Policy making is an important function of every country’s government as well as of its organizations. It involves putting in place a plan or framework of decisions to guide government itself and its organizations in taking actions towards the achievement of certain objectives. Policies are set around core matters of public interest such as economics, public education, culture, foreign affairs, law, agriculture etc. and they generally contain guidelines, rules and even legislations and regulations. Setting effective policies is important as it sets the foundation for governmental actions as well as serves as a monitoring benchmark for the same.
This article looks at meaning of and differences between two types of economic policies – monetary policy and fiscal policy.
Definitions and meanings
Monetary policy is a macroeconomic policy which is aimed at regulating the supply and flow of money in a country’ economy. It is generally formulated by the central bank of the country and is directed towards controlling economic growth and maintaining economic stability in the country. Examples of central banks that prepare and announce monetary policies include Federal Reserve System of USA, Reserve Bank of India and State Bank of Pakistan.
Based on its central objective, a monetary policy can be either contractionary or expansionary in nature. It is said to be contractionary when its purpose is to control inflation by restricting money supply. When, on the other hand, the purpose is to boost growth by increasing money supply in the economy, the policy is named as expansionary monetary policy.
The objective of either controlling inflation or boosting growth is achieved by applying several tools in the monetary policy. These primarily include the following:
(a). Open market operations:
This involves buying or selling of short-term government bonds by the central bank. If the monetary policy is intended to increase supply of money in the economy, the central bank can buy the government bonds from commercial banks operating in the country. This action increases the money available with banks and, hence, increases its circulation in the economy. On the other hand, if the monetary policy is looking to curb inflation by decreasing the supply of money in the country, the central bank sells these bonds to commercial banks. This action decreases the cash flow and reserves with bank and, in turn, reduces the availability of money in the economy.
(b). Modification of interest rates:
The central banks charge an interest on the money they lend to commercial banks. They often modify their interest rate and use it as a tool for controlling the supply of money in the country. When the central bank of a country intends to boost the money supply, it lowers its interest rate and when it intends to restrict the same, it raises its interest rate on the money lent to banks.
(c). Banking reserve requirements:
The central banks in many countries require commercial banks to hold certain percentage of their deposits as reserve, either in their vault or at the central bank. The reserve requirement is basically imposed to make sure that the commercial banks are able to honor the possible withdrawal requests made by their depositors. However, a central bank, on its disposal, can use this mandatory reserve requirement as a tool to influence money supply in the economy. For example, It can lower the reserve requirement to make more money available with banks, which, in turn, would increase the money supply in the economy. On the other side, a higher reserve requirement would reduce the money available with banks and, hence, its supply in the economy.
Fiscal policy is a central government policy that lays out the government’s plan for its revenues and expenses for the period, directed towards managing economic development in the country. The government is generally responsible for managing its finances as well as promoting economic development in its country. For this, it collects revenues from public in the form of various direct and indirect taxes and spend the same on public welfare . All these activities are managed by the government through formulating a fiscal policy.
The annual fiscal policy typically sets out estimates of tax collection during the period as well as government spending, bifurcated across public projects from infrastructure and health to employment generation and general public welfare.
Like monetary policy, a government’s fiscal policy can be expansionary or contractionary in nature, depending on its objectives. An expansionary fiscal policy is aimed at boosting growth by increasing availability of money with the public. This can be done by reducing taxes or increasing expenditure on public works. A contractionary fiscal policy, on the other hand, is mainly focused on reducing inflation by decreasing availability of money with the public. This can be achieved by raising various tax rates, imposing new taxes or reducing expenditure on public works etc.
A fiscal policy also details whether a fiscal surplus or fiscal deficit is expected. It is generally set out annually and is implemented by means of various legislations and sub-policies.
Difference between monetary and fiscal policy
The seven key points of difference between monetary and fiscal policy have been listed below:
- A monetary policy is a macroeconomic policy that seeks to regulate the supply of money in the economy, so as to control economic and price growth in the country.
- A fiscal policy is a macroeconomic policy that sets out budgeted tax revenues and targeted spending of the government that can impact economic development at large.
2. Drafted and announced by
- A monetary policy is formulated and announced by the central bank of the country.
- A fiscal policy is formulated and announced by the central government through its finance ministry.
- The purpose of a monetary policy is to regulate flow of money in the economy to control economic growth and stability.
- The purpose of a fiscal policy is broader and includes setting out various means directed towards the country’s economic development.
- The tools applied by a monetary policy include buying and selling of government securities, modification of interest rates and bank reserve requirements.
- Government taxes and government spending are the primary tools that are employed by the fiscal policy for furthering its objectives.
5. Frequency of declaration
- A monetary policy can be modified and declared several times in a fiscal year – typically announced each quarter.
- A fiscal policy is generally prepared annually for a fiscal year.
- A monetary policy is a sub set of fiscal policy with a narrower scope, generally limited to controlling the flow of money.
- A fiscal policy has a wider scope and includes several aspects that impact economic development of the country.
- A monetary policy enlists actual action and thus represents actual policy implementation.
- A fiscal policy is more of a plan of action and is subsequently implemented through several other policies and legislations at micro level.
Both monetary and fiscal policy are important tools in the hands of government and its organizations to control finances of the country. Without an appropriate fiscal policy in place, long-term economic development of the country will suffer. At the same time, an inappropriate monetary policy can severely impact liquidity in the economy. Thus, both these policies need to be suitably drafted, monitored and implemented to achieve holistic economic growth and development of the country.