Monetary vs Fiscal Policy

Monetary and Fiscal policy are tools used by the central bank and the government to get the national economy closer to achieving the macroeconomic goals: low unemployment, price stability, high but sustainable pace of economic growth. Monetary policy is a blanket term for the actions of a central bank. Through monetary policy the central bank manages interest rates and controls how much money flows in the economy. The fiscal policy pertains to decisions by the government which impacts its spending and borrowing activities, one big way the government does this is by regulating the taxation. 

The economy is like a large ship and for the comfort of its passengers, it needs to be stable so that its passengers (includes households and corporations) feel safe and confident in their consumption and saving decisions. The proper tuning between the monetary and fiscal policy is crucial to cushioning the national economic ship in rough waters.

Monetary Policy and how it works:

The central banks (like RBI in India and The Federal Reserve/ The Fed) are vested with the responsibility to conduct monetary policy. It is through the fuel of monetary policy the central bank controls the fire of inflation in a country. The objective is to maintain price stability which is a necessary requirement for sustainable growth.

The central bank has three main tools utilizing which it controls the money supply in an economy:

  1. Open Market Operations: The central banks can directly affect the money supply in an economy by buying and selling government securities. They buy government securities to increase the money supply and sell government securities to absorb liquidity.
  2. Changing Cash Reserve Ratio: The central banks can change the average daily balance a bank is required to maintain with the reserve bank, this is the reserve ratio. If the money supply is to be increased, the amount of cash in reserves required can be decreased and vice versa. 
  3. Changing Discount Rate (Repo Rate): It is the rate at which the central bank provides overnight liquidity to banks when they seek to increase their cash reserves. This rate indirectly dictates the rate the bank will charge the borrowers. Theoretically, a lower discount rate motivates the banks to hold lesser money in their cash reserves, increasing the demand for money.

Fiscal Policy and how it works:

Governments are the largest borrowers in world debt markets. Fiscal policy refers to the actions of the government related to taxation and government spending. The impact of fiscal policy on the economy is a hot topic of discussion amongst economists. The government can increase spending to reignite the economy by increasing its spending, often referred to as stimulus spending. The balance between the revenue generated from taxes and the spending is key. For example, when the government spends more than it compensates for by tax receipts, the government fuels this spending by issuing debt securities like government bonds and mounting debt in the process, this is deficit spending.

If the government seems fit to control and reduce the rate of growth and decrease the amount of money flowing in the economy it can do so by increasing the tax rates in order to pull some money out of the economy. And if the goal is to increase business activity, this can be done by lowering tax rates and offering tax rebates to fan the embers of economic growth. The government can specifically tailor the tax policies and spending policies for a particular sector to either boost or curb the growth rates.

The Fiscal and Monetary response of India to the COVID-19 pandemic:

These policies are directed towards common economic goals for the country in the situation of financial distress, These measures are meant to minimize the economic damage caused by the virus and ease the stress on the financial system by means of monetary and fiscal policies.

Fiscal- Up Till March 26th, 2020, the Government of India has announced several stimuli and support packages to target specific sectors, workers in the health sector and in the lower wage bracket, like the 150 billion rupees(0.1% of GDP) commitment by the government to devote to the healthcare infrastructure. Measures have also been taken to ease the tax compliance burden for multiple sectors. The aggregate of fiscal measures by various state governments to support lower-income households amounts to 0.2% of the national GDP.

Monetary-  The Reserve Bank of India has reduced the repo rates by 75 basis points(bps) to 4.4%, the cash reserve ratio has also been reduced by 100bps.  They have also relaxed certain regulations regarding repayments of loans. All these measures are directed towards aiding in meeting the short term liquidity needs and reducing the financial strain for the government, lenders, and borrowers.

Which one is better and the bottom line:

It is important to understand that both the policies do not independently impact each other and that the central bank must carefully analyze the fiscal policies to craft the monetary policy. Similarly, the economic results of the monetary policies are to be considered when the policymakers draft the fiscal policies so that they are aligned to achieve the same economic goals. For example based on the central bank’s move- higher growth and/or higher inflation vs. slower growth and/or lower inflation—can affect policy makers' approach to taxation and government spending.

Between the two tools, fiscal policy is generally considered to be sharper and capable of having a greater impact, because in most nations the public sectors employ a significant portion of the population, thus it can lead to increased income and employment. The fiscal policies are meant to directly target the aggregate demand, hence impacting the underlying economy. History is a testament that these policies, individually or together have exacerbated an economic expansion that eventually led to damaging consequences for the economy. Hence, a bit of luck and careful study of the balance between the impact of the two policies is essential in steering the economic ship towards its goals. Studies have shown that the effects of fiscal policy have a greater impact over longer periods of time, whereas monetary policy makes waves in the short term.

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