Armchair economists and expert policymakers alike often mix up the ideas of monetary policy and fiscal policy, two very different elements that both heavily influence and alter the livelihoods of peoples all over the world. Both forms of policy involve economics at micro and macro levels, and both are largely decided by state governments. When policymakers look to affect a country’s economy – either slow it down, heat it up, or alter it anyway – they look to both of these types of policy as top-down tools to help them reach their policy goals.
Typically, monetary policy is decided by an (often not publicly elected) central bank, while fiscal policy is decided by a country’s government.
Monetary policy is all in the name – it is policy that primarily involves the value, creating, and management of a country’s money supply. Monetary policy is most closely tied to a country’s financial institutions, namely banks. By coordinating and setting rules for banks, and also allowing banks and other investors to purchase government bonds, monetary policy can both stimulate and slow down economies. By increasing the money supply and lowering interest rates so that more money is lent out, monetary policy can encourage economic growth and allow for more people to get loans, start businesses, and make purchases. By decreasing the money supply and upping interest rates, monetary policy can slow down an economy that is “heating up”, or encouraging too much spending and taking on too much debt.
While it seems counterproductive for monetary policy to “slow down” an economy, raising interest rates and tightening the money supply (pulling money out of the system) is often a short-term, manageable amount of pain that is used to head off large scale, major crises. If a country’s interest rates are too low and too much debt is being taken out, that debt can heavily harm an economy when people become unable to pay back their loans. This can trigger a crisis, which often causes job loss, financial loss, and sometimes decades of economic pain for a country.
Monetary policy also tries to balance inflation, or the value of its currency, to levels that are most beneficial for that particular country. Inflation typically means that the value of money is dropping, sometimes as a function of more money being created or from a country’s currency being seen as not stable. Inflation has some upsides – it gives those in debt an easier time paying back their loans, and it allows exporters to sell more products to other countries. However, it also causes costs to increase – both the cost of regular goods, such as food and energy and also the cost of any goods that are imported from foreign countries. Deflation, on the other hand, is when a country’s currency increases in value. Deflation is good for those who are lenders, as well as those who are living off of their savings (typically older, wealthier citizens). Deflation causes countries to have a harder time exporting products, because their products cost more, but allows a country to buy more from foreign countries since their currency is so strong.
Fiscal policy is how cities, states, and countries decide to spend their funds, on everything from military and technology to science and roads. Fiscal policy is often heavily debated, and when people speak of government debt or government spending, they are discussing fiscal policy. Fiscal policy can strengthen an economy by injecting money into a country’s economy or providing services. A country that spends heavily on science, for example, would not just reap the benefits of advancements in science but also by creating jobs for more scientists, as well as the people that support those scientists.
The money for fiscal policy, however, must come from somewhere, and the most common source for funding is from taxes. Fiscal policy then is the decision of where tax money should be allocated to, as well as where that money should come from. Countries can also decide to fund their spending by deficit spending, or borrowing money in order to be able to spend it.