Fiscal Vs. Monetary Policy: Which Tools Should The Government Use And When?

There are various tools utilized by officials when they deem the economy needs some extra support. Some of these actions are taken by federal, state and local governments. Other levers are pulled by central banks.

When talking about what actions can be taken by governments and what needs to be done by the regulators of the money supply, we’re discussing fiscal vs. monetary policy. Let’s take a deeper look at the interplay of these forces.

What’s The Difference Between Fiscal And Monetary Policy?

Fiscal and monetary policy are the two tools governments have to influence an ailing economy. Fiscal policy rests with the spending and taxation strategies of the central government, while monetary policy in the U.S. is controlled by the Federal Reserve and focuses on the amount of money available in the economy.

A shortcut to remembering this is that governments have the power of the purse. Central banks influence how much money is actually circulating through the economy. The rest of this post will explore how this works at a deeper level.

What Is Fiscal Policy?

State and local governments have control over fiscal policy within their jurisdictions, but because the federal government is the one most readers of this post are going to have in common, let’s focus our fiscal policy discussions on that level.

At its heart, fiscal policy is about the taxation and spending choices passed through both houses of the U.S. Congress and signed into law by the president as part of the budget negotiation process.

As an example of how complicated this gets, let’s take a look at how cutting spending impacts the economy vs. a decision to increase spending on benefits or projects. This discussion will be entirely theoretical and should not be seen as discussing any particular policy.

One of the measures that governments seek to keep under control is their debt to gross domestic product (GDP) ratio. GDP is a measure of overall economic growth within a country. As a general rule, you don’t want your debt increasing faster than your GDP.

If you cut spending, you can cut back on debt, which is a factor that can help lower the ratio of debt to economic growth. However, it’s slightly more complicated because government spending is a component of GDP. If the government cuts too much spending, the opposite effect can happen.

When a government increases benefits or funds a project, on one hand this can increase the government’s debt load. On the other hand, government spending is part of GDP. Consumers may also see more money in their pocket either because of an increase in government entitlements or because they’re hired to work on the project. This can give consumers more money to spend, which is a direct component of GDP. Also, more demand for products and services can mean more people hired to provide those services and make those products.

The basic point here is that there may not be one right answer and it’s often a balancing act.

Spending Vs Taxation

The government has two levers it can pull when it comes to fiscal policy: spending and taxation. When a government wants to boost the economy, they spend money to build programs that create jobs or expand social benefits to put money directly in the pockets of the citizens. For all the reasons we’ve listed above, deployed correctly, this can give the economy a boost.

However, there’s no such thing as free money. Eventually, someone has to pay the piper. Governments are funded through taxation. When taxes go up to pay for programs and entitlements, this has the effect of pulling money out of the economy. While the debt gets paid off, this can also slow growth.

Austerity Vs Stimulus

As the effects of the 2008 financial crisis spread across the world, the United States chose to do a couple of things that had the effect of contributing to economic growth in a big way. One, the U.S. government chose to spend a lot of money in order to kickstart the economy. One example of this was the first-time home buyer tax credit instituted because housing was and remains a huge part of the economy.

At the same time, the Federal Reserve, the U.S. central bank, chose to slash short-term interest rates to near zero. Because the Fed funds rate is the one at which banks borrow funds from each other, lowering this rate tends to mean that rates come down for all sorts of loan and credit options.

If the cost of borrowing money is cheaper, people will borrow more and use the money to plow into businesses to finance the purchase of goods and services. This tends to lead to higher employment as businesses look to meet demand.

In contrast to the U.S., Europe used austerity measures in response to the debt crisis and the recession that followed. This theory says that you should respond to debt by cutting budgets to the bone in order to reduce debt.

The problem is that in a recession, rather than doing things to support the economy and give it a boost, cutting spending can sometimes make things worse as people lose jobs. Additionally, because there’s no government support going into people’s pockets in a time of crisis, they aren’t spending, so demand tanks.

Where the U.S. began to thrive, it took Europe a much longer time to recover after 2008. The continent endured two separate recessions in relatively short order. Of course, you do eventually have to pay off debt. Ideally, governments do this when things are going well and they can still have moderate growth even with austerity measures in place. However, pulling supports out is a good way to lose votes. Once people have something, it’s hard to take it away again.

Austerity Pros And Cons

When governments turn to austerity measures, the first thing that happens is that government programs get cut. People who were employed by the government are suddenly without a source of income and cut spending significantly on goods and services. As a result, overall demand decreases and other businesses lay off workers. This can create cyclical unemployment as things start to spiral.

It’s for this reason that austerity may be intuitive when sources of government revenue dry up, but this can also be counterproductive if not done extremely well.

Pro: Targeted Cuts

One good thing about austerity measures is that they can be very targeted. You're getting rid of specific programs in order to trim budgetary fat and hopefully create a leaner, more efficient form of government that doesn't need to rely on as much revenue.

Pro Now, Con Later: Smaller Government Deficits (In The Short Run)

Another benefit in the short run is that when you undertake a program of austerity, you run smaller government deficits. By shrinking government, you make it less costly to run.

The longer-term problem with this is that governments tend to invest in programs for the longer-term health of the economy like research and education, which the private sector has less of an incentive to do. Still, being seen as an area that has the next big thing in any particular industry can attract investment and tax dollars.

If you’re not seen as a center of talent and innovation, you’ll have a harder time attracting business investment. This means an even smaller tax base in the longer-term. Because of this, cutting funds for certain government programs may help in the short term, but hurt in the future.

Con: Economic Decisions Made By Politicians

Elected government officials serve at the pleasure of the governed. Because of this, politicians are always conscious of how they can sell this to their constituency. For that reason, they may decide that the best option for the economy based on a spreadsheet or economic data is too tough to ask the people to stomach.

No one wants to pay more in taxes than they have to, even if it means cutting into government debt. At the same time, for the reason we mentioned above, it’s very difficult to cut government programs once people have them. When faced with this dilemma, even the most well-meaning elected official is likely thinking about the fallout of even the best possible policy decision.

Con: Timing Problems

Countries including the United States tend to have very specific dates by which budgetary measures must be approved. When you’re making decisions on budget, you need to get it done. However, the timelines for the budget don’t necessarily lineup with an economic cycle. So if you had to make a change in light of new data, you could find yourself hamstrung as an official.

When there’s a big economic shock like the one we just experienced, you have less ability to react to it if the austerity measures are tied to a particular yearly budget.

Con: Heightens Recessionary Pressures

When a government cuts spending, this can actually depress demand in the middle of a recession because people don’t have money in their pockets. When that happens, businesses cut prices and lay off workers. Now those workers don’t have money to buy goods and services and the cycle continues.

Moreover, at a certain point, prices go down enough that people begin to think to themselves: Why buy now when the price will be lowered tomorrow?

Stimulus Pros And Cons

Stimulus involves the government spending money. This has the impact of putting more money into the economy and supporting people either through jobs or expanded government programs. However, all economic decisions have winners and losers. Let’s go over some of the pros and cons.

Pro: Puts Money In Pockets

The fastest and simplest way to put more money into the economy is to give it directly to people to spend and get the economy going again. Congress and the president did this with a series of economic impact payments in 2020 – 2021. They also expanded benefit programs for unemployment for those who couldn't find work so that they could continue to spend and participate in the economy. Finally, they began paying the child tax credit upfront.

Provisions like these tend to be very economically popular. It’s a good way for politicians to show they’re doing something when the fate of the economy is uncertain.

Pro: Reduces Unemployment

Because there is more demand for goods and services, this tends to reduce the unemployment rate because businesses hire to meet increased demand. As more people are rehired, they also have money to spend, which further contributes to the healing of the economy.

Pro: Stimulates Economic Growth

The demand for new products and services created by the stimulus and the new employment that's driven by this all adds up to economic growth.

Con: Increases Inflationary Pressures

A little bit of inflation is generally considered a good thing because it encourages people to buy now rather than waiting to see if the price might go up. Right now, the Fed believes 2% annual inflation is optimal.

However, when people have more money in their pockets from stimulus, they’re often willing to pay more than they normally would for goods and services. On one hand, this is good because it encourages business to staff up to meet increased demand. On the other, this can cause prices to rise faster than regulators might like. It’s a fine line between a little bit of inflation and a lot of inflation. You don’t want to get to the point where you’re paying $10 for a pack of gum.

The United States is experiencing higher than normal levels of inflation at the moment. The Fed believes this short-term inflation problem is caused by supply being slower to ramp up as everything restarts after the economic shutdowns of last year. They see the current situation as manageable.

Con: Paying For It

The other big con to stimulus is that eventually you have to pay for it. As we mentioned before, you're not going to find many people in this world who are going to volunteer to pay higher taxes. However, eventually the bill comes due. This is something Congress and the president are wrestling with in their current discussions of the budget.

What Is Monetary Policy?

If government has the power to decide how to spend its money, then the Federal Reserve and other central banks around the world influence how much money is in the wallet. The function of monetary policy is to impact the money supply. Central banks also have an effect on interest rates, although they don’t control them directly. Finally, they have some sway with the banks in how much credit is available based on interest rates.

The Fed’s mission in all of this is a dual mandate of both maintaining high levels of employment and price stability. Sometimes those goals come into conflict, so as with fiscal policy, everything is a high wire act.

Expansionary Vs. Contractionary Policy

Central banks like the Fed can either act in ways that stimulate and add more money into the economy, referred to as expansionary policy, or they can undertake contractionary policy and pull money out of the economy. We’ll get more into when governments use these policies in the following sections.

When To Expand

Central banks tend to put expansionary policies in place when they see a recession coming on or they’re in the midst of one. Signs of this may be that the unemployment rate is creeping higher or inflation is so low that prices might actually be going down. This discourages people buying now. If there is no demand, businesses lay off workers and things get worse.

When To Contract

On the other hand, the Federal Reserve and other central banks might take action to slow things down if they start to see signs that the economy is becoming overheated. A good example of this would be what happened in the 1970s and early 1980s. In a condition called stagflation, prices began to rise so fast that people didn’t know what the dollar was worth from one day to the next. Prices were so out of control that people felt they couldn’t afford to buy many goods and services.

Faced with decreased demand and eventually higher interest rates, businesses started laying off workers and the unemployment rate became stubbornly high. The Fed finally reacted to raise interest rates enough to get the money supply under control, but the impact lasted for much of the rest of the decade.

Expansionary Policy Pros And Cons

When the Fed enacts a program of expansionary policy to support the economy, as with anything, it has pros and cons.

Pro: Credit Is Widely Available

One of the first things the Fed and other central banks have done over the last couple recessions is act to aggressively cut interest rates. This has the impact of making money cheaper to borrow and greatly expanding access to credit. This stimulates business investment and can speed up the rehiring process. When people get jobs, they have more money to spend and more demand is created.

Pro: More Money For Most

Although there are limits to eligibility, the U.S. and governments around the world generally gave direct payments to most of their citizens during the COVID-19 crisis. This had the effect of giving them more money to spend on goods and services. As such, businesses staffed up to meet the demand.

Con: Tools Are Blunt

The Fed as well as government stakeholders are limited in what they can do. It's very difficult to tailor a policy that targets the areas of greatest need. Additionally, there are situations when one group can’t benefit without another losing. As an example, raising interest rates makes it more difficult to buy expensive items like cars and homes, but savers would be happy to earn more interest.

Con: Inflation Can Follow Expansionary Policies

Because more money in the economy means more money for people to buy goods and services, they are willing to pay higher prices, which leads to inflation. However, if inflation rises too fast, you end up in the same stagflation situation mentioned earlier. If not done carefully, expansionary policies could end up leading to future pain.

Contractionary Policy Pros And Cons

We've seen the benefits and drawbacks of expansionary policy, but what about a contractionary stance?

Pro: Takes Excess Money Out Of The Economy

This is an unscientific estimate, but I'm willing to bet that 99.5% of the world would never tell you they have too much money. However, regardless of whether anyone will say it, there are signs that there's too much money floating around when inflation rises so high that you don't know what the price of a loaf of bread will be tomorrow. If that happens, you're right back where you were in the 1970s and 1980s.

Pro: Effective At Restoring Economic Fundamentals

When the inflation crisis was happening in the 1970s and ‘80s, the Fed chairman was Paul Volcker. He instituted a policy of "tough medicine." This involved the Fed raising interest rates until inflation was under control. Just how much? In late 1980, the lowest rate banks were charging their best customers, referred to as the prime rate, was above 21%.

The policy did work because the United States hasn't experienced a bout of inflation like that since. However, there were long-lasting and severe consequences.

Con: Taking Money Out Of An Economy Can Cause A Deep Recession

The high interest rates did solve the inflation problem, but they also made it extremely hard to get your hands on money. Businesses were unable to invest and people were laid off in extremely high numbers. The unemployment rate remained that way into the late ‘80s.

Con: Taking Money Out Of The Economy Causes Real Pain For Real People

As the above demonstrates, there are no easy choices for the Fed. In bringing inflation under control, millions of jobs were sacrificed. This put many Americans in a very tough spot economically. As such, decisions have to be undertaken very carefully.

When Should Governments Use These Tools?

The answer to this question is likely the subject of many a doctoral thesis in economics and also no doubt inspires hot debate in the halls of Congress and the White House. While we won’t answer this question here, we can briefly touch on some of the factors at play.

Timing The Economy

Negotiating any government budget involves no shortage of disagreements and debate. The process involves a great deal back and forth and takes a long time. Because of this, governments are slow to react to changing economic conditions on the ground. For this reason, it’s difficult to come up with a targeted solution to help give the economy enough of a boost to get support, but not so much as to create future inflation issues.

Political And Economic Consensus Can Be Difficult to Reach

The jobs of politicians and economists are fundamentally different. When you add the fact that one group has to answer to voters every 2 – 6 years, it quickly becomes apparent that there’s sometimes a fundamental mismatch in priorities. The thing that wins politically may not make a ton of sense from an economic perspective and what an economist thinks should be done can be a tough pill to swallow for voters electing the politician.

Are We Heading For A Recession?

Most recently, the United States experienced a 2-month recession when large swaths of the economy shut down for a while as a result of the pandemic. The future is much harder to predict. There are still certain things that remain worrisome. Among these is the quickening pace of inflation and unemployment remaining stubbornly high.

Although we don’t have a crystal ball, we can help you prepare for a recession

The Bottom Line: Economic Intervention Can Help Moderate Economic Cycles If Used Correctly

As is the case with all market-based economies around the world, the U.S. government and the Federal Reserve use a combination of fiscal and monetary policy to influence the U.S. economy, but it’s not something anyone has direct control over. We’ve gone over a lot of tools, but no one can fully influence what’s going to happen next.

Caution isn’t always a bad thing. If you’re concerned about where the future might lead, here are some tips on how to improve your financial health.