Monetary and Fiscal Stimulus Explained
What Is Monetary Stimulus?
Monetary stimulus is when the government uses monetary policy to increase the money supply in order to encourage economic growth. This can be done by buying bonds from banks, which in turn encourages them to lend more money.
The hope is that this will lead to an increase in consumer spending and investment, which will help to boost economic growth.
How Does Monetary Stimulus Work?
Monetary stimulus works by increasing the supply of money available to borrow. It’s typically done in either of these two ways:
Making Lending Cheaper
Lending is made cheaper by reducing the interest rates that banks have to pay on reserves that they park at the central bank. This is called the “Policy Rate”.
When the Policy Rate is lowered, it becomes cheaper for banks to borrow money and they are more likely to lend it out to businesses and consumers.
Purchasing Bonds from Banks
The government can also purchase bonds from banks. When the government buys a bond, it pays the face value of the bond plus interest.
The buying of bonds by the government increases the amount of money in circulation, which in turn encourages lending and borrowing.
How Does Monetary Stimulus Help the Economy?
An economic recession means less and slow revenue for businesses as customers decrease. This will gradually push businesses to try to reduce operating costs by laying off workers or closing down. With workers being fearful of losing their source of income, saving becomes an automatic response which causes the slow circulation of money in the economy.
The hope of monetary stimulus is that an increase in the money supply will lead to increased consumer spending and investment, which will help to boost economic growth.
Monetary stimulus often works by lowering interest rates, which makes borrowing cheaper. Companies are more likely to borrow money when it’s cheap for them to do so.
It also encourages consumers who have saved up their money to spend rather than save it because the opportunity cost of saving becomes less attractive.
When businesses see customers spending on products, they’re more likely to invest in new projects because the demand for their goods is higher than before. More investments means more jobs, so it stimulates employment as well. This helps people get back on their feet financially rather than relying on government assistance.
What Is Fiscal Stimulus?
Fiscal stimulus is when the government uses fiscal policy to increase government spending or decrease taxes in order to encourage economic growth. This can be done by increasing government spending on things like infrastructure projects or by giving tax breaks to businesses and consumers.
How Does Fiscal Stimulus Work?
There are three ways that the government can use fiscal policy to stimulate the economy:
Increasing Government Spending
When the government increases its spending, it puts more money into the economy. This can help to increase demand for goods and services, which will help to boost economic growth.
Sometimes tax incentives are used as a way of encouraging businesses and consumers to invest in projects that will be financially beneficial for them. This can have the same effect as increasing government spending, because it puts more money into the economy to help it grow.
However, tax incentives can also encourage certain behaviors depending on what kind of a tax break they provide.
For example, a reduction in income taxes could encourage people to work harder so that they have more disposable income at the end of each pay period. This would boost economic growth by increasing employment levels and consumer spending.
Giving Cash Directly to Consumers or Businesses
During the Great Recession, the government employed the strategy of giving money directly to people in the form of financial support or “stimulus check.” This aims to give consumers and businesses extra money to spend, which will help increase consumer spending.
However, it can also have the opposite effect because people are more likely to save if they are uncertain about the future of the economy. When people do not spend their stimulus check money on goods, companies will not receive enough revenue for their services or products and economic growth may be stymied.
How Does Fiscal Stimulus Help the Economy?
Fiscal stimulus is considered one form of a short-term economic stimulus, which aims to boost economic activity in the present by encouraging spending and investment. Fiscal stimulus can encourage businesses to invest more money into their companies or projects that will help them gain future revenue.
It also encourages consumers to increase their spending levels during down times because the opportunity cost for not doing so is lower if they receive cash from the government. When consumer spending increases, it helps businesses gain more revenue and provides jobs for workers who may have been fearful of losing employment during a recession.
Spender of Last Resort
The government acts as a spender of last resort by increasing its spending when the private sector is not spending enough money to stimulate economic growth.
Payer of Last Resort
The government acts as a payer of last resort by giving money directly to people in times where there are not enough jobs available.
Monetary and Fiscal Stimulus: Which Is a Better Strategy?
There are pros and cons to using monetary and fiscal stimulus to help the economy. Monetary stimulus can be used as a short-term or long-term measure, while fiscal stimulus is typically used as a short-term measure.
Fiscal stimulus can help to increase demand for goods and services, which will help to boost economic growth. However, it can also have the opposite effect because people are more likely to save if they are uncertain about the future of the economy.
Monetary stimulus can help to encourage businesses to invest more money into their companies or projects that will help them gain future revenue. However, it can also lead to an increase in inflation because it increases the money supply.
Thus, it ultimately depends on the situation and what will have the most positive impact on the economy.
It is important to weigh the pros and cons of both monetary and fiscal stimulus in order to make the most informed decision for the health of the economy.
In difficult times, it can be tempting to rely on quick fixes, but a more nuanced understanding of the pros and cons of these measures can help policymakers choose the right tool for the job.
With an electorate that is increasingly savvy about economics, it is more important than ever for policymakers to understand the basics of both monetary and fiscal stimulus. Doing so will allow them to make informed decisions that will benefit all members of society.
Disclaimer: The above references an opinion and is for information purposes only. It is not intended to be investment advice. Seek a duly licensed professional for investment advice.
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®), 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.