Basics
Monetary policy is typically implemented by a central bank, while fiscal policy decisions are set by the national government. However, both monetary and fiscal policy may be used to influence the performance of the economy in the short run.
In general, a stimulative monetary policy is expected to improve the economy's rate of growth of output (measured by Gross Domestic Product or GDP) in the quarters ahead; tight or restrictive monetary policy is designed to slow the economy in the future to offset inflationary pressures. Likewise, stimulative fiscal policies, tax cuts, and spending increases are normally expected to stimulate economic growth in the short run, while tax increases and spending cuts tend to slow the rate of future economic expansion
FISCAL - ADV
Governments often use fiscal policy tools in times of a weak economy. In times of an economic recession or depression, government policymakers hope that fiscal policy will provide a short-term economic stimulus that leads to long-term growth. The temporal measure is meant to action as a transitional solution to keep viable enterprises from being stifled by intermittent solvency issues.
Many economists contend that government fiscal policy has a multiplier effect. As government increases spending or reduces the amount of taxes people pay, it increases the overall demand for goods and services in the economy. Public investment in one industry encourages consumption in that sector of the economy. Higher consumption correlates with higher demand, in turn higher supply and thereby illustrates the multiplier effect.
FISCAL - DISADV
Higher government spending often leads to higher interest rates, which reduces investment and overall demand for goods and services by making it more expensive to borrow money. Economists call this phenomenon the "crowding out" effect.
Fiscal stimulus requires for the printing of fiat legal tender to inject liquidity into the real economy. The volume of cash credit is not backed by real gross productivity. Cash injections based on nominal central bank intervention are inflationary and dilute real earnings and net worth. The fiscal measure must be withdrawn at a later date, through taxation, to sterilize the anomaly.
MONETARY - ADV
Expansionary monetary policy, such as buying government bonds from the public, reducing banks' reserve requirements or cutting key interest rates expand the money supply by putting more money into circulation or increasing the percentage of deposits that banks are able to lend.
Contractionary monetary policy, such as selling government bonds to the public, raising reserve requirements or boosting interest rates, reduces the money supply by taking money out of circulation and reducing lending by banks. Central banks use contractionary measures, such as raising interest rates, to counter inflationary pressures.
MONETARY - DISADV
A failure to regulate the supply of money leads to hyperinflation that destroys the value of money, rendering a currency worthless in terms of its purchasing power. Emerging nations in Eastern Europe and South America learned this hard lesson in the 1990s, when the printing of currency to finance government operations grew the money supply at a rapid rate and ignited high rates of inflation.
Moral hazard and adverse selection also comes into play here. Private enterprise which expect to be backed up by public funds and regulatory intervention in times of distress will tend to engage in excessive risk-taking and thereby anticipate that any subsequent fallout from their negligence will be fully redressed using public taxpayer funds. This contradicts the principle of perfect market competition.
