Monetary vs. Fiscal Policy: What’s the Difference?

Unless you’ve been too busy looking at the latest Clinton/Trump memes or playing the PPAP video on loop, then you’ve probably noticed that more than a few economic hotshots are now asking their governments for fiscal policy changes.

What the heck is fiscal policy and how is it different from monetary policy?!

First, you have to know that both policies aim to influence how fast or slow consumer prices (inflation) and economic growth (GDP) rise. After all, both have to grow at sustainable rates to prevent economic imbalances. Both policies have their advantages, but they also have limitations. Let’s take a closer look:

What is Monetary Policy?

Monetary policies aim to control the supply of money circulating in the economy. They’re implemented by central banks and monetary authorities which are usually quasi-independent. That is, they make the calls but their decisions can sometimes be influenced by the government, businesses, and other market players.

Central banks usually control money supply in three ways:

  • Interest rate – The rate it’s charging regular banks for borrowing money.
  • Required reserve ratio (RRR) – The percentage of customer deposits regular banks are required to park in the central bank.
  • Open market operations – The buying (selling) of government or corporate debt, effectively lending (withholding) money to market players.

Lately, central bankers such as the Fed and the BOE have also used forward guidance, or the act of sharing their biases and future plans in an attempt to influence spending decisions of households and businesses as well as reduce speculations on their next meetings.

In an expansionary monetary policy, central banks would attempt to increase economic activity by lowering their interest rates and/or RRR and buying “safe” and high-rated debts. In theory, more money flowing to regular banks would translate to more business lending and household spending.

In a contractionary monetary policy, central banks want to dial down the money supply by raising its interest rates and/or RRR and sell their debt holdings. Borrowing for average Joes and Janes would get harder, which would limit economic activity.

Monetary policies are quicker to implement, as they don’t require the approval of other market players. However, their impact may be limited when market players don’t respond to classic economic correlations. For example, regular banks may use their extra moolah to pay debts and hoard cash instead of lending them to businesses and households, diminishing the impact of expansionary monetary policies.

What is Fiscal Policy?

Nothing quasi about this one! Fiscal policies are straight up from the government. They get their money and influence economic activity in two ways:

  • Taxes – As in the one you have to declare to the IRS.
  • Government spending – This includes infrastructure spending as well as debt market activities like buying and selling Treasury bills and bonds. Government spending directly affects GDP.

In an expansionary fiscal policy, the government would stimulate growth either by lowering taxes or step up its spending efforts in targeted industries, investments, and communities. Infrastructure spending, in particular, directly creates jobs, which further increases spending capabilities of regular households.

In a contractionary fiscal policy, the government would cool down economic activity either by its raising taxes or decreasing its spending activities.

Unlike monetary policies, fiscal policies can be more targeted and can directly influence aggregate demand. However, fiscal policy changes take longer to implement, as they’ll have to go through government dialogues and processes in order get approved.

Why they must work hand in hand

In his speech before the European Parliament this week, ECB Governor Mario Draghi threatened that “if no other policy is in place, the length of time for the effectiveness of our monetary policy will be longer,” adding that “actions by national governments are needed to unleash growth.

forex playersJapan’s officials are also calling for government action, with BOJ Deputy Governor Hiroshi Nakaso sharing that “The BOJ took bold steps last week … but that alone isn’t enough. There needs to be structural reforms to promote innovation.” Heck, even central banks such as the BOE, RBA, and RBNZ have warned against the limitations of their policies!

Clearly there’s only so much a low interest rate or bajillions worth of asset purchases can do. This is especially problematic for central banks such as the ECB and the BOJ, who are still struggling to meet their inflation targets despite lowering their rates to negative levels and buying tons of assets.

Likewise, too much government spending *cough* China *cough* and not enough monetary guidance can lead to market uncertainty and imbalanced growth.

For now it looks like a lot of major central banks have pushed the pedal to the metal but have little to show for their efforts. How far are they willing to go before they flip the table and cry “Uncle?” Does this mean that market players will look to government officials for clues on inflation and economic growth down the road? What do you think?


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