Too embarrassed to ask: what is the difference between monetary policy and fiscal policy?

Governments and central banks have two main tools for influencing a country's economic growth: monetary policy and fiscal policy. But what are they, what is the difference, and how do they work?

When it comes to influencing economic growth in a country, the authorities are considered to have two main levers. These are monetary policy and fiscal policy.

Monetary policy is managed by central banks who aim to meet economic goals set by governments. They do this by influencing the amount of money circulating in the economy. For example, most central banks, including the Bank of England, are asked to target a specific level of inflation. This is usually around 2%. By the way, there is no specific rationale behind the 2% target; it’s just generally viewed to be roughly the “right” amount of inflation for most developed economies.

The central bank influences the cost of borrowing by raising or cutting interest rates, or printing money to buy government bonds and other assets. In theory, when it’s cheaper to borrow money and less rewarding to save, people and companies will invest and spend more. That boosts growth, which should eventually drive up inflation. If inflation gets too high, the central bank raises interest rates. That raises the cost of borrowing and encourages saving over consumption, which should slow growth and choke off inflation.

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Fiscal policy, on the other hand, refers to the tools used by governments to influence the economy. Governments can raise and lower taxes. They can also direct spending at specific industries or groups of people. Fiscal policy is more targeted and arguably more powerful than monetary policy. But clearly, it is also more political. It creates winners and losers in a much more explicit manner than monetary policy.

One core feature of economic management in the late 1990s and the run-up to the 2008 financial crisis was an increasing reliance on monetary policy to smooth over ups and downs in the economy. In effect, governments delegated macro-economic management to their central banks. Nobody really complained because most economies seemed to be pottering along merrily. However, the 2008 financial crisis shattered that illusion. Since then, economic growth has been weak, while at the same time soaring asset prices have fueled a perception of growing inequality. Faith in monetary policy has been eroded.

Meanwhile, fiscal policy – such as subsidising wages – is now being used to tackle the effects of pandemic lockdowns. This is likely to last long beyond Covid, and has some serious implications for investors. To learn more about this huge political and economic shift, subscribe to MoneyWeek magazine.