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. Fiscal policy is the 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. (See Who sets fiscal policy, the president or congress?)
Central banks have typically used monetary policy to either stimulate an economy or to check its growth. The theory is that, by incentivizing individuals and businesses to borrow and spend, monetary policy can 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 Federal Reserve, also known as the "Fed," has frequently used three different policy tools to influence the economy: opening market operations, changing reserve requirements for banks and setting the discount rate. Open market operations are carried out on a daily basis where the Fed buys and sells U.S. government bonds to either inject money into the economy or pull money out of circulation. 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. The Fed can also target changes in the discount rate (the interest rate it charges on loans it makes to financial institutions), which is intended to impact short-term interest rates across the entire economy.
Generally speaking, the aim of most government fiscal policies is 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 changes in government spending policies or in government tax policies.
If a government believes there is not enough business activity in an economy, it can increase the amount of money it spends, often referred to as "stimulus" spending. If there are not enough tax receipts to pay for the spending increases, governments borrow money by issuing debt securities such as government bonds and, in the process, accumulate debt; this is referred to as deficit spending. (For details, see What is the role of deficit spending in fiscal policy?)
By increasing taxes, governments pull money out of the economy and slow business activity. But typically, fiscal policy is 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 – and sometimes, its actions based on considerations that are not entirely economic. For this reason, the numerous fiscal policy tools are often hotly debated among economists and political observers.
Which is More Effective: Monetary or Fiscal Policy?
In terms of improving the real economy, expansionary fiscal policy is more effective. In terms of the financial economy, expansionary monetary policy is the better choice. Both types work through different channels and impact individuals and corporations in different ways.
Fiscal policy affects consumers positively for the most part, as it leads to increased employment and income. Essentially, it is targeting 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. Fiscal policy can also have the effect of creating assetbubbles if the market and incentives become too distorted.
Monetary policy has less impact on the real economy. Case in point: the Great Depression, during which the Federal Reserve was particularly aggressive on a historical scale. Its actions prevented deflation and economic collapse but did not generate significant economic growth to reverse the lost output and jobs.
Expansionary monetary policy can have limited effects on growth by increasing asset prices and lowering the costs of borrowing, making companies more profitable. In addition, it has the psychological benefits of taking worse-case economic scenarios off the table. As with fiscal policy, extended periods of low borrowing costs can create asset bubbles that are only apparent in hindsight.
Another crucial difference between the two is that fiscal policy can be targeted, while monetary policy is more of a blunt tool in terms of expanding and contracting the money supply to influence inflation and growth.
Learn more about how the economy is controlled with A Look at Fiscal and Monetary Policy.
How To Write A Macroeconomic Policy Mix Essay In HSC Economics
Thinking about some of the harder topics in the syllabus, and a possible question that could be examined, I thought it would be a good idea to offer a step by step overview of writing an essay on macroeconomic policy.
Post written by Chloe Segal (10th in the state Economics, 11th in the state Business Studies and 4th in the state English Advanced 2015). See all articles first and personally get in touch with our state rankers here
I know a lot of people struggle with this topic due to the shear amount of content that has to be covered in a short essay, so if that’s you then take a look at this guide and hopefully I will clarify all your queries and leave you feeling confident to write this essay in the HSC!
For this guide, the sample question I have chosen is:
Assess the effectiveness of macroeconomic policies in achieving economic objectives in the Australian economy.
What to include in the introduction?
In the introduction you need to include three main points:
- Explain what constitutes macroeconomic policy — i.e. fiscal and monetary policy collectively represent macroeconomic policy tools
Example: Macroeconomic policies refer to fiscal policy and monetary policy, which have a countercyclical role in reducing fluctuations in the business cycle.
2. Define fiscal and monetary policy and incorporate a current statistic
Example: Monetary policy refers to actions by the RBA to influence the supply and cost of credit in the economy. The main tool of monetary policy is the RBA’s use of domestic market operations to influence the cash rate or interest paid of overnight loans from the cash market or short-term money market. This involves buying and selling second hand commonwealth government bonds and repurchase agreements. Currently, the RBA has set the cash rate at 1.5% in an effort to stimulate aggregate demand.
Fiscal policy is a countercyclical macroeconomic policy that involves the use of taxation and government expenditure to allocate resources to achieve economic objectives and general policy goals. These goals relate to internal balance and therefore aim to achieve price stability and a sustainable rate of economic growth. Currently, the government has adopted a contractionary fiscal stance, aiming to reduce the budget deficit which is currently 2.4% of GDP.
3. Explain what economic objectives fiscal and monetary policy target and briefly mention the effectiveness of current macroeconomic policies
Example: Recently, the effectiveness of monetary and fiscal policy in achieving objectives related to inflation, economic growth, unemployment and income distribution, has been hindered by external influences related to economic conditions in the global economy.
In terms of structuring your body paragraphs I recommend creating a table which has economic objectives as rows and fiscal and monetary policy as columns. Then for each cell write summary notes on policies to discuss and evaluate whether they were effective or not.
You can also structure your response in terms of time periods. As conditions in the economy fluctuate, economic objectives change so fiscal policy and monetary policy have to be flexible and adapt to meet new objectives throughout the different time periods.
Sample body paragraph on fiscal policy:
Fiscal policy can be deemed effective during the GFC as the Australian economy remained resilient in the face of external shocks. Cyclical unemployment was minimized as the rate of unemployment fell from a peak of 5.8% in 2009 to 5.2% by 2011, reflecting the positive impact of targeted education policies and unemployment initiatives. In addition, the Australian economy avoided a deflationary spiral as fiscal policy lifted inflation from 1.7% in 2009 to 3.3% in 2011. Fiscal stimulus lifted economic growth from 1.1% in 2009 to reach trend growth of 3% by 2011, shielding the Australia economy from the repercussions of a recession.
Sample body paragraph on monetary policy:
The effectiveness of fiscal policy was supported by a parallel approach taken by the RBA, which adopted an expansionary monetary policy stance during the GFC, through lowering the cash rate from 7.25% in 2008 to 3% in 2009. The objectives of monetary policy were akin to those of fiscal policy, with an added emphasis on achieving the inflation rate target of 2–3% over the medium term. To achieve the objective of price stability the RBA adopted a loose monetary policy stance by buying second hand Commonwealth government securities and depositing funds in exchange settlement accounts, increasing the supply of loanable funds. This boost to liquidity put downwards pressure on the cash rate.
Points to discuss when addressing effectiveness of fiscal and monetary policy
- More effective during a boom
- Quicker to implement but slower to impact (6 to 18 month time lag)
- Rarely effective when used on its own (needs to be supported by similar fiscal policy settings — currently working in opposite directions due to fiscal consolidation)
- Effective during the GFC (prevented recession — one quarter of negative economic growth)
- Independent from political pressure
- Breakdown in the transmission mechanism (banks don’t pass on interest rate cuts, consumers still reluctant to increase consumption, $A may not decrease)
- Limited as it is demand based and cannot target structural weaknesses (targets demand pull inflation not cost push inflation)
- Cannot successfully address the problem of a high CAD because it cannot bring about a structural improvement in international competitiveness or the level of national savings
- More effective during a downturn due to the shorter time lag
- Political constraints (election cycle, lobby groups)
- Avoided recession during the GFC
- Can target specific types of inflation and unemployment
- Slower to implement but quicker to impact
Incorporation of diagrams
Monetary policy diagrams
- Cash rate diagram
- Aggregate demand aggregate supply diagram
- Short Run Phillips Curve
- Deflationary gap diagram
- Inflationary gap diagram
Fiscal policy diagrams
- Inflation rate diagram (cost push or demand pull)
- Negative externalities diagram (social cost)
- Lorenz Curve
Incorporation of quotations
In terms of quotations always try to find something from the RBA’s website for monetary policy. You could use the following quotation to support an argument about effectiveness:
Glenn Stevens (on the reason why monetary policy in Australia is losing its effectiveness):
‘On the demand side, it seems more difficult to generate growth in spending in an economy where households are carrying significant debt.’
This means that the marginal return the RBA gets, in terms of an uplift in economic growth, for any given 25 point rate cut, is falling because Australian’s either are unwilling, or unable, to take on any more debt. Therefore, you could argue that rising levels of household debt are a factor constraining the effectiveness of monetary policy in achieving objectives related to economic growth and inflation targeting.
In terms of the effectiveness of fiscal policy you could quote Arthur Sinodinos (Australian political) who argues:
‘Structural reforms will release the handbrake on growth by improving the allocation of resources and relieving capacity constraints.’
Post written by Chloe Segal (10th in the state Economics, 11th in the state Business Studies and 4th in the state English Advanced 2015)