Question

Explain the concepts of fiscal and monetary policy. Who conducts them and how do they work their way through the economy?

Answer 1

Fiscal policy refers to the whole body of policies dealing with the revenue and expenditure process of the government. Monetary policy, on the other hand, refers to the policies made by the monetary authority of the country targeting the flow of money supply and maintaining the interest rates of a country. Fiscal policy is conducted by the government of a country whereas the monetary policy is conducted by the central bank of a country.

How Fiscal Policy work :

When an economy is facing a recession, the government can lower tax rates and increase subsidy payments, so that the disposable income available in the hands of the citizens increases in the economy and there are more investments made by firms and more demand for labor by these firms. In this way, unemployment decreases and wages of the employees rises. The government can also increase its spending by investing in infrastructure of the country such as roads and railways, so that with improved infrastructure, the transportation of goods from one place to another becomes easier and with that the economy improves. On the other hand, when the economy is facing excessive inflation, the government can increase the tax rate, decrease subsidy payments and decreases its aggregate expenditure to lower the money supply in the economy.

How Monetary Policy work:

When an economy is facing a recession, the Central Bank can lower the interest rate so that more firms can borrow from the banks at a lower interest rate and then they can invest more in their businesses. This leads to increase in the money supply in the economy. The Central Bank can also increase the money supply by printing more money so that there is more spending in the economy which would lead to increase in aggregate demand and lower unemployment. On the other hand, when the economy is facing excessive inflation, the Central Bank can increase the interest rate and stop printing any further money and thus lower money supply.