Financial Concept: Fiscal Policy versus Monetary Policy

When I first started my formal journey in financial planning, I find myself confused between these 2 terms related to macroeconomics. They sound similar but are actually distinctly different. Here is how you classify them the next time people talk about government budget, base lending rate (BLR), interest rate, deficit,  ringgit closed weaker against US dollar, etc.

See also a related post on business cycle

Fiscal Policy

Purpose: The use of government budget to influence income distribution and economic activity.

Instruments used: Government spending and taxation.

2 approaches employed

Expansionary fiscal policy

Government spending higher than tax revenue.

To drive up aggregate demand, government increases spending and decreases tax rates.  This aims to spur economic growth during recession.

Contractionary fiscal policy

Government spending lower than tax revenue.

To reduce aggregate demand, government reduces spending and  increases taxes. This aims to slow economic growth and keep inflation in check.

monetary fiscal policy

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Monetary policy

Purpose: The policy implemented by central bank to regulate money supply in a country.

Instruments used: Open market operation, base lending rate and reserve requirement change.

2 approaches employed

Expansionary monetary policy
Increases money supply by reducing interest rates and financial institutions money reserve requirement.

Lower interest rates lead to higher levels of capital investment because it is now cheaper to borrow money.

The value of the domestic currency is now weaker relative foreign currencies because its demand falls. In other words, Forex rate decreases.

Exports increases, while imports decreases.

Contractionary monetary policy
Decreases money supply by increasing interest rates and financial institutions money reserve requirement.

Higher interest rates lead to lower levels of capital investment because it is now more expensive to borrow money.

The value of the domestic currency is now stronger relative foreign currencies because its demand rises. In other words, Forex rate increases.

Exports decreases, while imports increases.

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