Monetary policy and fiscal policy

Monetary policy and fiscal policy refer to the two most widely recognized
tools used to influence a nation's economic activity. Monetary policy is primarily
concerned with the management of interest rates and the total supply of money in
circulation and is generally carried out by central banks such as the U.S. Federal
Reserve. Fiscal policy is the collective term for the taxing and spending actions of
governments. In the United States, the national fiscal policy is determined by the
executive and legislative branches of the government.

Monetary policy

Monetary policy consists of the process of drafting, announcing and

implementing the plan of actions taken by the central bank, currency board or other
competent regulatory authority of a country that determines the scope and impact
of the key drivers of the economic activity in that country. Activities which are
integral to monetary policy consists of management of money supply and interest
rates which are aimed at achieving macroeconomic objectives like controlling
inflation, consumption, growth and liquidity. These are achieved by actions such as
modifying the interest rate, buying or selling government bonds, regulating foreign
exchange rates, and changing the amount of money banks are required to maintain
as reserves.
Fiscal policy

Fiscal Policy refers to the use of the spending levels and tax rates to
influence the economy. It is the sister strategy to monetary policy which deals with
the central bank’s influence over a nation’s money supply. The governing bodies
use combinations of both these policies to achieve the desired economic goals.
Thus, the essential tools of fiscal policy are taxing and spending.

How Do Fiscal and Monetary Policies Affect Aggregate Demand?

Fiscal policy affects aggregate demand through changes in government

spending and taxation. Government spending and taxation influence employment
and household income, which dictate consumer spending and investment.
Monetary policy impacts the money supply in an economy, which influences
interest rates and the inflation rate. Also, monetary policy impacts business
expansion, net exports, employment, the cost of debt and the relative cost of
consumption versus saving.

Aggregate demand measures the demand for an economy's gross domestic product
(GDP). This value is calculated by the following equation:

AD = C + I + G + (X-M), where

AD refers to aggregate demand, C refers to total consumer spending, I refers to

total investment, G refers to government expenditure and (X-M) refers to net
exports (total exports - total imports).

Fiscal policy determines government spending and tax rates. Expansionary

fiscal policy, usually enacted in response to recessions or employment shocks,
increases government spending in areas such as infrastructure, education and
unemployment benefits. According to Keynesian economics, these programs
prevent a negative shift in aggregate demand by stabilizing employment among
government employees and people involved with stimulated industries. Extended
unemployment benefits help stabilize the consumption and investment of
individuals who become unemployed during a recession.

Monetary policy is enacted by central banks by manipulating the money supply

in an economy. The money supply influences interest rates and inflation, both of
which are major determinants of employment, cost of debt and consumption levels.
Expansionary monetary policy entails a central bank either buying Treasury notes,
decreasing interest rates on loans to banks or reducing the reserve requirement. All
of these actions increase the money supply and lead to lower interest rates. This
creates incentives for banks to loan and businesses to borrow. Debt-funded
business expansion positively affects consumer spending and investment through
employment, thereby increasing aggregate demand.

Monetary Policy Shifts AD

In the case of contractionary monetary policy, the money supply in the economy
is decreased which further leads to a decrease in the nominal output, also known as
the Gross Domestic Product (GDP). Additionally, the declined money supply in the
market also leads to reduced spending by the consumers which thus shifts the
aggregate demand curve to the right.

In the case of expansionary monetary policy, the central bank increases the
money supply in the market by purchasing government bonds, and this pumps
money into the market, and also decreases the interest rate as banks have more
cash to loan to firms. Thus, firms begin to invest in order to increase output i.e.
increased GDP. This leads to increase in employment. Additionally, as there is
more money in the market, the consumer spending increases as well. All this
activity shifts the aggregate demand curve to the left.

Fiscal Policy Influences AD

In pursuing expansionary fiscal policy, the government either increases

spending, or reduces taxes or does a combination of both. As mentioned above,
increase in the government spending shifts the AD curve to the right. Reduced
taxes mean the consumer has more dispensable income at hand, and so can
purchase more. This as well shifts the AD curve to the right. Plus, a combination of
both increased government spending and reduced taxes also works in shifting the
AD curve to the right. The extent of the shift in the AD curve due to government
spending depends on the size of the spending multiplier, while the shift in the AD
curve in response to tax cuts depends on the size of the tax multiplier.

The government uses a contractionary fiscal policy when there is a demand-

pull inflation. It also facilitates in paying off unwanted debt. In the case of
contractionary fiscal policy, the government either decreases spending, or raises
taxes, or does a combination of the two. Less money rotation in the market leads to
decline in the output which means reduced GDP. The consumer spending also
takes a dip as there is lesser money available for expenses. Contractionary fiscal
policy shifts the AD curve to the left. If the tax revenues exceed government
spending then this type of policy leads to a budget surplus.