Subject 9. Interrelationships between Fiscal and Monetary Policy

Governments use fiscal and monetary policies to respond to changes in the business cycle. Although both fiscal and monetary policy can alter aggregate demand, they work through different channels. Consider the effects of using monetary or fiscal policy to increase aggregate demand:

  • Central banks can respond with lower interest rates and an expanded money supply. This will lead to an increase in investment and consumer spending. Since investment spending results in a large capital stock, incomes in the future will also be higher. However, inflation may result.
  • Keynes argued that the government should boost spending but that if this is financed by higher borrowing, it may result in higher interest rates and lower investment. The net result (by adjusting the increase in G) is the same increase in aggregate demand. However, since investment spending is lower, the capital stock is lower than it would have been and future incomes will be lower.

Monetary policy and fiscal policy are not interchangeable. When the economy is in a recession, monetary policy may be ineffective in increasing spending and income. In this case, fiscal policy might be more effective in stimulating demand. Other economists disagree; they argue that changes in monetary policy can impact consumer and business behaviour quite quickly and strongly.

However, there may be factors which make fiscal policy ineffective aside from the usual crowding-out phenomena. Future-oriented consumption theories based round the concept of rational expectations hold that individuals "undo" government fiscal policy through changes in their own behaviour - for example, if government spending and borrowing rises, people may expect an increase in the tax burden in future years, and therefore increase their current savings in anticipation of this.

Monetary and fiscal policies also differ in the speed with which each takes effect. The time lags are variable and they can conceivably work against one another unless the government and central bank coordinate their objectives.

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thekobe: expectation of an increase in the tax burden in future years and thus increase in current savings is known as Ricardo Barro effect