Fiscal and Monetary Policy Interactions - ReviewEcon.com (2024)

FAQs

What are the interactions between monetary and fiscal policy? ›

An expansionary fiscal policy, then, leads to an expansionary monetary policy, fueling inflationary pressures, causing a possible real appreciation of the currency and hence balance of payments difficulties, potentially even resulting in a currency (and/or banking) crisis.

A policy mix is a combination of measures enacted by both fiscal and monetary policymakers in order to strengthen or stabilize a nation's economy. Monetary policy is managed by a nation's central bank while the federal government is responsible for fiscal policy. Fiscal policy involves spending money and raising money.

How does fiscal policy impact the loanable funds market? Expansionary fiscal policy increases the deficit. As a result, the government must borrow more and increase its debt. That increased borrowing increases interest rates and crowds out private investment.

Governments influence the economy by changing the level and types of taxes, the extent and composition of spending, and the degree and form of borrowing. Governments directly and indirectly influence how economic resources are used.

If one policy is expansionary and the other is working to slow the economy down, they will cancel each other out and create instability. While real-life policy is more complicated than policy in Nad, it's a good jumping-off point to understand the importance of coordinating policy.

Fiscal policy impacts aggregate demand through changes in government spending and taxation. Those factors influence employment and household income, which then impact consumer spending and investment. Monetary policy impacts the money supply in an economy, which influences interest rates and the inflation rate.

Since monetary and fiscal policy both shift the Aggregate Demand curve in the short run, the key to figuring out how the combination will impact the price level and real output (and with output, employment), is to figure out which direction each action will shift the AD curve then reconcile the two.

The Bottom Line

Monetary and fiscal policy tools are used in concert to help keep economic growth stable with low inflation, low unemployment, and stable prices.

Fiscal policy is the spending and taxing policies used by Congress and the president to influence and stabilize the economy. Monetary policy is the tools used by the Federal Open Market Committee to influence the availability of credit and the money supply.

In the short term, governments may focus on macroeconomic stabilization—for example, expanding spending or cutting taxes to stimulate an ailing economy, or slashing spending or raising taxes to combat rising inflation or to help reduce external vulnerabilities.

How does fiscal policy affect inflation? ›

Fiscal policy can contribute to lowering inflation both by directly reducing aggregate demand and by making the disinflationary policy package more credible. Inflation is typically fought through tightening monetary policy which raises interest rates and causes a recession that lowers price pressures.

Answer and Explanation:

Contractionary fiscal policy would shift the IS curve to the left to IS1, whereas expansionary monetary policy would shift the LM curve to the right - LM1. The policy mix would create no effect of output, and output Y* remains the same. But, the real interest rate falls from r* to r1.

Fiscal policy can be changed more quickly than monetary policy. Fiscal policy has much shorter delays due to the smaller number of legislators involved.

Expansionary policy often has the unintended consequence of creating (or increasing) inflation. The Federal Reserve usually has to choose between combatting unemployment and inflation; any policies set forth to battle one usually increases the other.

An expansionary fiscal policy lowers tax rates or increases spending to increase aggregate demand and fuel economic growth. A contractionary fiscal policy raises rates or cuts spending to prevent or reduce inflation.

Monetary policy reaches people, businesses and governments through the financial system. By adjusting our interest rates, for instance, we can influence how expensive it is for people and businesses to borrow money from banks. That affects how much people and businesses spend and invest.

They operate at cross-purposes because monetary policy focuses on the money supply to control inflation, while fiscal policy on the aggregate demand by stimulating consumption.