Fiscal and Monetary Policy: What Are They, And Why Are They Important?

The words “fiscal” and “monetary” are thrown around in many economic conversations. Politicians often mention how they will bring forth or implement more funding to help stimulate the economy, and you’ve always wondered what automatic stabilizers really did. What does it all mean?

Many policies exist and are carried out by the Government and Bank of Canada in order to help regulate the current state of the economy. These include both fiscal and monetary policies.

Fiscal policy is a stabilization policy that is carried out by governments in order to minimize the size of the peaks and troughs in the business & economic cycle, in an attempt to keep the economy as close to a linear growth trend as possible. In fact, the implementation of fiscal policy helps to reduce inflationary gaps — and is often implemented to avoid an economy from plummeting into a recession. There are two main types of fiscal policies, expansionary fiscal policy, and contractionary fiscal policy.

Expansionary fiscal policy is used to avoid a recessionary gap in the economic cycle. This means that when a country is experiencing increased levels of unemployment (they are below the full employment level), as well as a lower GDP (Gross Domestic Product) value, expansionary fiscal policy is used to “push” aggregate demand levels back up to full capacity. It is used to stimulate the economy, which is normally done in one of three ways:

1. Decreasing taxes
2. Increasing the amount of spending by the Government
3. Both 1) and 2) simultaneously

Contractionary Fiscal Policy, however, is used when the economy is experiencing inflation. When unemployment levels are low, and the country is experiencing high levels of GDP growth, the government may choose to implement contractionary fiscal policy, meaning that they are SLOWING the economy. This is also done in three possible ways:

1. Increase taxes
2. Limit/lower Government spending
3. Both 1) and 2) simultaneously

Both contractionary and expansionary fiscal policy are used by the government when it wishes to change the current state of the economy through DIRECT ACTION.

Sometimes, it takes too long for fiscal policy to become implemented — so “automatic stabilizers” also exist, that require no direct action from the government. These include things like Employment Insurance (EI) and welfare payments, which can be issued automatically to help give the economy and its people the “boost” they need to avoid economic disparity.

What about Monetary Policy?

On the other hand, monetary policy is delivered through the Bank of Canada, a crown corporation created during the Great Depression. Monetary policy is a policy that deals with controlling interest rates (ensuring they are predictable and low), and is utilized to ensure that the currency remains stable, reliable and trustworthy for Canadians to use.

Why does it matter?

Fiscal and monetary policy are both used to regulate the economy! Take a look at the news — due to COVID-19, Canadian Prime Minister Justin Trudeau and many government sectors are currently implementing both fiscal and monetary policy in order to help guide Canada’s economy away from a potential recession.