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