How Fiscal & Monetary Policies Affect the Economy

by Walter Johnson

Fiscal and monetary policy work hand in hand to stimulate or depress economic activity. Primarily, these levers of central financial policy affect the economy by stimulating or harming demand. Not only current policies, but expected future policies affect economic activity and investor confidence in ways too numerous to detail. Monetary policy focuses on the price of money to investors, while fiscal policies are aimed at the basic, "tax and spend" priorities of federal or state government.

Monetary Policy

The price of money is one of the most significant economic indicators. Interest rates are, among other things, signals to the economy that the banking authorities want to either spur investment or keep the currency strong. A strong currency usually implies higher rates, which attract foreign capital and investor confidence on the stability of assets. When interest rates are lowered, money is cheaper and spending increases. This can also depreciate the currency and cause capital to flee. On the other hand, cheaper money can also mean boosted exports.


Taxes are some of the most direct ways that government can steer the economy. On the one hand, the state can spend money to assist the unemployed or provide services to the poor and ill. On the other, it can simply let people keep more of what they earn through lowering taxes. In both cases, demand is increased since more money ends up in the pockets of consumers due to either positive or negative state action. High taxes can cause firms to leave the country, or these can simply be passed on to the consumer through higher prices. The supply side argument holds that high taxes do not raise more revenue because economic activity is lessened, it merely allows the state to spend more money.


Commonly called the "tax on the poor," inflation is the harmful depreciation of the currency. While debts are worth less, so are savings. Wages are worth less than before, which means, in effect, workers work the same amount for less money. Technically, inflation is the placing of cash in circulation that does not have "work" to do. Money without purpose adds to inflation. Money that is injected into the economy equal to increases in production or consumption does not add to inflation. Money injected into the economy over and above its ability to serve production or consumption is "useless" money, and hence, harms the economy through inflation.


J.M. Keynes became famous for positing -- putting it simply -- that the state should act as a stabilizer for economic downturns. Since prices do not react quickly to changes in economic reality, the state should serve as a balance for the problems inherent in a complex market. In other words, the government should assist the economy during hard times by injecting more cash into circulation for the sake of keeping demand high. Libertarian economists answer that this means more money must be extracted from the productive economy so it can be spent on the government's favored constituents. The more money taken from production, the less work that will be created and hence, unemployment will increase. These debates, as of the time of publication, are still going strong.

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