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Fiscal and Monetary Policy 101

Fiscal and monetary policies are tools used by the government and the central bank to either speed up or slow down the economy. At its simplest, fiscal policy is about government spending and taxation, and monetary policy is about the central bank setting the money supply and interest rates.

Fiscal and monetary policy both affect GDP growth, unemployment rates, and the amount of spending and saving that occurs within an economy, either directly or indirectly.

Wait, why would a government want to slow the economy?

While economic growth is indisputably good, sometimes fast and uncontrolled economic growth can become unsustainable and creates other problems like high inflation. We aim for a fairly stable economy, where we enjoy steady economic growth without having to endure deep troughs of economic contraction.

What is fiscal policy?

Fiscal policy refers to the use of government spending, taxation, or borrowing to stimulate or slow the economy. Fiscal stimulus occurs when a government increases its spending to boost the economy. A fiscal contraction occurs when a government decreases its spending to slow economic growth. Fiscal policy is determined by the federal Minister of Finance and approved by the Federal Government.

How does fiscal policy work?

Governments spend on many different programs in the economy. For example, governments often fund big infrastructure projects through which they directly inject money into the economy by creating new jobs and buying materials. This then creates a series of ripple effects – the newly created jobs for engineers, construction workers, and project managers enable these people to spend money on housing, restaurants, coffee, cars, bicycles, etc. Everyone spending money means more money in everyone’s pockets and a stronger and more rapidly growing economy (economists call this “the multiplier effect”). Because government spending comprises such a significant portion of economic activity, during a fiscal contraction the government can reduce their spending to help slow the economy.

Changes to tax rates will have a similar effect and also fall into the category of fiscal policy: higher tax rates mean people spend less money (because they pocket less), whereas lower tax rates mean people spend more money (because they pocket more).

What is monetary policy?

Monetary policy refers to a change in the money supply (i.e. the amount of money circulating in the economy). The objective of monetary policy is to target an inflation rate or interest rate, which affects the way people spend and save money.

Expansionary monetary policy is used to stimulate the economy and entails an increase in the supply of money, which translates to lower federal interest rates. A low interest rate stimulates the economy by encouraging people to invest in the economy themselves (it’s now cheaper to buy a house or a car!). Contractionary monetary policy is used to slow economic growth and is initiated by a decrease in the supply of money (we see this as higher interest rates).

The Central Bank, a crown corporation, determines monetary policy. In Canada, our Central Bank is called the “Bank of Canada” (BoC) and is led by the Governor of the Bank of Canada, Stephen Poloz. The BoC’s primary responsibility is to print money, but just how much money to print is complicated. As an aside, the BoC is also the banker for the government and for commercial banks and provides loans to financial institutions.

How does monetary policy work?

To increase the money supply, the BoC prints more money or announces a lower interest rate. To decrease the money supply, the Bank can announce a higher interest rate or it can sell government bonds. In the latter case, money is removed from the economic system when cash is transferred from the bond buyer to the central bank.

In the case of expansionary monetary policy, the BoC increases the money supply which lowers the interest rate. A lower interest rates means it is less lucrative for businesses to save money, so they instead can access loans at a cheaper rate and spend money on new infrastructure, labour, products, and services, thereby stimulating the economy. This helps combat unemployment in a recession.

Expansionary monetary policy also increases the inflation rate. As the interest rate falls and people spend more money, the demand for more goods and services pushes wages and other prices higher and higher. Overtime, everything in the economy becomes more expensive, which we call inflation.

In the case of contractionary monetary policy, the BoC decreases the money supply which raises the interest rate, slows spending, and slows inflation.

Monetary policy is most effective when small adjustments are required; it cannot single-handedly pull an economy out of a deep recession, but is generally effective in enticing businesses to spend more. It also takes a bit of time for businesses to respond to changes in interest rates, as it takes time to adjust business plans, hire more people, and move forward with projects.

Can you use both fiscal and monetary policy at the same time?

Yes! In fact, fiscal policy and monetary policy work best when used together. It’s called “accommodative monetary policy” and here’s how it works:

In a recession, the government spends money to stimulate the economy, employ more people, and encourage people to spend more money. The central bank lowers the interest rate (which means savings don’t earn them as much money), further encouraging people to spend money.

The opposite is true in good economic times: fiscal contraction, or reduced government spending, leads to less investment made by the government in the economy and thereby slower economic growth. This is supported by a higher interest rate, which encourages people to save money.

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