Fiscal Vs Monetary Policy
Below is the Difference Between Monetary and Fiscal Policy:-
The monetary policy allows there to be liquidity in the economy and the economy remains stable throughout. On the other hand, the fiscal policy warrants that the economy grows and develops through the government’s revenue collections and government’s suitable expenditure.
Monetary policy is created according to the economic conditions of the country. Fiscal policy is created every year after evaluating the outcomes of the previous year.
Monetary policy is actually a subset of fiscal policy. Whereas, the fiscal policy ensures the overall well-being of the economy.
Monetary policy is controlled by the central bank of the country. Fiscal policy on the other hand, is controlled by the country's ministry of finance.
Monetary policy does not impose any political influence. Fiscal policy on the other hand, possesses reasonable political influence.
Difference Between Fiscal and Monetary Policy
Following is a comparison table of Fiscal vs. Monetary Policy:-
How Monetary Policy Works?
The Central Bank has an inflation target of 2%. If they feel inflation is going to rise above the inflation target, because of economic growth being too quick, then they will surge interest rates.
Higher interest rates increase borrowing costs and decrease consumer spending and investment, resulting in lower inflation and lower aggregate demand.
If the country’s economy went into recession, the Central Bank of the country would cut interest rates.
Which is More Effective Monetary or Fiscal Policy?
Apart from difference between fiscal and monetary policy, monetary policy in recent decades has become more popular because:
Monetary policy is issued by the Central Bank, and thus minimizes political influence (e.g. politicians may cut interest rates in the wake to have a booming economy ahead of a general election)
Fiscal policy can impose more supply side effects on a larger economy. E.g. to minimize inflation – higher tax and lower spending would not be well-liked, and the government may be unwilling to pursue this. In addition, lower spending could result in reduced public services, and higher income tax could cause disincentives to work.
Monetary policy is much faster to execute. Rate of interest can be set every month. A decision to raise government spending may take time to gauge where to spend the money.
Expansionary fiscal policy (for e.g. higher government spending) may result in special interest groups thrusting for spending which isn’t really useful and then proves complex to reduce when the recession is over.
Conclusion
Both are quite significant for the growth and development of a country’s economy. But they have several applications as well as merits and demerits. The fiscal policy caters to the country through its collections of money and the appropriate expenditure. If the fiscal policy fails, it will also impact the monetary policy of the company.
FAQs on Difference Between Monetary Policy and Fiscal Policy
1. What is the main difference between monetary policy and fiscal policy?
The main difference lies in who implements the policy and the tools they use. Monetary policy is managed by a country's central bank (the Reserve Bank of India - RBI) and deals with managing the money supply and interest rates to control inflation and stabilise the economy. In contrast, fiscal policy is controlled by the government and involves the use of government spending and taxation to influence economic activity. For more details, you can explore the essentials of fiscal policy.
2. What are the key tools used in monetary and fiscal policy?
The tools are distinct for each policy:
Monetary Policy Tools (used by the RBI): These include quantitative instruments like the Repo Rate, Reverse Repo Rate, Cash Reserve Ratio (CRR), and Statutory Liquidity Ratio (SLR), along with Open Market Operations (OMOs). Qualitative tools like margin requirements are also used.
Fiscal Policy Tools (used by the Government): These primarily include Taxation (changing direct and indirect tax rates) and Government Spending (on infrastructure, healthcare, defence, and subsidies).
A detailed look at the instruments of monetary policy can provide deeper insight.
3. Who controls monetary and fiscal policy in India?
In India, the roles are clearly defined. Monetary policy is formulated and implemented by the Reserve Bank of India (RBI), specifically through its six-member Monetary Policy Committee (MPC). Fiscal policy, on the other hand, is the responsibility of the Government of India, managed through the Ministry of Finance, and is presented annually as part of the Union Budget.
4. Is there an easy way to remember the difference between fiscal and monetary policy?
Yes, a simple way to remember is by association. Think of 'M' in Monetary for 'Money' supply, which is managed by the central bank. For Fiscal policy, think of the government's 'Fiscal' year and its budget, which involves finances, taxation, and spending. This helps associate monetary policy with the banking system and fiscal policy with government actions.
5. How do monetary and fiscal policies work together to control inflation?
To control inflation, both policies can be used in a complementary, contractionary manner. The RBI can implement a tight monetary policy by increasing interest rates (like the repo rate), making borrowing expensive and reducing the money supply. Simultaneously, the government can use a tight fiscal policy by increasing taxes (which reduces disposable income) and cutting its own spending. Both actions work together to decrease overall demand in the economy, thus helping to control inflation.
6. Which policy is more effective in a recession: monetary or fiscal?
The effectiveness depends on the severity of the recession. While monetary policy (like cutting interest rates) is quicker to implement, it can become ineffective in a deep recession, a situation known as a 'liquidity trap.' In such cases, even with very low interest rates, banks may be unwilling to lend and consumers unwilling to borrow. Here, fiscal policy (like increased government spending on public projects) is often considered more powerful because it directly injects demand into the economy, creates jobs, and boosts confidence.
7. Can the objectives of monetary and fiscal policy ever conflict?
Yes, conflicts can arise due to different priorities. For example, a government might pursue an expansionary fiscal policy (cutting taxes, increasing spending) to boost economic growth and employment, especially before an election. This can lead to high inflation. The central bank, with a mandate for price stability, might find this problematic and implement a contractionary monetary policy (raising interest rates) to curb the inflation caused by the government's actions. This highlights the importance of coordination between the government and the central bank.
