What Is the Difference Between Fiscal Policy and Monetary Policy?

Monetary Policy: Defined

Monetary policy is the process by which a nation’s central bank controls the supply of money. This can be done in a number of ways, but most commonly it is done through interest rates. The central bank can raise or lower interest rates to try and stimulate or slow down the economy. The Federal Reserve decides whether or not to expand or contract the economy based on a variety of metrics, including gross domestic product (GDP), unemployment, and inflation. The goal of stimulating the economy is to improve GDP. Meanwhile, more restrictive monetary policy is intended to slow the economy in order to manage inflation in the present or future.

Fiscal Policy: Defined

The fiscal policy describes the taxation and spending by the government. With this, it is possible to influence the economy through increases or decreases in taxes and/or expenditures of money by the government. It can also be used to try and maintain a balanced budget for the country. Some common examples of fiscal policies include: increasing federal income tax rates, increasing government spending on public programs, increasing/decreasing taxes for certain types of income (i.e., capital gains), and decreasing government transfer payments (welfare).

Monetary vs Fiscal Authorities

The Federal Reserve is considered to be the monetary authority whereas the President & Congress are responsible for making fiscal policy decisions through tax & spending measures. The 2 policies are yoked together: Monetary policy can only be effective if it is aligned with the government’s fiscal policy objectives. For instance, if the Federal Reserve wants to increase spending in the economy, it would need the President & Congress to agree to cut taxes or increase government spending. On the other hand, if the Federal Reserve wants to decrease spending in the economy, it would need the President & Congress to agree to increase taxes or decrease government spending.

The Difference Between Monetary and Fiscal Policy

While the monetary and fiscal policy is related, they are two different ways of managing the economy. Monetary policy is focused on controlling the money supply while fiscal policy is focused on controlling taxation and spending by the government. Monetary policy works most effectively when it is aligned with fiscal policy objectives. However, officials must be careful about using fiscal policy to influence monetary authorities because this can result in runaway inflation. For instance, if a nation’s central bank wants to stimulate the economy by lowering interest rates further, the President & Congress can decide to spend more. But if this leads to runaway inflation, the central bank will need to raise rates again, which could lead to a recession or even a depression. On a similar note, fiscal policy has been less effective since the Great Recession of 2008 because many governments have failed to implement policies that align with expansionary monetary policy. For example, some countries have raised taxes or cut spending as the central bank has been trying to stimulate the economy. In other cases, some countries have simply failed to implement any fiscal stimulus at all as rates have been kept low by the central bank.

Why It’s Important to Understand Fiscal and Monetary Policies

It is important for citizens and policy-makers alike to understand the difference between monetary and fiscal policy because they can have a significant impact on economic growth and stability. For citizens, it is important to be able to hold their government accountable for effective fiscal policymaking. And for policy-makers, it is important to be able to use both policies in an appropriate way to manage the economy.

The Bottom Line

Fiscal and monetary policies are related but different ways of managing the economy. Monetary policy focuses on controlling the money supply while fiscal policy focuses on controlling taxation and spending by the government. These policies are yoked together, with each having to be effective for the other to be effective as well. Finally, it is important for citizens and policy-makers to understand how these policies work together to manage the economy.

Monetary policy is focused on controlling the money supply while fiscal policy is focused on controlling taxation and spending by the government.
The objectives of monetary policy vary depending on the country, but can generally be summed up as: 1. low and stable inflation, and 2. high employment and economic growth.
Fiscal policy can only be effective if it is aligned with the government's monetary policy objectives. For instance, if the Federal Reserve wants to increase spending in the economy, it needs officials in charge of fiscal policy to agree with this objective. If fiscal and monetary policies are not aligned, then they can work against each other, which can result in lower economic growth or even recession.
A liquidity trap occurs when interest rates are already very low and people are not borrowing or spending money because they don't see attractive investment opportunities. This can lead to lower economic growth or even recession.
Fiscal policy can help to manage the business cycle by affecting aggregate demand. For example, if the government decides to increase spending in the economy during a recession, it can help to stimulate growth. Conversely, if the government decides to reduce spending in the economy during an expansion, it can help to cool down the economy.

True Tamplin, BSc, CEPF®

About the Author
True Tamplin, BSc, CEPF®

True Tamplin is a published author, public speaker, CEO of UpDigital, and founder of Finance Strategists.

True is a Certified Educator in Personal Finance (CEPF®), author of The Handy Financial Ratios Guide, a member of the Society for Advancing Business Editing and Writing, contributes to his financial education site, Finance Strategists, and has spoken to various financial communities such as the CFA Institute, as well as university students like his Alma mater, Biola University, where he received a bachelor of science in business and data analytics.

To learn more about True, visit his personal website, view his author profile on Amazon, or check out his speaker profile on the CFA Institute website.