetary policy are importantly different in that they affect interest rates in opposite ways.  Monetary policy, by construction, lowers interest rates when it seeks to stimulate the economy and raises them when it seeks to cool the economy down.  Expansionary fiscal policy, on the other hand, is often thought to lead to increases in interest rates.

To see why this is, recall that expansionary fiscal policy, whether in the form of spending increases or tax cuts, generally results in increasing the government's budget deficit.  In order to fund the increase in the deficit, the government must increase its borrowing by issuing more Treasury bonds.  This increases the overall demand for borrowing in an economy, which, as with all demand increases, leads to an increase in real interest rates via the market for loanable funds.  (Alternatively, the increase in the deficit can be formulated as a decrease in national saving, which again leads to increased real interest rates.)

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Differences in Policy Lags

Monetary and fiscal policy are also differentiated in that they are subject to different sorts of logistical lags.

First, the Federal Reserve has the opportunity to change course with monetary policy fairly frequently, since the Federal Open Market Committee meets a number of times throughout the year.  In contrast, changes in fiscal policy require updates to the government's budget, which needs to be designed, discussed, and approved by Congress and generally happens only once per year. Therefore, it could be the case that the government could see a problem that could be solved by fiscal policy but not have the logistical ability to implement the solution.  Another potential delay with fiscal policy is that the government must find ways to spend that begin a virtuous cycle of economic activity without being overly distortionary to the long-run industrial composition of the economy.  (This is what policy makers are complaining about when they bemoan a lack of "shovel-ready" projects.)

On the upside, however, the impacts of expansionary fiscal policy are pretty immediate once projects are identified and funded.  In contrast, the effects of expansionary monetary policy can take a while to filter through the economy and have significant effects.