Question

Discuss the main differences between fiscal policy and monetary policy. What steps or actions does the government take to influence or pursue either type of policy?

Answer 1

Fiscal policy is the policy of the federal Government and monetary policy is the policy of the central bank or the central monetary authority. Fiscal policy actions take much longer time to show their effects relative to the monetary policy actions because of different kinds of lags. Fiscal expansion raises the rate of interest while monetary expansion reduces it. The effect of a fiscal policy on trade balance is opposite in relation with the effect of monetary policy on the trade balance.

Government it uses taxes and government spending under fiscal policy. In contrast, Central Bank uses various tools to influence the money supply under monetary policy. In case of an expansionary fiscal policy, government it increases its spending or cut taxes to stimulate aggregate demand. Central Bank on the other side, conducts an expansionary monetary policy by reducing the federal funds rate. This can be done by open market purchase of government securities, reducing reserve requirement, or reducing the discount rate. This again stimulates aggregate demand.