Monetary Policy vs. Fiscal Policy

Monetary Policy vs. Fiscal Policy

Monetary policy and Fiscal policy are two significant tools used by nations across the world to tackle their macroeconomic issues like inflation, economic growth, national spending, household savings and more such.

Monetary policy:

Monetary policy is a macroeconomic tool at the hands of nation’s apex bank i.e.  the central bank. Through monetary policy, the central bank has the authority stimulate the economy or check the level of growth by influencing the level of interest rate, sale/purchase of government bonds, regulating foreign exchange rates as reserve requirements of central banks.

The monetary policy of any country has an impact on various sides of the economy such as attaining stability in the gross domestic product, growth rate, unemployment, liquidity support and inflation check of that particular economy as well as maintain a foreign exchange rate in a predictable range.

In Australia, the Reserve bank of Australia takes monetary policy decision based on the current economic and financial conditions on a monthly basis, the outlook for the economy quarterly and the financial stability risks. Based on these three parameters, the policy is recommended in the board meeting where the final cash rate decision is communicated in public. The cash rate announced influences the interest rate which in turn will influence the economic activity and thus impacts the inflation of the country. The cash rate target is a point where RBA’s lending rate and RBA’s deposit rate intersect each other.

Fiscal Policy:

Fiscal policy is a method by which the government of any particular country puts a control on the spending level as well as the tax rate of that economy. Through the fiscal policy, the policy makers try to maintain a steady price in the economy, an employment level as well as the economic growth. In case the economy is sluggish then the fiscal policy stimulates the economy and also puts a check on the economy in case the economy is growing beyond the control. The recession also impacts the aggregate demand of an economy. Aggregate demand is defined as the total number of final goods and services in an economy which can be mathematically expressed as,

Aggregate Demand = Consumption + Investment + Govt Spending + Net Exports

There are two types of fiscal policies: Expansionary Fiscal Policy and Contractionary Fiscal Policy.

Expansionary Fiscal Policy: Expansionary Fiscal Policy comes into the picture when an economy is going through the recession phase. Under the expansionary fiscal policy, the government either increases its spending or they lower the taxes. To minimize the recessionary gap, the government increase their spending, thus increasing the aggregate demand curve. In other words, an increase in spending will create demand for goods and services.

At the same time, the government may also opt for tax reduction, which increases the purchasing power of the individuals. Thus, increasing the demand for goods and services and helps the aggregate demand curve to shift towards the right which will help in reducing the recessionary gap.

Contractionary Fiscal Policy: Contractionary Fiscal Policy is utilized by any government when the growth rate of an economy is out of control, and it leads to inflation and asset bubble. In a situation of inflation, the government tries to reduce its spending and increase the taxes which will decrease the aggregate demand for goods and services. The other option with the government is that they can raise the taxes which will slow down the growth rate and the consumer will have less money for consumption which indirectly reduces the aggregate demand curve.


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