Monetary and Fiscal Policies

Governments regulate economic activities to achieve high employment levels, low inflation, stable economic growth and the balance of external payments. The two main tools for this regulation are fiscal policy and monetary policy. Through the fiscal policy, governments manage national income by taxation and spending. And, through the monetary policy, governments control the money supply. Central Banks are appointed for this purpose.

Fiscal policy

"Fiscal policy is the term used to describe all of the government’s decisions regarding taxation and spending". When governments want to increase the money available to populace, they lower the taxes and raise spending (expansionary fiscal policy); in contrast, when they want to decrease the money available to populace, they raise the taxes and lower spending (contractionary fiscal policy).

Transmission Mechanisms of Fiscal Policy

In order to see how the fiscal policy is affecting the national income, we can use gross domestic product (GDP) equation, which will give total value of final goods and services by summing up the expenditures. The result will roughly be equal to the national income. This equation was originally used by Keynes (1936) and he formed the basis of modern macro economy:

Y = C(Y - T) + I + G + NX

,where Y is national income, C is consumption spending, I is investment spending, G is government spending, and NX is net exports. The Consumption is dependent on the income that remains after tax payments (disposable income), so it has Y and T parameters. Another important thing to note is that consumption spending excludes savings or spending from borrowed funds like mortgages.

From the formula above it can be said that when taxes (T) are reduced, assuming Y is stable at the start, consumption (C) increases, causing an increase at national income (Y). Increasing government spending (G) leads an increase at national income (Y) too.

Fiscal policy is the most important tool to affect GDP. The expansionary policy usually yields to greater national income along with higher prices. It is also dependent on the existing state of the economy and the business cycles. If the economy is in recession, expansionary policy revives unused productive capacity and unemployed workers. This will raise the output of economy without changing the price level. If the workers were already fully utilized, same expansionary policy would have more impact on prices rather than output.

Another point is that its impact is not the same on every worker group. Depending on the rational and the aim of the policy, tax cut may affect only on the middle class. And, since it is the largest group, new taxes are introduced on this same class. When it comes to spending, effected worker group is even more specific. Decisions like building a new bridge could only affect people who will work in this industry and the number is very limited. This certainly will not be enough to have an impact on aggregate value of GDP.

Monetary Policy

Monetary policy is simply described as the policies to change the money supply and money supply is "the total amount of currency plus deposits held by the public". Central Banks may follow expansionary fiscal policy by purchasing government bonds, decreasing the reserve requirement, and decreasing the discount rate or may follow contractionary monetary policy by selling government bonds, increasing the reserve requirement, and increasing the discount rate.

Transmission Mechanisms of Money Supply

When central banks sell bonds, currency held by populace is exchanged with bonds resulting in a shrink in the money supply. In the same manner, when central banks purchases bonds, currency flows to populace and money supply increases.

Central banks can also change the reserve requirements ("the percentage of funds that member banks have to maintain on deposit at all times")  If central bank increases the reserve requirement, member banks require holding more reserve and making less loans, resulting in a decrease in money supply. When reserve requirement is decreased, member banks can make more loan and money supply increases.

The last instrument that central banks use is the national interest rate. It is the interest rate charged by a central bank on a loan to a member bank and when it is increased; commercial banks will be less likely to borrow money and will make fewer loans, resulting in a decrease in money supply. When it is decreased, commercial banks are encouraged to make loans and also willing to lend this money to populace. Result is an increase in money supply.

Primary target of the monetary policy is money supply. With an expansionary monetary policy, money supply rises. This pulls the interest rates down, consumer spending rises and new workers will join to economy. However the excess of money will end up with higher inflation, if the economy is running in full capacity. This causes the fall of money value and exchange rate. When the contractionary policy is in operation, interest rates rise, consumer spending falls and inflation abates. If the economy is running under its capacity unemployment problem may emerge.

Having less money than what the economy needs, causing the rise in its value will also encourage populace to purchase goods from overseas and also making difficult for national companies for exporting. This will lead deficit in import-export balance (external payment balance) and this has to be financed by other resources.

Lags in Monetary and Fiscal Policies

Time lags occur between the onset of an economic problem and the full impact of the policy. These lags can be categorized in two main groups which are inside lag (getting the policy activated) and outside lag (the impact of the policy). The inside lags are recognition lag, decision lag, and implementation lag and the one outside lag is impact lag. Monetary and fiscal policies differ in the speed, especially for the inside lags.

Recognition lag is the time to identify the actual problem. It takes time to collect and analyze economic data. For example unemployment and inflation data are usually available one month later and production and income data are reported quarterly or even longer. Once data is accumulated, it must be analyzed and determined that a problem is looming and a decision must be taken.

Once the problem is identified, the course of action needs to be decided. And if this decision is taken by government, there might be necessary to pass legislations, laws or administrative rules, which are usually debated by the parliament to select the most appropriate policies. For example, if expansionary policy will be used, government has to decide whether to go for purchases or transfer payments. If it goes for purchases, then what types of goods or services are purchased? If taxes are decreased, which taxes are cut and who receives the extra income? These decisions could take days, weeks, or months and they constitute decision lag.

Time that is spent to implement selected policy is called implementation lag. For the spending example, appropriate government agencies are contacted. These agencies require bids to identify product suppliers. The recruitment process also contributes to implementation lag.

Inside lags are likely to take several months. A best case scenario involves at least two months. One month to recognize the problem and another month to select and implement the appropriation policy.

Impact Lag is the time it takes for the policy actions to influence the economy and see the results on the producers and consumers.

If we compare the monetary and fiscal policy lags, the impact lag will be similar, since the economy works through itself. Recognition lag will be similar too, because central banks and governments will use the same collected data. However decision and implementation lags differ for monetary and fiscal policies. For the monetary policy, decision lags are relatively short. Central banks are devoted for this and their committee meets very often. Implementation lags are short as well. Once the decision is made, the implementation can start through financial markets in a very short time. Fiscal policy decisions are made by government and it may take a long time for a parliament to come up with a settled decision and also approved by the prime minister.

The implementation lag is likely to be longer since it will comprise government agencies and bureaucracies, which will make sure that all rules and procedures are followed.

Goals of Monetary and Fiscal Policies

It is obvious to think that monetary and fiscal policies will be effective when they share same goals. These goals are usually common for most economies and they can be summarized as sustainable growth and high employment while maintaining stable prices.

Fiscal decisions are taken by governments and they are usually put in to action as a long term objectives. While meeting these objectives, monetary policy can be used to smooth out falls and rises in the short term. For example, when there is a recession, central banks can intervene the economy by lowering interest rates for a quick stabilization, which prevents long run problems, like employment losses. However, prolonging monetary policy may trigger problems like inflation, since there will be excess of money. Therefore monetary policy must be preferred for short or middle term objectives.


Two examples of government action over interest rates in US took place between 1999 and 2001 as depicted in Figure. In 2001 the Federal Reserve made 11 reductions in the overnight interest rate. These actions were to stimulate growth in the face of a slowing economy. In contrast, in 1999 and 2000 when the economy was experiencing very rapid growth and a potentially unsustainable expansion without an increase in the rate of inflation, the Federal Reserve raised the federal funds to slow down the overheated economy.

The Effectiveness of Monetary and Fiscal Policies

Both policies and their instruments have certain advantages, in terms of speed and effectiveness. Therefore, correct policy must be selected as a main tool by studying the problem and predicting outcomes in the short and long terms.

Among the instruments of monetary policy, open market operations are most common tool. Central banks can quickly exchange money with bonds. For the short term need of money, governments tend to use this tool to finance its budget deficits.

The second widely used tool is national interest rate. However it has a limit and when it hits to zero, it can no more be reduced. Zero-interest rate policy was used in Japan in 1999. In order to stimulate slowing economy, they lowered the overnight nominal interest rate to zero. However, for the stimulation of economy, monetary policy may not be effective alone and must be supported with fiscal policy, so that the burden can be shared. And In this Japanese economy case, the policy did not created the effect as much as expected and the rate was again lowered to zero in March 2001. Economists argue that government should have used more aggressive fiscal policy, even by taking the budget deficit risks.

The reserve requirement is extremely powerful as it may cause huge money flows in the economy and has the risk of rocketing interest rates and the price levels very quickly. So it is used only in the event of serious economic problems.

It is suggested that fiscal policy is more suitable to fight unemployment while monetary policy may be more effective to fight inflation. With the tools of monetary policy and following expansionary policies, it would take longer to sort out unemployment, since it depends on the private sector to launch new investments. However, governments’ certain spending policies like dam construction or road improvement directly opens new vacancies, reducing low employment rates faster. In the case of a fight against inflation, fiscal policies may be on the slow side, whereas monetary policies are able to eliminate the excess of money quickly.

Another reason for the governments to prefer monetary policy to fiscal policies may be based on the political reasons. At the end, fighting inflation requires government to take unpopular actions like reducing spending or raising taxes. Governments, which used fiscal policies, seemed to struggle as it happened in the United States in 1980s.


We have seen that governments can meet their targets by selecting correct policies. Problems must be studied carefully and main policy must be selected accordingly.

In order to be successful, governments’ fiscal policies and central banks’ monetary policies must be in coordination. Monetary policy can be used for quick stabilization, since its management is faster at decision and implementation phases. And also economy’s existing state must be considered to avoid unexpected outcomes. Macro economy management evolved in the last century by taking lessons from the experiences. Today, we have lots of successful examples and we know that through the right policies, economies can stay away from crisis while achieving desirable results.



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