Government has two powerful tools to drive economy in the right decision. One is fiscal policy and the other one is monetary policy. When used correctly, they usually have same results in stimulating the economy and slowdowns when it goes high.Government uses a mix of monetary policy and fiscal policy, which helps to control economic phenomena.
Fiscal policy is the system by which government maintains its spending level and tax rate, which monitor and influence a country’s economy. Fiscal policy influences a nation’s money supply. It is a sister strategy to monetary policy and is processed through RBI. Based on the theory of production levels British economist John Keynes, government influence macroeconomic production levels by increase or decreasing the tax levels and spending. Fiscal policy helps to increase employment and curb inflation. Hence, fiscal policy plays a vital role in managing country’s economy.
It is the policy, which controlled by the monetary authority of a country, which is central bank or RBI. It controls either the short-term borrowings of the country or money supply of the government. It mainly focuses on the inflation of the country and the interest rate, which signifies price stability.
Types of monetary policy:
Monetary policy is useful in the context of expansionary and contractionary. Expansionary policy is when monetary authority to stimulate the economy. Expansionary also maintain short-term interest rate at much lower than usual rate, it usually helps to combat unemployment in recession by lowering interest rates. By increasing the aggregate demand, the gross domestic product also increases in a country.
Contractionary policy is just the opposite of expansionary policy. It maintains short-term interest rate higher than the usual rate. It initiates to slow down the growth rate in the money supply and even shrinks the growth. It helps to slows economic growth and lowers inflation. Lowering down the inflation leads to more job opportunities and it lowers the economic growth in order to reduce expense of the government.
Fiscal policy affects aggregate demand through changes in government spending and taxation of a country. It affects employment and household income, which influences consumer spending and investment. Monetary policy influences money supply in an economy and affects the inflation rate and interest rate. Monetary policy also influences expansion, net exports, employment and cost of debt. All these directly and indirectly affect the aggregate demand of the economy.
Fiscal policy relates to Keynesian economics, it prevents negative shift in term of aggregate demand by stabilizing employment structure and investment of those became unemployed during inflation.
Fiscal and monetary policies help to restore a country’s economy to full employment output. The central bank of a country operates under dual mandate, which encourages reformation of economic structure of a country.
Formulae used to indicate the impact of two policies:
Nominal interest rate= real interest rate + expected inflation
Fiscal policy and monetary policy undergoes without political intervention of a country.
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