Monetary versus fiscal policy and the roles of fiscal policy

Two levers, one goal

A single household or company rarely moves a large economy. Governments do, for two reasons: the public sector employs a big share of workers and accounts for a big share of spending, and governments are the largest borrowers in debt markets.

Policy that shapes the macroeconomy comes in two forms. Monetary policy is what the central bank does to influence the quantity of money and credit, for example by setting interest rates. Central banks range from fully independent of government to acting simply as the government's agent. Fiscal policy is the government's own decisions about taxation and spending.

Both can be used to speed up an economy that is slowing or to cool one that is overheating. The common objective is an environment of positive, stable growth and low, stable inflation. In that setting households can plan consumption and saving, and companies can focus on investing, paying their bondholders and earning profits.

The job is hard: economies are hit by shocks such as energy-price jumps, some economists believe in natural cycles, and history has plenty of cases where policy itself fed a boom that ended badly.

What fiscal policy is for

Fiscal policy influences three things. First, the overall level of aggregate demand (what households and companies plan to spend) and therefore real GDP. Second, the distribution of income and wealth across the population. Third, the allocation of resources between sectors and economic agents.

Analysis usually focuses on the gap between spending and revenue, not on their levels. An expansionary package raises demand: cutting personal income tax lifts disposable income; cutting sales taxes lowers prices and raises real incomes; cutting corporate tax lifts profits and may raise capital spending; cutting tax on savings income raises savers' disposable income; and new public spending on schools or hospitals raises incomes directly.

These links are not mechanical. In a deep recession, households may save an income-tax cut as a precaution rather than spend it. That is the root of a long debate. Keynesians argue fiscal policy has powerful effects on demand, output and jobs when there is a lot of spare capacity. Monetarists argue fiscal changes only affect demand temporarily and that monetary policy is the better tool for restraining or boosting inflation.

The budget balance and automatic stabilizers

The budget surplus or deficit is government revenue minus expenditure over a fixed period such as a fiscal year. Revenue is measured net of transfer payments; spending includes interest on government debt. If the two are equal, the budget is balanced.

Analysts read the year-on-year change in the balance as a sign of direction: a larger surplus (or smaller deficit) points to contractionary policy, a larger deficit points to expansionary policy. A package that raises some spending but offsets it fully with other cuts or tax rises leaves the balance unchanged and is neutral.

Part of the balance moves on its own. In a downturn, unemployment benefits rise and tax receipts fall, which props up demand. In a boom, progressive taxes take a rising share of income, which restrains demand. These automatic stabilizers need no decision and no forecast, and they reduce output swings. They differ from discretionary fiscal policy, which is a deliberate change in spending or tax rates.

Automatic stabilizers act like shock absorbers on a car: they do not steer, but they make every bump smaller without the driver doing anything.