What are the similarities and the differences between monetary and fiscal policies quizlet

Macroeconomists generally point out that both monetary policy — using money supply and interest rates to affect aggregate demand in an economy — and fiscal policy — using the levels of government spending and taxation to affect aggregate demand in an economy- are similar in that they can both be used to try to stimulate an economy in recession and rein in an economy that is overheating.  The two types of policies are not entirely interchangeable, however, and it's important to understand the subtleties of how they differ in order to analyze what type of policy is appropriate in a given economic situation.

Effects on Interest Rates

Fiscal policy and monetary policy are importantly different in that they affect interest rates in opposite ways.  Monetary policy, by construction, lowers interest rates when it seeks to stimulate the economy and raises them when it seeks to cool the economy down.  Expansionary fiscal policy, on the other hand, is often thought to lead to increases in interest rates.

To see why this is, recall that expansionary fiscal policy, whether in the form of spending increases or tax cuts, generally results in increasing the government's budget deficit.  In order to fund the increase in the deficit, the government must increase its borrowing by issuing more Treasury bonds.  This increases the overall demand for borrowing in an economy, which, as with all demand increases, leads to an increase in real interest rates via the market for loanable funds.  (Alternatively, the increase in the deficit can be formulated as a decrease in national saving, which again leads to increased real interest rates.)

Differences in Policy Lags

Monetary and fiscal policy are also differentiated in that they are subject to different sorts of logistical lags.

First, the Federal Reserve has the opportunity to change course with monetary policy fairly frequently, since the Federal Open Market Committee meets a number of times throughout the year.  In contrast, changes in fiscal policy require updates to the government's budget, which needs to be designed, discussed, and approved by Congress and generally happens only once per year. Therefore, it could be the case that the government could see a problem that could be solved by fiscal policy but not have the logistical ability to implement the solution.  Another potential delay with fiscal policy is that the government must find ways to spend that begin a virtuous cycle of economic activity without being overly distortionary to the long-run industrial composition of the economy.  (This is what policy makers are complaining about when they bemoan a lack of "shovel-ready" projects.)

On the upside, however, the impacts of expansionary fiscal policy are pretty immediate once projects are identified and funded.  In contrast, the effects of expansionary monetary policy can take a while to filter through the economy and have significant effects.

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. 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. 

Key Takeaways

• Both monetary and fiscal policy are macroeconomic tools used to manage or stimulate the economy.
• Monetary policy addresses interest rates and the supply of money in circulation, and it is generally managed by a central bank.
• Fiscal policy addresses taxation and government spending, and it is generally determined by government legislation.
• Monetary policy and fiscal policy together have great influence over a nation's economy, its businesses, and its consumers.

Central banks typically have used 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 Federal Reserve, also known as the "Fed," frequently has used three different policy tools to influence the economy: open market operations, changing reserve requirements for banks and setting the discount rate. 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. 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 also can 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.

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.

Expansionary monetary policy can have limited effects on growth by increasing asset prices and lowering the costs of borrowing, making companies more profitable.

Monetary policy seeks to spark economic activity, while fiscal policy seeks to address either total spending, the total composition of spending, or both.

Fiscal Policy

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.

In comparing the two, fiscal policy generally has a greater impact on consumers than monetary policy, as it can lead to increased employment and income.

By increasing taxes, governments pull money out of the economy and slow business activity. 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—sometimes, its actions are based on considerations that are not entirely economic. For this reason, fiscal policy often is hotly debated among economists and political observers.

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.

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.

What is the similarities and differences between monetary policy and fiscal policy?

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