16 Advantages and Disadvantages of Fiscal and Monetary Policy

There are two primary actions that governments rely upon when influences an economy at the macro level. The first is called fiscal policy, while the other option is monetary policy.

A fiscal policy determines how the government can earn money through taxation, and then dictates how those funds should be spent. As a way to assist the economy, there may be legislative changes that cut taxes while increasing domestic spending. If the economy is heating up too much, then taxes will be raised while spending declines.

Monetary policy involves the use of central banks to manage interest rates and the overall currency supply for the economy. When the economy begins to falter, then you will see interest rates being cut or reduces with this policy, which makes it less expensive to take on debt while increasing the supply of currency. If there is too much growth occurring, then a tighter monetary policy through the raising of interest rates and removal of currency occurs to cool things down.

These are the pros and cons of monetary policy to consider when studying macroeconomics.

List of the Pros of Monetary Policy

1. It is a way to effectively control inflation in the economy.
Inflation is often treated as a negative from an outside perspective because it causes the price of goods and services to rise. Having a small amount of it is actually healthy for a growing economy because it encourages investment activities. This event can also allow employees to expect higher wages for the work they provide. By raising the target interest rate under monetary policy, investment becomes more expensive. That means economic growth is slowed somewhat because of this reaction, which allows the central bank to manage inflation levels.

2. It is a policy that is fairly easy to implement.
Central banks have the capacity to act quickly when they sense there is an issue with the monetary policy. Their toolbox is filled with options that can be implemented on a moment’s notice sometimes. Even if there is only a signal from the central banks that indicates an action on the monetary policy will occur, the stock market will respond as if the actions were taken. Although there can be some lag time in this process to see results, you will still see forward progress happen almost immediately.

Although there is a minimal risk of non-compliance, financial institutions typically work with one another to provide the foundational support of the economy. They are ready to implement the ideas of the central banks immediately, especially if there are incentives in place to do so.

3. It provides multiple tools to use so that the goals of monetary policy are achievable.
In the United States, the Federal Reserve has four specific tools in its toolbox: interest on reserves, the discount rate, open market operations, and reserve requirements. Each option works in a specific way to encourage the economy to travel in a specific result. Decrease the amount of money necessary to be held in cash can increase what is available to the banking system. Buying and selling securities is a reliable tool as well. Paying interest on excess reserves can even influence bank lending.

The central banks can decide to use all of these tools simultaneously, individually, or in whatever combination they think is appropriate to help the economy.

4. It comes from a position of political neutrality.
Most central banks are politically neutral, which means the election cycles do not influence the decisions which are made for the economy. Unpopular actions are therefore possible to take before or during an election because there is zero political fallout from the activity. This advantage does not apply to state-run central banks who can oust the leadership of the institution when a different party comes to power. The goal of monetary policy is to influence the macroeconomy more than to make it possible for specific people to come into power.

5. It can boost the export levels for the national economy.
Central banks can use the monetary policy to weaken the overall currency value on the global stage. This process occurs when there are lower interest rates or an increase to the money supply. When a currency receives devaluing on the global market, then the action serves to boost exports because the goods and services provided domestically are cheaper to purchase internationally.

When there are more international purchases for goods or services, then domestic production levels can increase despite the lack of local customers. Monetary policy can make it so that the local economy is funded with international currency.

6. It offers a way to promote transparency in the economic system.
Monetary policies can create predictable results with the tools which are available to the central banks. The caveat of this advantage is that those who implement the tools must use them as intended for them to work. When movement occurs in either direction to encourage or restrict how economic systems move, then the status quo is maintained because the design of each decision makes it possible for households and institutions to make meaningful decisions about their future. There isn’t a need to wait for the effects of each choice to become measurable because there is certainty in what each tool can provide.

7. It offers financial independence from government policies.
The independent nature of the central banks allows for the monetary policy to be kept separate from legislative policy. That doesn’t mean the government won’t try to influence the decisions which are made using the tools that are available, but it does not give elected officials the opportunity to control them at a whim. It is a policy which allows all economic decisions to be kept separate from the political ones, reducing the risk of having the structure of the government be based on monetary performance instead of societal need.

List of the Cons of Monetary Policy

1. It comes with the risk of hyperinflation.
When interest rates are set too low in an economy, then it is not unusual for an excessive amount of borrowing to occur because the interest rates are artificially cheap. This process creates what is called a “speculative bubble.” It causes prices to increase too quickly, and often to levels that are ridiculously high. When you add more money to the economy to counter this situation, then inflation can run out of control because of the supply and demand principles that are present.

If more money is available in circulation, then the value of each unit is worth less if demand levels remain the same. That means items become more expensive because the currency has less overall value to it.

2. It takes time for the changes in monetary policy to occur.
Because we are dealing with a macroeconomy in monetary policy, the changes which the central banks make need time to filter down through the economy. Even when the alterations occur rapidly, the effects can take months (and sometimes years) to materialize. That is why you will often hear economists describe currency as being a veil. A monetary policy can help to stimulate the economy in the short-term, but it has no long-term effects except for a general increase in pricing. The actual economic output which occurs does not receive the boost one would expect.

3. It comes with some specific technical limitations.
The interest rates for the macroeconomy can only lowered nominally to 0%. That means the actions of the central bank are naturally limited by this policy tool of the rates are already very low. If they stay too depressed for an extended time, then a monetary policy can eventually lead the economy into a liquidity trap. That means this option tends to work better when there are moments of expansion and growth when compared to recessions.

Some banks are experimenting with a negative interest rate policy to see if there are potential economic benefits with a change to this technical limitation, but the results from these activities will not be known for quite some time.

4. It can boost the import levels for the national economy.
If the nation’s currency becomes stronger due to the monetary policy of the central bank, then it hurts the exporters while helping the importers. The reason why this option is a disadvantage is that it can also adversely impact domestic manufacturing, whereas an increase in exports can stimulate it. Although one will always see pain on their bottom line based on the overall strength of a currency, we typically want to see more exports than imports because that would lead to a positive trade balance.

5. It can impact the national economy with one decision.
The impact of the monetary policy tools that are used by the central banks of a country have a nationwide impact. Even one choice can be enough to create a ripple effective that can create adverse results just as easily as it can offer benefits. Because it is a macroeconomy decision, there is no way to alter the impact on local segments of the economy which may not need any stimulus. Some regions might even need more help than what is currently offered by the choices made. That means you cannot use monetary policy as a way to solve specific problems or boost industry segments or economic regions.

6. It cannot guarantee economic growth.
Although there is predictability in the implementation of monetary policy, there is still one rule of macroeconomics that still applies: nothing is guaranteed. Businesses, people, and the government all have free will. It is up to each individual or group to decide to take on debt when it is advantageous to do so or hold spending when it becomes necessary. There are consumers who will spend when interest rates are high, and then hold when they are low. You will never see 100% compliance across an entire nation with the policies that receive a priority throughout the year. The outliers can create something unpredictable if there are enough of them to influence what happens.

7. It always causes someone to lose.
The reality of any financial market is that someone will lose just about every time someone else strikes it big. Monetary policy works in the same way. Some people will find success with their decisions and some will not. We are all importers and exporters in some ways, so the only way to guard against the sweeping changes that are made on the macroeconomic level is to switch gears based on what is seen. Importers can decide to become exporters, and the reverse is also true.

8. It typically works on a national level, but not at a global level.
The benefits of a monetary policy are typically seen when the decisions are implemented at a national level. When there is a global struggle to experience economic growth, then the tools that are in the toolbox of the central bank may not be useful. Even when there is the choice to lower interest rates during a worldwide recession, there are fewer export opportunities available because no one is spending as much money. That means you could potentially see steep declines in all sectors. Before any choices are made, there must be an evaluation of global health to insure the intended results are achievable.

9. It can discourage expansion opportunities for businesses.
Businesses like a certain amount of long-term security available to them when contemplating significant financial decisions. If there is the threat of an increase in the interest rate, then a company might decide to stall on their decision to expand operations. Should this occur, then the result would be less production, higher prices, and less consumer access to the goods or services created. Some customers would stop buying items because they could no longer afford what they want. That is why markets react so quickly to even the perceived threat of a change. The decisions made today impact the 5-year and 10-year plans of companies, creating a chain reaction throughout the economy.

These monetary policy pros and cons serve as a guide which helps the central banks decide which tools can benefit the microeconomy. Their choices are based on whether there is growth or recession present. The goal is often to achieve slow, sustainable growth without overheating to prevent adverse actions.