Question

Explain the difference between fiscal and monetary policy. Who makes each of these policies? Explain. Also, explain any 2 (two) steps that can be taken to increase the supply of money in circulation by using monetary policy.

Answer 1

Monetary policy and fiscal policy are tools used to influence economic activity of the nation. Monetary policy is the tool used by central bank to control the money supply in the economy by varying the interest rates. Fiscal policy is the collective term for the taxing and spending actions of the government.It is created and managed by the legislature of the government. The differences between both are:

• Monetary policy addresses interest rates and adjust money in circulation while fiscal policy deals with spending by government.
• Monetary policy is determined by a central bank of the country (for eg: Federal Reserve) while fiscal policy is managed by government.
• Fiscal policy could have no specific target other than boosting economic growth while monetary policy control inflation.
• Fiscal policy discourages borrowings by the government and addresses the issue of stagflation where unemployment increases with economic pressure. While monetary policy depends upon the conditions in the economy.
• In case of deflation, expansionary monetary policy is adopted while in case of inflation, contractionary monetary policy is adopted. Fiscal policy can be implemented by regulating the taxes and expenditure of the government.
• Monetary policy is independent from political pressure while fiscal policy is more prone to political pressure.
• Monetary policy affects the housing market and investment opportunities in the economy while fiscal policy affects government borrowing.

The steps that can be used by the central banks to increase the money supply in circulation are :

• ​​​​​​Central banks can reduce the short term interest rates and increase the long term interest rates. It can encourage the banks to lend more at lesser interest and can make the people purchase loans to increase spending.
• The Cash Reserve Ratio are maintained in the banks according to Basel-III norms and reducing the statutory reserves in banks can make the banks have more liquid money for lending purposes. This can also boost the money supply.
• Open market operations are carried out by banks by selling the government securities. If they want to increase the money supply in the market, they buy back the government securities and releases more money into the market.