Fiscal policy and monetary policy play an important role in the economy in uncontrollable situations. So a basic understanding of what they are all about would be helpful.
It is a government policy which aims to support the economy through changes in the government’s spending and taxes. It usually coexists with the monetary policy implemented by central banks which has similar goals and will be discussed later in this post.
The main goals of fiscal policy are to maintain economic growth, the stability of prices and high employment rate.
On the basis of two important components of fiscal policy, which are government expenditures and taxes, it can be divided into three types:-
1. Expansionary fiscal policy – It is a widely used policy, in which the government increases its expenditures and cuts the taxes. It is basically undertaken at the time of recession to boost the economy.
2. Contractionary fiscal policy – It is a rarely used policy in which government decreases its expenditures and increases the taxes in order to control high inflation prevailing in the economy during the strong economic growth.
3. Neutral policy – In this type of policy, the economy is stable and the government’s expenditure is balanced by tax revenue which has a neutral effect on the economy.
With similar goals but different approach, monetary policy is a central bank policy concerned with the money supply in the economy.
Following are certain tools used by central banks to implement the monetary policy:-
1. Open market operations – Buying and selling of government securities such as bonds by the central bank in an open market is called open market operations. Buying of securities add money to the banking system which increases the lending capacity of banks at low interest rates which ultimately encourages more businesses or investments. The selling of securities has opposite effects as it decreases the money supply in the economy with high interest rates.
2. Discount rates – It is the interest rate at which the central bank lends to other banks. In case of high interest rates, the cost of borrowing for the banks increases and ultimately for their customers also. This discourages new businesses and investments. It also works conversely where the central bank lends at lower interest rates to the banks that can further provide loans at a lower interest rate to their customers.
3. Reserve ratio requirement – Central Bank basically set up a minimum amount of reserve that must be held by the banks which is a specific percentage of their deposits. By raising the reserve ratio requirement, banks have to decrease their lending capacity which ultimately decreases the money supply and by lowering the reserve ratio requirement lending capacity and asset-buying capacity of banks increases which increases the money supply in the economy. Reserve ratio requirement impacts directly on lending and buying operations of banks.
On the basis of objectives, monetary policy is divided into two types:-
1. Expansionary monetary policy – This type of policy is used by central banks as it aims to increase the money supply in the economy and reviving the economy by lowering the interest rates and reserve requirements for banks or buying government securities to encourage more businesses and investments in the market.
2. Contractionary monetary policy– This type of policy is used by the central bank during the high inflation period as it aims to decrease the money supply in the economy and slowing down the economic growth to control inflation. It is done by raising the interest rates and reserve ratio requirement for banks or selling government securities.