Monetary Policy vs. Fiscal Policy: What's the Difference?

Monetary Policy vs. Fiscal Policy: An Overview

Monetary policy and fiscal policy refer to the two most widely recognized tools used to influence a nation's economic activity. Monetary policy is primarily concerned with the management of interest rates and the total supply of money in circulation and is generally carried out by central banks, such as the U.S. Federal Reserve (Fed). Fiscal policy is a collective term for the taxing and spending actions of governments. In the United States, the national fiscal policy is determined by the executive and legislative branches of the government. 

Monetary Policy

Central banks typically use monetary policy to either stimulate an economy or to check its growth. By incentivizing individuals and businesses to borrow and spend, the monetary policy aims to spur economic activity. Conversely, by restricting spending and incentivizing savings, monetary policy can act as a brake on inflation and other issues associated with an overheated economy.

The Fed frequently uses three different policy tools to influence the economy:

• Open Market Operations: Open market operations are carried out on a daily basis when the Fed buys and sells U.S. government bonds to either inject money into the economy or pull money out of circulation.
• Reserve Requirements: By setting the reserve ratio, or the percentage of deposits that banks are required to keep in reserve, the Fed directly influences the amount of money created when banks make loans.
• Discount Rate: The Fed also can target changes in the discount rate, which is the interest rate it charges on loans it makes to financial institutions. This tool is intended to impact short-term interest rates across the entire economy.

Monetary policy is more of a blunt tool in terms of expanding and contracting the money supply to influence inflation and growth and it has less impact on the real economy. For example, the Fed was aggressive during the Great Depression. Its actions prevented deflation and economic collapse but did not generate significant economic growth to reverse the lost output and jobs.

Contractionary vs. Expansionary Monetary Policy

Monetary policies can be either contractionary or expansionary. Implementing one type of policy depends on the current economic climate and the ultimate goals.

• Contractionary Monetary Policy: Central banks will use contractionary monetary policies when inflation becomes a concern as the economy gets overheated. In this case, prices rise as purchasing power drops.
• Expansionary Monetary Policy: This type of monetary policy is used to help spur growth when can there's a recession or slowdown. Expansionary monetary policies have limited effects on growth by increasing asset prices and lowering the costs of borrowing, making companies more profitable.

Fiscal Policy

Fiscal policy refers to the steps that governments take in order to influence the direction of the economy. But rather than encouraging or restricting spending by businesses and consumers, fiscal policy aims to target the total level of spending, the total composition of spending, or both in an economy.

The two most widely used means of affecting fiscal policy are:

• Government Spending Policies: Governments can increase the amount of money they spend if they believe there is not enough business activity in an economy. This is often referred to as stimulus spending. They can borrow money by issuing debt securities (like government bonds) if there are not enough tax receipts to pay for the spending increases, allowing them to accumulate debt. This is referred to as deficit spending.
• Government Tax Policies: By increasing taxes, governments pull money out of the economy and slow business activity. Fiscal policy is typically used when the government seeks to stimulate the economy. It might lower taxes or offer tax rebates in an effort to encourage economic growth. Influencing economic outcomes via fiscal policy is one of the core tenets of Keynesian economics.

When a government spends money or changes tax policy, it must choose where to spend or what to tax. In doing so, government fiscal policy can target specific communities, industries, investments, or commodities to either favor or discourage production—sometimes, its actions are based on considerations that are not entirely economic. For this reason, fiscal policy is often hotly debated among economists and political observers.

Fiscal policy essentially targets aggregate demand. Companies also benefit as they see increased revenues. However, if the economy is near full capacity, expansionary fiscal policy risks sparking inflation. This inflation eats away at the margins of certain corporations in competitive industries that may not be able to easily pass on costs to customers; it also eats away at the funds of people on a fixed income.

Contractionary vs. Expansionary Fiscal Policy

Governments can execute their fiscal policies through contractionary or expansionary measures:

• Contractionary Fiscal Policy: Governments can turn to contractionary measures to slow down the economy and curb inflation. These steps include raising taxes and reducing government spending. It isn't uncommon that a recession follows to bring balance back to the economy.
• Expansionary Fiscal Policy: This is commonly done during recessions to encourage people to spend. Governments often turn to measures like stimulus checks issued to taxpayers. They may also increase government spending as a way to boost employment. Expansionary fiscal policies are commonly associated with deficit spending.

Key Differences

While the overall goal of monetary and fiscal policy is generally the same—to influence the economy—there are inherent differences between the two.

Among the key differences between monetary and fiscal policy is the party responsible for carrying them out. Monetary policy is carried out by a nation's central bank, such as the Fed in the U.S., the Bank of Canada (BOC), and the Bank of England. Fiscal policy, on the other hand, is the sole responsibility of a country's government.

The tools that are used are also distinct between the two. While monetary policy relies on open market operations, reserve requirements, and/or the discount rate, fiscal policy involves the use of government spending and/or changes in government tax policies.

The Bottom Line

Both fiscal and monetary policy play a large role in managing the economy and both have direct and indirect impacts on personal and household finances. Fiscal policy involves tax and spending decisions set by the government, and will impact individuals' tax bill or provide them with employment from government projects. Monetary policy is set by the central bank and can boost consumer spending through lower interest rates that make borrowing cheaper on everything from credit cards to mortgages.