What is the relationship between monetary and fiscal policy

Difference between monetary and fiscal policy | Economics Help

what is the relationship between monetary and fiscal policy

Monetary policy is announced by RBI and changes are made bimonthly. Interest rate is a major policy instrument through which changes in money supply takes. The most important difference between the fiscal policy and monetary policy is provided here in tabular form. Fiscal policy is mainly related to. What is the difference between monetary policy (interest rates) and fiscal policy ( government spending and tax? Evaluating most effective.

Level of government spending Levels of taxation To increase demand and economic growth, the government will cut tax and increase spending leading to a higher budget deficit To reduce demand and reduce inflation, the government can increase tax rates and cut spending leading to a smaller budget deficit Example of expansionary fiscal policy In a recession, the government may decide to increase borrowing and spend more on infrastructure spending.

  • Difference between monetary and fiscal policy

The idea is that this increase in government spending creates an injection of money into the economy and helps to create jobs. There may also be a multiplier effectwhere the initial injection into the economy causes a further round of higher spending. This increase in aggregate demand can help the economy to get out of recession. Expansionary fiscal policy If the government felt inflation was a problem, they could pursue deflationary fiscal policy higher tax and lower spending to reduce the rate of economic growth.

Which is more effective monetary or fiscal policy? In recent decades, monetary policy has become more popular because: Monetary policy is set by the Central Bank, and therefore reduces political influence e.

Difference Between Fiscal Policy and Monetary Policy (with Comparison Chart) - Key Differences

Also, lower spending could lead to reduced public services, and the higher income tax could create disincentives to work. Monetarists argue expansionary fiscal policy larger budget deficit is likely to cause crowding out — higher government spending reduces private sector expenditure, and higher government borrowing pushes up interest rates. However, this analysis is disputed Expansionary fiscal policy e.

Monetary Policy vs Fiscal Policy - Money and Banking Part 9 - Indian Economy

Passive monetary policy is one that sets interest rates to accommodate fiscal policies. In case of an active fiscal policy and a passive monetary policy, when the economy faces an expansionary fiscal shock that raises the price level, money growth passively increases as well because the monetary authority is forced to accommodate these shocks.

But in case both the authorities are active, then the expansionary pressures created by the fiscal authority are contained to some extent by the monetary policies.

Interaction between monetary and fiscal policies

Supply shock[ edit ] During a negative supply shockthe fiscal and monetary authorities may follow conflicting policies if they do not coordinate, as the fiscal authorities would follow expansionary policies to bring the output back to its original state while the monetary authorities would follow contractionary policies so as to reduce the inflation created due to the cutback in output caused by the supply shock.

Demand shock[ edit ] During a demand shock a sudden significant rise or fall in aggregate demand due to external factors without a corresponding change in output, inflation or deflation may result.

what is the relationship between monetary and fiscal policy

Here monetary and fiscal policies may work in harmony. Both the authorities would follow expansionary policies in case of a negative demand shock in order to bring back the demand at its original state while they would follow contractionary policies during a positive demand shock in order to reduce the excess aggregate demand and bring inflation under control.

Fiscal shock and policy rate shock[ edit ] In case of a positive fiscal shock increase in fiscal deficitsaggregate output may rise beyond potential sustainable output due to the fiscally induced rise in aggregate demand.

what is the relationship between monetary and fiscal policy

Subsequently, this leads to dissavings and lowering of investments which would depress output in the long run. Monetary authorities react in a countercyclical way to this, tightening monetary policy in the short run but perhaps in the long run adopting quantitative easing to counter the longer-term fall in output.

what is the relationship between monetary and fiscal policy

In case of policy shocks consisting of a sudden positive negative change in banking policy rates such as the statutory liquidity ratiocash reserve ratio or the repo ratesthe fiscal authority initially reacts by following expansionary contractionary policy but subsequently reverses. Presence of monetary union[ edit ] When an economy is a part of a monetary unionits monetary authority is no longer able to conduct its monetary policies independently in response to the needs of the economy.

Difference Between Fiscal Policy and Monetary Policy

Under such a situation the interaction between fiscal and monetary policies undergoes certain changes. Generally, the monetary union follows policies to keep the overall inflation at such levels so as to keep the overall gap between the actual aggregate consumption and desired consumption close to zero. Fiscal policies are then used to minimise the country specific welfare losses arising out of such policies.