The Differences Between Fiscal and Monetary Policy

Monetary policy is a way to control the amount of money that is flowing through an economy. It has been the most used type of growth tool since the 2008 global financial crisis. At that time, central banks lowered rates to spur banks to lend money and people to borrow money. When those plans failed, the central banks began quantitative easing programs to buy troubled assets or bonds. This was done to increase the amount of cash in circulation and achieve the same outcomes.

Fiscal stimulus is a way to control the economy by cutting spending and raising taxes. While there is a lot of debate on the topic, there’s little doubt that spending cuts and higher taxes lead to slower growth. These efforts could also harm monetary goals by undoing any gains made by them. Some experts think that this is why the global economy has failed to rebound to what it was before the 2008 crisis.

Learn about how these paths differ and how they can both be used in the right way to foster lasting economic growth.

Limits of Monetary Policy

The goal of monetary policy is to control the supply of money to promote stable job numbers, prices, and economic growth. Since it cannot control the economy in a direct way, there are limits to the power of this plan in meeting these goals.

A trap occurs when a central bank’s efforts to inject cash flow into an economy fails to lower rates and bring growth. Often, this occurs when people start to hoard money rather than spend it on goods and services. These actions tend to push short-term rates toward zero as prices remain stagnant. When that happens, central banks have few options left to combat the issue.

Deflation occurs when the rate of inflation falls below zero and brings up the value of real money over time. Since prices are falling, people tend to hoard more cash and make the problem worse over time in what’s called a "deflationary spiral." Deflation also increases the real value of debt and may lead to a recession as people and businesses struggle to repay debt and insist on saving cash and investing in capital.

Fiscal Stimulus vs. Austerity

The goal of fiscal policy is to adjust government spending and tax rates to promote the same goal as monetary policy—a stable and growing economy. Like monetary plans, fiscal plans alone can’t control how well the economy does.

Fiscal stimulus is the attempt to increase spending to bring about growth. In most cases, this increase in spending makes the growth rate of public debt go up. It is hoped that when the economy gets better, the gap will be filled. Governments acting to improve things may also decide to lower tax rates to put more cash into people's pockets to spur them to spend more.

Austerity is the opposite process. It occurs when a government cuts back on spending and increases taxes to reduce debt and improve its financial footing. Often, austerity results in a decrease in economic growth as people and businesses spend more money on taxes and rely less on government projects or jobs as a money source. These measures are often done by third-party creditors looking to ensure that debts owed to them are paid.

Conflicts in Policies

At times, fiscal policy runs in contrast to monetary policy, even more so during times of great economic worry. After a downturn occurs, central banks often try to fix things by making capital easier to get. A fiscal policy might take an approach of reining in government spending and raising taxes. That can hamper spending by people and offset any effects that arise from other growth efforts.

Governments may take these actions to improve public finances or meet the demands of banks and creditors. For instance, Greece was forced into fiscal austerity by its European creditors, which ended up slowing its growth rates. This action ran contrary to—and canceled out—the European Central Bank’s low-interest-rate plan that was used to improve growth in the Eurozone.

Most economists agree that a mix of pro-growth monetary and fiscal policy is needed to truly support growth.

The Bottom Line

Monetary and fiscal policy are the most used tools for maintaining a healthy economy over time. While these plans have the same goals, they do not always run on the same paths. Monetary plans may bring growth through low rates, but fiscal plans may hurt growth through higher taxes and reduced public spending. The end result is that these efforts may end up canceling each other out.