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 RBI. 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.
Monetary Policy
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 Reserve bank, also known as the “RBI,” 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 GoI buys and sells 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 RBI directly influences the amount of money created when banks make loans. The RBI 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.
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.
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.
Similarities and differences between Fiscal and Monetary Policy
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