Monetary and Fiscal Policies

19.12.2017 |

Episode #7 of the course Introduction to macroeconomics by Doha Soliman, CFA


Welcome to Day 7! Today, we’ll discuss monetary and fiscal policies. But before we get into details, let’s briefly explain what monetary and fiscal policies entail.


Monetary Policy

Monetary policy refers to the actions taken by an economy’s central monetary authority. It includes controlling currency reserves (how much of the currency is kept in vaults), regulating inflation, setting interest rates, and buying and selling government bonds. Monetary policy can be expansionary or contractionary.

Expansionary monetary policy is intended to expand the growth of money supply, thus printing more money, decreasing the interest rate, and essentially, keeping money flowing within the economy to stimulate spending and increase the GDP. Conversely, contractionary monetary policy works in the opposite way, decreasing the money supply and raising interest rates. This is done in inflationary periods, or when the economy is booming and the government wants to slow the pace of growth in order to keep the currency at sustainable levels.

The central authority conducts extensive research on unemployment levels, sales, and consumption within an economy to maintain a steady balance between stagnation and booms. While it may sound counterintuitive that a central bank would work to decrease the growth output of an economy, as we saw in our inflation lesson, high inflation and rapid growth in the economy can have devastating effects on its long-term sustainability.

An example of why the central authority works hard to keep the money supply balanced can be demonstrated by looking at economy’s imports and exports. For instance, if the money supply is high and a currency loses some of its value, an economy might have a hard time trading on the international front. While the exports would increase due to a cheaper currency, the imports would drastically be reduced.


Fiscal Policy

As we discussed earlier today, monetary policy is only one of two ways the government regulates an economy. The second means is through fiscal policy. This relates to the actions a government takes in stimulating or slowing down an economy through government spending and taxation.

Keynesian economics is a term that was coined based on the works of John Maynard Keynes, one of pioneers of modern-day economics. It advocates for governments to increase their spending and cut taxes during recessions and to decrease their spending when an economy is booming. His theory has greatly shaped many governments to adopt this model and to change their spending and taxation levels based on economy’s short-term health. This model can be explained simply through an example.

If the economy is suffering and a recession is looming, the government can increase their spending on infrastructure, for instance. By doing so, they create more jobs and inject more money in the economy, and this will have a multiplier effect on the economy as a whole. When individuals have more jobs, they consume more, thus creating even more jobs.

An opposite effect is done by increasing taxes. As taxes increase, individuals have less disposable income (income to spend on non-essentials) and are less likely to make new purchases or spend on luxury, which in fact has a multiplier effect and slows down production and ultimately, job creation.

Governments generally combine monetary and fiscal policy to find a balance to maintain a steady growth within an economy and internationally through trade.

Now that we’ve completed an overview of monetary and fiscal policy, tomorrow, we’ll cover an important component of fiscal policy: taxation. We’ll look into different tax systems and discuss their overall effect on the economy.


Recommended book

Economic Facts and Fallacies by Thomas Sowell


Share with friends