Explain the difference between fiscal policy and monetary policy. Discuss how each of these approaches can be used to influence the state of the economy.
http://www.econlib.org/library/Enc/FiscalPolicy.html
http://www.investorwords.com/3097/monetary_policy.html
Fiscal policy and monetary policy are two important tools used by governments to influence the state of the economy. Let's first define each one and then discuss how they can be used to achieve their respective goals.
Fiscal policy refers to the use of government spending and taxation to impact the overall economy. It involves decisions on how much the government should spend on public goods and services, as well as how much money it should collect through taxes. By adjusting these variables, the government can either stimulate or slow down economic activity.
To understand the impact of fiscal policy, you can examine the following aspects:
1. Government spending: When the government increases its budget for public expenditure, such as infrastructure development, education, healthcare, and defense, it often creates job opportunities and injects money into the economy. This additional spending can stimulate economic growth and increase aggregate demand.
2. Taxation: The government can influence the economy by adjusting tax rates. During recessions or times of low economic activity, the government may decrease taxes to encourage increased spending and investment. Conversely, during periods of high inflation, the government may increase taxes to reduce consumer demand and control prices.
3. Deficit and debt: Fiscal policy can also be influenced by the government's borrowing and accumulation of debt. Governments may run budget deficits by spending more than they collect in taxes, which can stimulate the economy. Conversely, excessive deficits and debt can have negative consequences, such as inflation or crowding out private investment.
On the other hand, monetary policy refers to actions taken by central banks to manage the money supply and interest rates to influence economic activity. The main objective of monetary policy is to promote price stability and ensure the stability of the financial system. Central banks use several tools to control monetary policy, including:
1. Interest rates: Central banks have the authority to set interest rates, which affects borrowing costs for both individuals and businesses. By increasing interest rates, they can reduce borrowing and discourage spending, which can help control inflation. Conversely, decreasing interest rates encourages borrowing, investment, and consumer spending, stimulating economic growth.
2. Reserve requirements: Central banks also use reserve requirements to control the amount of money that commercial banks must hold in reserves. By increasing requirements, central banks reduce the amount of money available for lending, thus slowing down economic activity. Conversely, decreasing reserve requirements provides more liquidity to banks, encouraging lending and stimulating the economy.
3. Open market operations: Central banks can intervene in financial markets by buying or selling government bonds. By purchasing bonds, they inject money into the economy, increasing liquidity and stimulating lending. Conversely, selling bonds reduces the money supply, which can help control inflationary pressures.
In summary, fiscal policy involves government spending and taxation decisions to influence the economy, while monetary policy focuses on managing the money supply and interest rates. Both policies play vital roles in influencing economic activity. Fiscal policy is primarily driven by government decisions, while monetary policy is implemented by central banks. By understanding the principles and objectives behind each policy, stakeholders can make informed decisions to influence the state of the economy.