Monetary Policy vs Fiscal Policy: Speed, Aim and Who Decides

Monetary policy changes the price and the quantity of money, and a central bank sets it, often and fast. Fiscal policy changes what a government spends and what it taxes, and a political process sets it, usually once a year and slowly. Neither speed nor reach is the difference that matters most. Who decides is, and who decides settles how each lever can be used at all.

Underneath that sit two levers that look interchangeable from a distance and are not. Both can be pointed at the same tired economy. Both can be described in a sentence beginning with the words loosen or tighten. But one of them belongs to a committee that can meet on a Thursday and change the cost of money by Friday, and the other belongs to an argument that has to be won in public, written into a document, voted on, and then executed by whichever office actually spends the money. The committee's rate and the government's budget are not two speeds of the same thing. The two are different instruments that happen to point at the same target.

The household version does most of the work here, so try it at that scale first. A large residential building is short of money. The landlord can cut the rent, and a rent cut takes one notice on the board and reaches all sixty flats on the first of next month, identically, whether a household needed it or not. Or the residents can vote at a general body meeting to spend from the building fund on repairing the four flats whose ceilings actually leak. The repair reaches exactly the right four flats, and it takes three meetings, a contractor and eleven weeks. One instrument is fast and cannot be aimed; the other can be aimed and is slow, and no amount of cleverness collapses that into a single better instrument.

The order below follows from that. The earlier notes in this sequence have already built monetary policy, so it is restated first and compactly. Fiscal policy is then built on its own, from nothing, and only as far as the contrast needs. A difference stated before either side is defined leaves a reader able to recite the difference and unable to state either of the two things being differenced. So nothing is contrasted until both stand alone.

Where these numbers come from. The Republic of Sankhya, an invented economy, carries every rate, gap and rupee amount worked through below, so the whole arithmetic can be followed on screen from one end to the other. India's own institutions and instruments keep their own names, and what any of them has actually published is available from the body that published it.

What does monetary policy do, in four answers?

Monetary policy is the lever that changes the price of money and how much of it is available. Four questions cover it, and each was answered at length earlier in this sequence, so the answers below are compressed.

Who decides: a committee sitting at the central bank, working to a mandateThe objective a body has been given by law, which it is expected to pursue and can be held to. Where a mandate comes from and how it is worded is a separate question. handed to it by statute rather than chosen by it. On what timetable: the committee meets on a published schedule, takes the decision in the room and announces it the same day, and can act between meetings when conditions demand it. What it moves: the policy rate, and with it the corridor of rates the money market has to live inside, plus the quantity of money the central bank is willing to supply. Who it reaches: everyone who borrows and everyone who lends, through the same channel, at the same time. Borrowers differ, so not everyone is reached equally. The unevenness comes from the borrowers rather than from any aim taken by the lever.

The arithmetic makes the fourth answer concrete, so work the Sankhya corridor once. The Republic of Sankhya runs a deposit floor of 5.75 per cent, a policy rate of 6.00 per cent and a lending ceiling of 6.25 per cent, so the corridor is 50 basis points wide and sits symmetrically around the policy rate. Cut the policy rate by 100 basis pointsOne hundredth of one percentage point. A move from 6.00 per cent to 5.00 per cent is a hundred basis points, and the unit exists so that small rate changes can be stated without arguing about decimal places. and the entire corridor slides left together, to a floor of 4.75, a policy rate of 5.00 and a ceiling of 5.25. Nothing was aimed anywhere. The whole structure moved.

The rest of what happens is a result rather than a mechanism. On the Sankhya schedule the money marketThe corner of the financial system in which banks and other large lenders place and take funds a few days at a time, frequently just overnight. Its plumbing is a separate subject. absorbs 95 of those 100 basis points within days, while new lending picks up only 40 basis points after one quarter, 60 after two, 72 after three and 78 after four. Twenty-two basis points never arrive at all: they stop somewhere inside the lending chain. The four quarters it takes to get even that far is the transmission lagThe delay between a policy rate moving and that move turning up in what a borrower or a saver is charged or paid. Worked out separately., and both the lag and the leak are worked out separately in the notes on transmission. The shape matters more for a comparison than the leak: the rate lever reaches a very large number of people, indirectly, through whoever happens to lend to them, and it takes about a year to finish arriving.

What is fiscal policy?

Fiscal policy is the lever that changes what a government spends and what it takes in tax. The definition stops there, and it has two sides that move independently: a government can add spending without touching tax, change tax without touching spending, or move both at once in the same direction or in opposite ones.

A definition is all the comparison requires. Fiscal policy is a large subject carrying arithmetic, constraints and failure modes of its own, set out properly in its own separate notes on government spending, taxation and the budget. Two words appear later and are worth naming now: the fiscal deficitThe gap between what a government spends in a period and what it receives, which it has to cover by borrowing. How it is measured and what constrains it is a separate subject., which is the constraint the spending side runs into, and the automatic stabiliserA part of a budget that changes on its own as conditions change, without anybody voting on it, such as a tax take that falls when incomes fall. Treated separately., which is the part of a budget that moves without anybody deciding anything.

Take fiscal policy through the same four questions monetary policy just answered. Who decides: a government proposes and a legislature votes, so the decision belongs to people who were elected and who can be removed. On what timetable: an annual budget cycle, with changes inside the year possible but requiring the same approval, so the gap between deciding something is needed and the money actually moving is measured in months. What it moves: a specific spending line or a specific tax, a named thing rather than a general condition. Who it reaches: whoever the line funds or the tax falls on, directly, with no intermediary deciding whether to pass it along.

Sankhya makes it concrete, on a small scale. The Republic of Sankhya approves an additional Rs 30,000 crore for repairing district roads in its eastern districts. The proposal is made, argued and voted, and two full quarters pass before it is approved. The first rupee is actually spent in the third quarter. On the assumptions used throughout, 20 per cent of the money has been spent by the end of quarter three, 45 per cent by quarter four, 75 per cent by quarter five and the full Rs 30,000 crore by quarter six. The line named the eastern districts, so every rupee lands there, and not one rupee reaches a household in a district the line did not name. That is the fiscal lever doing exactly what it does.

Where do the two levers actually differ?

Now that both levers stand on their own, set them beside each other. Four criteria do the work, and each of the four is a genuinely separate question rather than four ways of saying fast and slow.

The third row is the one most readers get backwards, so it is worth slowing down on. Reach splits into two different things that are easy to run together: how many people a lever touches, and how directly it touches them. A rate change has to travel through a lender who decides for its own reasons how much to pass on and to whom, so monetary policy scores very high on the first and low on the second. A payment made under a spending line arrives at the named recipient with nobody in between choosing to withhold part of it, so fiscal policy scores low on the first and very high on the second. Neither lever is broadly better at reaching people; they reach different numbers of people in different ways, and a comparison that collapses that into one word gets both wrong.

Why is the real trade speed against aim?

Put the two limitations side by side and the shape of the choice appears. Monetary policy can be changed in a day and cannot be aimed at anybody. Fiscal policy can be aimed at one district, one industry or one group of households and cannot be changed quickly. Neither of those is better than the other, and choosing between the two levers is not choosing the better tool but choosing which limitation to live with.

The Sankhya arithmetic makes the trade concrete on both sides. On the rate side, the decision takes a day, but the 100 basis point cut is still only 78 basis points through to new lending four quarters later, and the 22 basis points that never arrive cannot be recovered by deciding harder. On the spending side, the Rs 30,000 crore is settled in rupees the moment it is voted, and every rupee lands where the line named, but nothing at all had moved by the end of the second quarter and the last rupee is not spent until the sixth. Fast and blunt against slow and precise, on one economy, in one year.

The household version is the one that sticks, so return to the building for a moment. A rent cut reaches all sixty flats on the first of next month whether the ceiling leaks or not, and it is decided by one person in one afternoon. The repair fund reaches the four leaking flats and nobody else, and it takes three meetings. If the problem is that everybody in the building is short of money, the rent cut is the instrument that can actually address it. If the problem is four leaking ceilings, no rent cut in the world fixes a ceiling. The instruments are not ranked. The two answer differently shaped problems, and the shape of the problem is what a reader has to look at first.

Why is who decides the deepest difference?

Speed and aim are the differences a reader notices first. Who decides makes the other two possible. The two levers sit with different kinds of people, answerable to different things, and that is what determines the sort of decision each one is able to take at all.

A central bank committee with instrument independenceAn arrangement in which a body is given an objective by law but chooses the settings it uses to pursue that objective. Where it comes from and what limits it is treated separately. can take a decision that hurts now and helps later, because nobody can remove the committee for having taken it. Raising a rate into a slowdown is unpopular with every borrower in the country on the day it happens. A committee that cannot be dismissed for unpopularity can still do it. Exactly where that independence comes from, what it covers and what it does not is set out in the earlier notes on the central bank and its mandate, and only the consequence is used here.

A government answering to an electorate is in a genuinely different position, and the position is not a character flaw. Withdrawing a spending line that a district has come to rely on, or raising a tax, is a decision whose cost lands on identifiable people before the benefit lands on anybody, and the people it lands on vote. The next legislature can vote the line back, so the same arrangement that makes the decision hard to take also makes it easy to reverse. So the fiscal lever is structurally better at doing things people want and structurally worse at doing things nobody will thank anyone for until four years later.

None of this is a claim that one lever is better than the other, and reading it that way is precisely how both get misused. It is a claim that they are usable in different circumstances. Turn it around and the symmetry is obvious. Deciding who receives Rs 30,000 crore and who pays for it is a question about who deserves what, and a question about who deserves what belongs with people who can be voted out for answering it badly. Handing that decision to an unelected committee would be as poor a fit as handing an unpopular rate rise to a body facing an election. Each lever sits where it sits because of the kind of decision it has to make, and pretending either could simply take the other's job is where the misuse starts.

Can monetary policy and fiscal policy work against each other?

Yes, straightforwardly, and it happens without anybody doing anything wrong. One lever can be loosening while the other tightens, and the economy simply receives whatever the two add up to. The two answer to different objectives on different timetables, so neither party is misbehaving, and each can be doing its own job correctly while cancelling the other.

The same pair of decisions works out on Sankhya. The committee cuts the policy rate by 100 basis points because prices are soft, and on the published schedule that is worth 78 basis points on new lending after four quarters. On the assumption used throughout, that every basis point reaching new lending adds Rs 400 crore of demand over the following year, the rate cut is worth Rs 31,200 crore. In the same year the Sankhya government's borrowing runs into a constraint that has nothing at all to do with prices, so it cuts Rs 30,000 crore from its spending lines. Once both have fully arrived, the economy has received Rs 31,200 crore added and Rs 30,000 crore removed. The net is Rs 1,200 crore, 0.95 per cent of the shortfall the country was carrying. Two large decisions, taken competently, cancel almost exactly.

The timing makes it stranger still, and this is the part that catches analysts out. The rate leg is fully arrived at four quarters. The spending cut is only 45 per cent arrived at four quarters, so at that point the net looks like Rs 17,700 crore of loosening. Wait two more quarters and it collapses to Rs 1,200 crore. Nothing new was decided in between. The two levers landed on different schedules, so the same pair of decisions reads as loosening at one moment and as very nearly nothing at another, purely because of when it was looked at.

How would each lever meet the same Sankhya condition?

Set one condition and put both levers at it. The Republic of Sankhya finished its eighth year producing Rs 19,99,066 crore against an estimated potential of Rs 21,25,785 crore. The shortfall is Rs 1,26,719 crore, or 5.96 per cent of potential, and that shortfall is the output gapOutput set against a working estimate of what the same economy might have managed without strain, and the shortfall or excess left between the two. Building that estimate is its own subject. that both levers would be pointed at. Every conversion from a rate move to a rupee amount is an assumption rather than a measured relationship in any economy.

Read the last two rows together. The same two decisions, identical in size, produce Rs 61,200 crore when they point the same way and Rs 1,200 crore when they point opposite ways, and the difference between those two outcomes is fifty one times the smaller one. Nobody changed the size of anything. Only the direction changed.

A rupee crore figure is easy to read past, so the rate row is worth attaching a face to. The 78 basis points reach an actual borrower. On the Sankhya schedule a household with a home loan of Rs 30,00,000/- running twenty years, moving from 9.50 per cent to 8.72 per cent, pays Rs 26,454/- a month instead of Rs 27,964/-. The saving is Rs 1,510/- a month, 5.40 per cent of the instalment, and Rs 3,62,400/- over the full term on the published Sankhya figure, computed from the unrounded instalments rather than from the rounded monthly difference. The rate lever cannot be aimed at a district, and it still puts Rs 1,510/- a month back into every household that happened to be borrowing. The two halves together are the shape of what it can and cannot do.

Which question can never be settled from the facts?

Which lever suits which condition is left unsettled. The question sounds like the natural next step and is a different kind of question altogether: a judgement about what a country should do, made by people who are accountable for the answer.

Reach, though, can be described exactly. Monetary policy reaches everyone who borrows or lends, indirectly, within about a year, and reaches no region or sector in particular. Fiscal policy reaches exactly whoever a line names, directly, after the months it takes to be voted, and reaches nobody else. Both statements say what each lever can and cannot touch, and both hold regardless of what anybody thinks should be done. Reach is the part worth carrying away.

Taken together, the two yield one test, and it is a test about the problem rather than about the lever: whether the problem is one the lever can reach at all. A shortfall spread evenly across every household in the country is a problem a rate can reach. Four districts with a collapsed local industry is not, however large the rate move. The shape of the problem can be settled from the facts, and settling it stops well short of telling anybody what to do.

The Republic of Sankhya and the residential building are invented.
Educational material. Not advice on any investment, tax, budget or market position.