Governments cannot control an economy directly, but they can steer it. They use two sets of tools. Monetary policy works through money and credit, and it is run by the central bank. Fiscal policy works through government spending and taxation, and it is run by the government. Both aim at the same goals: stable prices, growth, high employment and a balanced external position.
The Institute of Chartered Accountants of Nigeria (ICAN) syllabus asks you to identify and explain the variables of each policy. The earlier Pathfinder diets ask regularly for the two policy approaches that governments use to meet macroeconomic objectives, so this is a topic where a clear, complete answer earns marks quickly.
In 30 seconds
Monetary policy controls the value, supply and cost of money. Its instruments are open market operations, reserve requirements, the discount rate, moral suasion, special deposits, selective credit control and credit ceilings. Contractionary monetary policy cuts the money supply to fight inflation. Expansionary monetary policy raises it to boost output and jobs. Fiscal policy uses taxes, government spending, public debt, the budget and subsidies.
Expansionary fiscal policy lowers taxes or raises spending. Contractionary fiscal policy does the opposite. A balanced policy keeps revenue equal to spending.
The macroeconomic goals
Both policies are used to pursue the same objectives:
- Price stability: keeping inflation low and predictable.
- Economic growth: a steady rise in the output of goods and services.
- Full employment: work for everyone who is willing and able to work.
- External balance: a balance of payments that is not in persistent deficit.
- Fair distribution of income and wealth. This goal is pursued mainly through fiscal policy.
Monetary policy
Monetary policy is a set of policies for controlling the value, supply and cost of money in the economy, in line with the expected level of economic activity. In Nigeria the Central Bank of Nigeria carries it out.
- Contractionary (restrictive) monetary policy aims to reduce the money supply.
- Expansionary monetary policy aims to increase it.
Instruments of monetary policy
| Instrument | What it is | To reduce the money supply | To increase it |
|---|---|---|---|
| Open market operations (OMO) | The central bank buys and sells securities on the open market to reach a target quantity of money | Sell government securities | Buy government securities |
| Reserve requirements | The percentage of banks’ deposit liabilities that they must hold with the central bank, such as the cash reserve ratio and the liquidity ratio | Raise the ratios | Lower the ratios |
| Discount rate | The central bank’s minimum lending rate, at which it rediscounts bills or lends to banks as lender of last resort. It influences other interest rates and the availability of credit | Raise it | Lower it |
| Moral suasion | Persuasion, not compulsion, to get banks to behave in a way that supports the policy | Ask banks to restrain lending | Ask banks to lend more |
| Special deposits | Non-interest-bearing deposits that the law may require banks to hold at the central bank, to back up other contractionary steps | Call for special deposits | Release them |
| Selective credit control | Credit rules telling banks which sectors to favour in lending | Restrict lending to certain sectors | Direct lending to priority sectors |
| Credit ceiling | An order limiting how fast banks may expand their credit, to protect internal and external stability | Tighten the ceiling | Relax it |
A numerical example: the effect of the reserve requirement
Suppose commercial banks hold deposits of ₦10 billion and must keep 20% as reserves with the central bank. They must hold ₦2 billion and can lend ₦8 billion. If the central bank raises the requirement to 30%, banks must hold ₦3 billion and can lend only ₦7 billion. Lending falls by ₦1 billion, so the policy reduces credit and the money supply.
Monetary policy against inflation and for employment
- Inflation. The central bank uses contractionary tools: selling government securities, raising reserve requirements, raising the discount rate and calling for special deposits. These cut the money supply and aggregate demand, which eases the pressure on prices.
- Unemployment and weak output. The bank uses the opposite, expansionary tools, to raise lending, spending, output and jobs.
Fiscal policy
Fiscal policy is the use of government spending and taxation to influence economic activity. Its goals are full employment, growth, price stability, external balance and a fairer spread of income and wealth.
Types of fiscal policy
| Type | What the government does | When it is used | Budget position |
|---|---|---|---|
| Expansionary | Cuts taxes or raises spending to lift consumption, investment and output | When the economy is below full employment, in a slowdown or recession | Spending exceeds revenue: a deficit budget |
| Contractionary | Raises taxes or cuts spending to reduce demand and output | When the economy is overheating, with rising inflation | Revenue exceeds spending: a surplus budget |
| Balanced (neutral) | Keeps taxes and spending equal | When the economy is at full employment and the aim is to keep stability | Revenue equals spending: a balanced budget |
Instruments of fiscal policy
- Taxes. Compulsory charges on people, goods and businesses to pay for government spending. They are direct (on income) or indirect (on spending). Lower taxes raise disposable income and demand.
- Government spending. Spending on projects and programmes and on goods and services. Cutting it eases inflation. In a recession, more spending on infrastructure raises demand and creates jobs.
- Public debt. The total borrowed by government at home and abroad, which equals all past deficits less all past surpluses. It is divided into external debt and internal (domestic) debt.
- The budget. A financial plan of expected income and spending for a period, usually a year, approved in advance and expressed in money terms.
- Subsidies. Financial support to firms or individuals to promote particular sectors or activities.
Monetary and fiscal policy compared
| Point | Monetary policy | Fiscal policy |
|---|---|---|
| Run by | The central bank | The government, with the legislature approving the budget |
| Works through | Money supply, credit and interest rates | Government spending, taxation and borrowing |
| Main tools | OMO, reserve requirements, discount rate, moral suasion | Taxes, spending, public debt, the budget, subsidies |
| Can be changed | Quickly, without legislation | More slowly, through the budget process |
| Also serves | Price stability and credit conditions | Redistribution of income and public services |
Worked example: choosing policy for the economy’s condition
Scenario. Inflation in an economy is rising fast and output is above its full-employment level. A year later a recession follows, with falling output and rising unemployment. Which policies should be used at each stage?
| Stage | Monetary policy | Fiscal policy |
|---|---|---|
| Overheating, with high inflation | Contractionary: sell government securities, raise reserve requirements and the discount rate | Contractionary: raise taxes or cut spending, aiming for a surplus budget |
| Recession, with rising unemployment | Expansionary: buy government securities, lower reserve requirements and the discount rate | Expansionary: cut taxes or raise spending, accepting a deficit budget |
In an answer, state the problem first, then the type of policy, then the instruments and how each works. A full answer ends with a limit: tight policy can slow growth, and expansionary policy can raise inflation or add to public debt.
Monetary and fiscal policy in more detail
How each instrument works, step by step
Open market operations. To reduce the money supply the central bank sells government securities. Buyers pay from their bank accounts, so banks have fewer reserves and lend less. To increase it, the bank buys securities and pays with new reserves. Reserve requirements. Raising the cash reserve ratio forces banks to hold more at the central bank, leaving less to lend.
The discount rate. A higher rate raises the cost of borrowing from the central bank, which pushes up other interest rates and discourages borrowing and spending. Moral suasion. The bank asks banks to restrain or expand lending, relying on their cooperation. Credit ceilings and selective controls. They directly limit how much and to whom banks lend.
The transmission to the economy
A fall in the money supply or a rise in interest rates raises the cost of credit, reduces borrowing for consumption and investment, and so lowers aggregate demand. Lower demand eases price pressure, but also slows output and employment, so the policy has a cost. An expansion works the other way: cheaper credit raises demand, output and jobs, but may raise prices.
Fiscal policy and the budget: the numbers
A government expects to collect ₦8 trillion and plans to spend ₦10 trillion. The budget is in deficit by ₦2 trillion, which it must finance by borrowing. That adds to public debt, which is the accumulation of past deficits less surpluses. If it plans to collect ₦10 trillion and spend ₦8 trillion, there is a surplus of ₦2 trillion, which can reduce debt. A balanced budget has equal revenue and spending.
The multiplier idea
When government spends an extra ₦1 billion, those who receive it spend part and save part, so a second round of spending follows, and a third. The total rise in income is a multiple of the original spending. If people spend 80% of extra income, the multiplier is 1 ÷ 0.20 = 5, so ₦1 billion of spending can raise income by up to ₦5 billion. Taxes and imports are leakages that reduce the multiplier in practice.
Limits and conflicts of the two policies
Tight monetary policy may raise unemployment. Expansionary fiscal policy financed by borrowing may raise public debt and push up interest rates, which can discourage private investment. Policies take time to act, and policy makers may disagree on the right mix, which is why the two are usually coordinated.
Common mistakes in the exam
- Mixing the two policies. Taxes and government spending belong to fiscal policy. Interest rates and reserve ratios belong to monetary policy.
- Getting the direction wrong. To cut the money supply, the central bank sells securities and raises the ratios.
- Confusing the budget positions. Expansionary policy tends to a deficit. Contractionary tends to a surplus.
- Naming instruments with no explanation of how they work.
- Forgetting that policies have limits and side-effects.
- Describing public debt as one year’s deficit. It is the accumulated total.
Quick revision
- Monetary policy: control of the value, supply and cost of money by the central bank.
- Instruments: OMO, reserve requirements, discount rate, moral suasion, special deposits, selective credit control, credit ceiling.
- Inflation calls for contractionary policy. Unemployment and recession call for expansionary policy.
- Fiscal policy: spending and taxation. Types: expansionary (deficit), contractionary (surplus), balanced.
- Instruments: taxes, government spending, public debt, the budget, subsidies.
Practice questions
These are original questions written in the style of the ICAN exam. Try each one before you open the answer.
Section A style: multiple choice
Question 1. Which of the following is an instrument of monetary policy?
- Income tax
- Open market operations
- Government spending on roads
- A subsidy to farmers
Show the answer
B. The other three are fiscal instruments.
Question 2. To reduce inflation through monetary policy, the central bank should:
- Buy government securities
- Lower reserve requirements
- Sell government securities
- Lower the discount rate
Show the answer
C. Selling securities takes money out of circulation. The other options increase the money supply.
Question 3. A government budget in which revenue exceeds expenditure is a:
- Deficit budget
- Surplus budget
- Neutral budget with no effect
- Recession budget
Show the answer
B. A surplus is associated with contractionary fiscal policy.
Question 4. Expansionary fiscal policy involves:
- Raising taxes
- Cutting government spending
- Lowering taxes or raising government spending
- Selling government securities
Show the answer
C. It raises demand and output. Option D is a monetary tool, and A and B are contractionary.
Question 5. Moral suasion is:
- A compulsory deposit with the central bank
- Persuasion of banks by the central bank to support its policy
- A tax on banks
- A limit on the rate of credit growth
Show the answer
B. It relies on persuasion, not on legal force.
Question 6. Monetary policy in Nigeria is carried out by:
- The Federal Ministry of Finance
- The Central Bank of Nigeria
- The Nigeria Revenue Service
- The National Assembly
Show the answer
B. The central bank runs monetary policy. The ministry and the legislature are involved in fiscal policy.
Question 7. To reduce the money supply through open market operations, the central bank should:
- Buy securities
- Sell securities
- Print money
- Lower reserve ratios
Show the answer
B. Selling securities takes money out of banks.
Question 8. A government plans to collect ₦8 trillion and spend ₦10 trillion. This budget is a:
- Surplus of ₦2 trillion
- Deficit of ₦2 trillion
- Balanced budget
- Surplus of ₦10 trillion
Show the answer
B. Spending exceeds revenue.
Question 9. If people spend 75% of extra income, the multiplier is:
- 2
- 4
- 0.75
- 3
Show the answer
B. 1 ÷ 0.25 = 4.
Question 10. Raising the cash reserve ratio is a monetary tool that:
- Increases bank lending
- Reduces funds banks can lend
- Cuts taxes
- Raises government spending
Show the answer
B. Banks must hold more in reserve.
Section B style: written questions
Question 11 (10 marks). Distinguish between monetary policy and fiscal policy, and state two instruments of each.
Show the marking guide
Monetary policy (3 marks). Control of the value, supply and cost of money by the central bank. Two instruments with a line each, such as open market operations and reserve requirements (2 marks).
Fiscal policy (3 marks). The use of government spending and taxation to influence the economy. Two instruments with a line each, such as taxes and government spending (2 marks).
Question 12 (20 marks). Inflation in an economy has risen sharply and output is above its full-employment level.
(a) Explain how the central bank could use three monetary instruments to reduce inflation. (9 marks)
(b) Explain how the government could use fiscal policy against the same problem. (6 marks)
(c) Distinguish between an expansionary, a contractionary and a balanced fiscal policy. (5 marks)
Show the marking guide
(a) 9 marks, 3 each. Open market operations: sell government securities, which takes money out of circulation. Reserve requirements: raise the cash reserve or liquidity ratio, so banks can lend less. Discount rate: raise it, so credit costs more and borrowing falls. Other acceptable answers: special deposits, a credit ceiling, moral suasion. Award 1 mark for naming the instrument, 1 for the action and 1 for the effect on money supply and demand.
(b) 6 marks. Contractionary fiscal policy (1). Raise taxes, which cuts disposable income and demand (2). Cut government spending (2). The aim of a surplus budget (1).
(c) 5 marks. Expansionary: lower taxes or higher spending, a deficit budget, used below full employment (2). Contractionary: higher taxes or lower spending, a surplus budget, used when inflation is rising (2). Balanced: taxes equal spending (1).
A further written question
Question 13 (10 marks). Explain how expansionary fiscal policy can be used to reduce unemployment, and state its limitations.
Model answers
Show the model answer to Question 11
Monetary policy is the control of the value, supply and cost of money by the central bank, using instruments such as open market operations and reserve requirements. For example, selling government securities reduces the money supply, and raising the cash reserve ratio reduces the funds banks can lend. Fiscal policy is the use of government spending and taxation to influence the economy, run by the government.
Its instruments include taxes, such as income tax, and government spending, such as spending on roads. The first works through money and credit, the second through the budget.
Show the model answer to Question 12
(a) Three monetary instruments. Open market operations: the central bank sells government securities, which takes money out of banks and reduces their lending. Reserve requirements: it raises the cash reserve or liquidity ratio, so banks can lend less. The discount rate: it raises its lending rate, so credit costs more and borrowing and spending fall. Together these reduce the money supply and demand and ease price pressure.
(b) Fiscal policy. The government should follow a contractionary policy. It can raise taxes, which reduces disposable income and demand, and cut its own spending. The aim is a surplus budget, so that government demand falls and price pressure eases.
(c) Types of fiscal policy. Expansionary: lower taxes or higher spending, usually with a deficit budget, used below full employment. Contractionary: higher taxes or lower spending, usually with a surplus, used when inflation is rising. Balanced: taxes equal spending.
Show the model answer to Question 13
In expansionary fiscal policy the government cuts taxes or raises spending. Lower taxes leave households and firms with more income to spend and invest. Higher spending, for example on roads and schools, creates demand and jobs directly, and the multiplier effect spreads it further as recipients spend part of the income. More demand leads firms to hire more labour, so cyclical unemployment falls.
Limitations: it usually leads to a deficit budget, adding to public debt and the cost of servicing it; borrowing may push up interest rates and discourage private investment; if the economy is near full capacity it may raise inflation instead of output; and it works with time lags, so the effect may arrive too late. It does not cure structural or frictional unemployment, which need training and better information.
Pathfinder on monetary and fiscal policy
These are the ICAN Pathfinder questions that test this topic. ICAN owns the questions and the suggested solutions, so we point you to them and do not copy them. Open your Pathfinder, attempt each question under exam conditions, then check your answer against the notes above.
From the earlier Business, Management and Finance paper. Part (b) asks for the two main policy approaches governments use to meet macroeconomic objectives, which are monetary and fiscal policy, and part (c) asks about protection of local industry.
Revise first: Monetary policy
From the earlier Business, Management and Finance paper. Part (b) again asks for the two policy approaches governments use to meet macroeconomic objectives.
Revise first: Fiscal policy
From the earlier Business, Management and Finance paper. Part (c) asks why governments develop economic policy. Revise the macroeconomic goals.
Revise first: The macroeconomic goals
From the earlier Business, Management and Finance paper. It asks for the policy approaches governments use to meet macroeconomic objectives and for the meaning of economic stagnation.
Revise first: Monetary and fiscal policy compared
Multiple-choice questions can test the instruments of each policy and the direction in which each is used. Check Section A of every diet you practise for items on these points.
Revise first: Choosing policy for the economy’s condition
Source: ICAN Pathfinder, Business Environment. Diets covered: May Diet, 2021 to May Diet, 2026. November Diet, 2024 is not yet mapped.
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