Fiscal vs Monetary Policy: Who Does What

Fiscal policy and monetary policy are the two ways government tries to steer total spending in the economy. They aim at the same target, aggregate demand, and they get confused because the labels sound alike. The cleanest way to keep them apart is to ask who holds the lever. Fiscal policy is set by Congress and the President and works through government spending, taxes and borrowing. Monetary policy is set by the central bank, the Federal Reserve, and works through money, credit and interest rates.

This post sets the two side by side, then covers the numbers each one gets tested on. It assumes the AD/AS picture from aggregate demand and aggregate supply explained.

The comparison at a glance

Both are countercyclical: stimulate in slumps and restrain in booms.

Fiscal policy

Expansionary fiscal policy raises AD through higher government spending or lower taxes, and it fits an economy with output below potential GDP. Below potential, shifting AD right raises output toward potential, lowers unemployment, and raises the price level only a little. Contractionary fiscal policy lowers AD through spending cuts or tax increases and fits an economy with output above potential, where the problem is overheating and rising prices.

Government purchases add to AD directly. Tax cuts work indirectly, through consumption (household tax cuts) and investment (business tax cuts). That difference is why the multipliers differ.

The multipliers

With fixed prices and lump-sum taxes, the course uses these:

• Spending multiplier = 1 / (1 - MPC)
• Tax multiplier = -MPC / (1 - MPC)

With an MPC of 0.80, the spending multiplier is 1 / 0.20 = 5.00, so a $100 billion rise in government purchases raises output by $500 billion. The tax multiplier is -0.80 / 0.20 = -4.00, so a $100 billion tax cut raises output by $400 billion. The tax cut does less because households save part of it. If the economy is $200 billion below potential and the MPC is 0.75, the multiplier is 4.00 and the policy needed to close the gap is 200 / 4.00 = $50 billion of extra government purchases, less than the whole gap.

With an income tax rate t, the multiplier becomes 1 / (1 - MPC x (1 - t)). At an MPC of 0.80 and a 25 percent tax rate that is 1 / (1 - 0.80 x 0.75) = 2.50. This dampening is part of why taxes act as stabilizers.

Automatic stabilizers versus discretionary policy

Discretionary fiscal policy needs a new law, such as stimulus checks. Automatic stabilizers are existing tax and spending rules that shift with the economy: unemployment insurance, food assistance and progressive income taxes. In a recession incomes and profits fall so tax revenue falls, while unemployment rises so benefit spending rises, and both support AD. Stabilizers act fast with no legislative lag, but they offset only part (roughly a tenth) of a shock.

Limits of discretionary fiscal policy

• Crowding out. Government borrowing raises interest rates and cuts business investment, so stimulus is weaker than expected. The textbook rule of thumb is that a deficit increase of 1% of GDP raises long-term interest rates by about 0.5 to 1.0 percentage point.
• Three lags, in order. Recognition (seeing that a recession has begun), legislative (passing the bill) and implementation (getting the money flowing). Policy that arrives late can do harm: expansion after recovery adds inflation.
• Temporary versus permanent. People respond less to temporary changes than to permanent ones.
• Politics. Politicians favor stimulus and resist restraint, so contractionary policy is rare.

Monetary policy

The Federal Reserve was created by Congress in 1913. It has a Board of Governors of 7 members plus 12 regional Reserve Banks. The FOMC, which sets the federal funds rate target, has 12 voters: the 7 governors and 5 Reserve Bank presidents, with the New York Fed president always voting. The Fed's goals are maximum employment, stable prices and moderate long-term interest rates, and it has had an explicit 2 percent inflation goal since January 2012.

The tools

• Open market operations. The Fed buys or sells government bonds. Buying bonds sends money to banks, so reserves and the money supply rise and interest rates fall. Selling bonds does the reverse.
• Discount rate. What the Fed charges banks that borrow from it, set above the federal funds rate.
• Reserve requirement. 0 percent since March 2020.
• Interest on reserve balances (IORB). Since 2008-09, with ample reserves, the FOMC steers the federal funds rate mainly with IORB. Lower IORB leads banks to lend reserves in the funds market, so the funds rate falls.
• Quantitative easing. Buying long-term Treasuries and mortgage-backed securities when short-term rates are near zero, to lower long-term rates.

The federal funds rate is the overnight rate banks charge each other for reserves.

How it reaches the economy

Expansionary monetary policy raises money and credit and lowers interest rates, shifting AD right. The chain is: the Fed lowers its target, other rates move the same way but by less, business investment and consumer borrowing for houses and cars rise, and AD shifts right. Contractionary policy does the reverse and is used against inflation. If output is above potential and inflation is rising, the central bank sells bonds to push rates up.

The real interest rate is the nominal rate minus the inflation rate. With a nominal rate of 5.0 percent and inflation of 1.5 percent, the real rate is 3.5 percent. The inflation and real value calculator will do this one for you.

Pitfalls

• Long and variable lags. Main effects may arrive one to three years out, and the delay is uncertain.
• Excess reserves. In a deep recession banks hold reserves rather than lend and borrowers are cautious, so loose policy can fall flat. Tightening works more reliably.
• Deflation. The real rate is nominal minus inflation, so unexpected deflation raises it. At a 0 percent nominal rate with 5 percent deflation, the real rate is 5 percent.
• Overshooting. Too loose can cause inflation, too tight can cause a recession.
• Bubbles and leverage cycles complicate the picture.

Which one is faster?

The course notes that monetary policy can change faster than fiscal policy, since the FOMC can act without legislation. Both agree that AD can control inflation. They split on recessions: Keynesians favor active stabilization, while neoclassicals stress the lags and say AD stimulus against recession is at best temporary. In the neoclassical view the long-run Phillips curve is vertical at the natural rate, so output is set by AS, and AD only moves the price level.

Exam traps

• Saying the Fed sets taxes, or Congress sets interest rates. Fiscal is Congress and the President, monetary is the Fed.
• Mixing up the direction of open market operations. Buying bonds lowers interest rates.
• Using the MPC itself as the multiplier. The multiplier is 1 / (1 - MPC).
• Calling the deficit the debt. The deficit is a one-year flow and the debt is the stock of all past deficits minus surpluses.
• Treating a percentage-point change as a percent change.

Practicing it

These topics reward questions that make you choose: given a recession, which policy, which direction, which side of the graph? Use the testing effect by covering the table above and rebuilding it. Fiscal policy is unit 17 and monetary policy is unit 15; what's in Principles of Macroeconomics maps the course and how to study for macroeconomics covers the order. Every point here is a card in the free macroeconomics course, and the economics formulas cheat sheet collects the multipliers and the money formulas in one place.