Intermediate Macroeconomic Theory and Policy
Fiscal and monetary policies are the major economic issues that directly affect the performance
of a country’s economy. Fiscal policy is the application of a government’s collection of revenues
in the form of taxes and expenditure processes in a way that influences the performance of the
economy. According to the Keynesian theory, when the level of taxes and spending budgets are
varied by the government it affects the aggregate demand and influences the rate of economic
activities. Fiscal policies are applied to stabilize a country’s economy. Monetary policies are
mostly related to the management of demand and supply of money in an economy. There are
several tools that are applied by governments to control the amount of money in an economy so
as to influence such outcomes as favorable economic growth, inflation, unemployment and
exchange rates. Fiscal and monetary policies are mostly target the improvement of the
performance of a country’s economy. This paper seeks to examine the relationship that exists
between the fiscal and the monetary policies as applied by most governments in an effort to
improve the performance of their economies.
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Monetary policies affect the availability of money in an economy. The government uses the
interest rates and other instruments to achieve its objective on the supply of money in the
economy. Expansionary policies lead to increased amounts of money in the economy while the
contractionary policies result in a reduction of the money supply. During a recession, the
government uses the expansionary measures by lowering the interest rates to counter the causes
of unemployment while during inflation the government applies contractionary measures by
increasing the rates of interests that ensures that excess amount of money in the economy is
removed. Interest rates are the major tools used by most governments to implement the monetary
policies through such operations like the open market operations that involve buying and selling
bonds, treasury bills and foreign currencies. (Heyne, Boettke and Prychitko, 2002)
Fiscal policies involve the use of the government’s revenue collection and expenses to influence
the operations of the economy which is different from the objectives of the monetary policies
which relate to the stabilization of the economy by controlling the supply of money in the
economy. Fiscal policies utilize the government taxes and expenditures to influence the
performance of the economy. By changing the rates or levels of taxation, the government can
increase or reduce the demand and the rate of economic activities while also distributing income
equitably. (Hansen, 2003)
Expansionary fiscal policies results in greater expenditure than the revenues from taxes that the
government is receiving. These is always achieved by reducing the taxes chargeable or
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increasing the levels of expenditure without adjusting the sources of revenues. The government
finally creates a deficit in its budget. (Heyne, Boettke and Prychitko, 2002)
The contractionary fiscal policy leads to greater taxation than government expenditure. This is
achieved by increased taxation and non adjustment of the expenditure budgets or reduced
expenditure. When the government needs to settle its deficits it uses the same tactics like the
open market operations in monetary policies through the sale of bonds, treasury bills and also
securities. Fiscal policies also help in countering the effects of recession. Fiscal policies and
monetary policies are utilized to improve the performance of the economy.
Neutral fiscal policies refer to instances where the economy is basically in the equilibrium
meaning that the government spending is totally funded by its tax revenues and its budget is
generally balancing without any deficit or surplus and its effect on the economy is neutral.
The Relationship between Monetary policies and the Fiscal policies
Monetary policies that target flexible rates of inflation which are needed to stabilize the economy
are the major objectives of the governments both fiscal and monetary policies. Both policies
have tremendous effect on the functioning of the economy and its financial management
systems. The policy rate of taxation or the interest rates for monetary and fiscal policies
respectively act as the tools for the government. The publication of forecasts on inflation rates
and the real economy by some countries federal or central banks act as a guide to the policy rate
determination. Other tools that can be utilized though they are unconventional in some countries
are the fixed rates lending rates which have longer maturity periods or the regular adjustments of
the composition and sizes of the assets of a country’s central bank such as quantitative easing on
money supply which affect long term interest rates and the future expectations of the short term
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rates and other interventions on foreign exchange which may prevent the currency appreciation
or depreciation. The monetary policy is controlled by a country’s central bank.
A country’s fiscal policy has a major objective of promoting and maintaining the country’s
financial system. The financial stability of a country depends on its ability to meet its payments
and expenditure budgets by transforming its savings into investments while adopting the
procedures of risk management that may threaten its major functions. Fiscal policies provide
analysis and financial stability reports that act as early indicators to any threats to the financial
stability of a country. During crisis, the central bank may adopt the use of such instruments as
the varying of the interest rate with longer maturity periods or lend as the last resort lender.
Fiscal policy and the monetary policies may by different but each one of them has an impact on
the rate of inflation. The monetary policy affects financial activities in a real economy and also
the interest rate of default and other charges which may result in credit losses on the company’s
loans, their assets and also affect the balance sheet. The fiscal policies affects the operations of
the financial markets especially after the introduction of increased taxes that leads to a ripple
effect on the various sectors of the economy and which subsequently affects the monetary policy.
The risk premiums (counterparty and credit liquidity) may also affect the fiscal policies and also
have an impact on the rate of inflation which lies on the domain of the monetary policy makers.
It follows that the fiscal policies have to be adopted in consideration or while taking into account
the monetary policies which also have to be adopted while considering or taking into account the
Whereas the two policies may be distinctively different each policy relies to some extent on the
outcome of the other. For example, the policy rate may be the best or the most effective policy
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for that may control inflation and also for resource utilization hence it can also achieve the major
objectives of the monetary policies.
The fiscal policy has a profound impact on inflation and also on real economy. A country’s
monetary policy impacts strongly on the government’s revenues and expenditures and can be the
major determining factor whether the government will end up with a surplus or a deficit in its
Expansionary fiscal policies may also lead to an increment in the money supply in the economy
which may also lead to a reduction in the effects of inflation in an economy just as much as the
monetary open market operations achieve when countering the effects of recession. (Mankiw,
2002) The contractionary fiscal policies can also achieve the same effects when there is inflation
in the country. Both policies can supplement the objectives of the other in their pursuit to
improve the performance and the growth of the economy. The government controls price
stability, employment and the general economy by using the fiscal policies to influence the rate
of the aggregate demand in the country’s economy. The Keynesian theory suggests that by
decreasing the tax rates and increasing the government spending achieves the objective of
creating the aggregate demand. (Larch and Nogueira, 2009) These methods are used during
recessions to gain full employment and achieve economic growth. Keynesian theory also
clarifies that reducing the level of spending in an economy also leads to reduction of government
spending and eventually the contraction of the economy hence the stabilization of prices during a
recession just like the use of the monetary policies when controlling recession.
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Hansen, B. (2003) The Economic Theory of Fiscal Policy, Volume 3. Routledge.
Heyne, P. T., Boettke, P. J. and Prychitko, D. L. (2002) The Economic Way of Thinking (10th
Ed). New York: Prentice Hall.
Larch, M. and Nogueira M. J. (2009) Fiscal Policy Making in the European Union – An
Assessment of Current Practice and Challenges. Routledge.
Mankiw, N. G. (2002) “Money Supply and Money Demand”. Macroeconomics (5th Ed) Worth.