Fiscal Policy and Monetary Policy: How They Work Together to Stabilize the Economy

Fiscal policy and monetary policy have significant differences. The government oversees fiscal policy while the Fed oversees monetary policy. The Fed is the central bank of the United States and controls the money supply. Supply and demand is not the only ways in which the economy is affected. Both fiscal policy and monetary policy play their part. Each has the ability to affect the economy in its own way, with its own advantages and disadvantages.

The Fed has the greatest ability to slow down the economy in order to promote full employment and counter inflation with monetary policy. The Fed increases interest rates to defer people from borrowing money. In this case, monetary policy is more effective then fiscal policy. In order for fiscal policy to have an affect on slowing down the economy, the government must raise taxes or decrease spending, neither of which is very appealing and politically costly. Since the government runs fiscal policy, they must adhere to all aspects of democracy, which can lead to delays and slows down the process.

The Fed has the advantage of being independent of the normal political process. They are able to make decisions quickly without the time consuming checks and balances associated with the political process. They are also at a disadvantage because they do not have all the support of that same political process. Perhaps the checks and balances system the government uses could be somewhat effective in the Fed without hindering the speed they are accustomed to.

Fiscal policy is more effective in promoting economic growth by increasing government spending or reducing tax rates, both of which are politically appealing. Here, fiscal policy is more effective than monetary policy. The Fed will use monetary policy to lower interest rates and promote economic growth. In recessionary times, people are more reluctant to spend or borrow money, even when rates are extremely low. There is still worry that expansion will not pay off and so people won’t borrow the money. At the same time, banks are more reluctant to lend money at the lower interest rate. This is why monetary policy is unlikely to induce economic growth in times of recession, leaving it up to fiscal policy to pick up the slack.

Both fiscal policy and monetary policy each serves its own purpose and is most effective in its own way. Monetary policy succeeds in slowing economic growth while fiscal policy succeeds in expanding economic growth. Together the two have the ability to stabilize the economy.