Fiscal and Monetary Policy

Governments can use both fiscal and monetary policies to move the economy from a
recessionary or expansionary gap. Fiscal policies include increased or decreased government
spending, increased or decreased taxation; on the other hand monetary policies include increased
or decreased money supply, changes in interest rate, etc.
One of the tools of fiscal policy is government spending, the initial equilibrium is represented by
the point E. With increased government spending, the IS curve shifts to the right and new
equilibrium is reached at point E, with increased level of output and higher interest rate.

Monetary policy can help the economy back to the long run equilibrium. Let the initial
equilibrium point is E, with an increase in money supply, the LM curve shifts to the right and
new equilibrium is reached at the E with a higher income level and lower interest rate (shown in
the figure below).

The major benefits of fiscal policy are:

(i)

Government spending can be directed to the areas like infrastructure, education, and

(ii)

housing. Announcement of fiscal policy can be implemented immediately.

Fiscal policy can be used to discourage negative externalities, for example, green

(iii)

taxes can be used to discourage polluting activities.

Fiscal policy is effective in times of recession as it provides the stimulus in the
economy by increasing the aggregate demand in the economy.

The major disadvantages of fiscal policy on the other hand are:

(i)

Fiscal policies are often subjected to gestation lags where there exits time lag between

(ii)
(iii)

identification of the problem to taking appropriate action and implementation.

Fiscal policies are often constrained by socio political concerns.
Fiscal policy may cause some unintended impact on private sector, when government
runs into a deficit it makes it difficult for the private sector to participate in the

(iv)

economic recovery as the supply of loanable funds decreases.

It is often possible that fiscal policies taken by local and state governments contradict
that of the central government.

The major advantages of monetary policy include:

(i)

Monetary policies have short gestation periods; they can be implemented with short

(ii)

time lags.
Monetary policy is conducted by the Central Bank of the economy, which can be

(iii)

taken with much political neutrality.

Can be very flexible and does not lead to budget deficit.

The major disadvantages of monetary policy on the other hand are:

(i)

Monetary policy cannot be directed for direct spending in the areas of infrastructure

(ii)

and spending may be wasted in speculations.

The policy is applicable nationally, cannot be applicable to specific states or areas.

Based on your analysis, does conducting fiscal and monetary policy result in the same
impacts on inflation or output levels? Be sure to talk about the tradeoffs (or lack thereof) that
exists between inflation and output in the short and long run.
In the short run society faces a trade-off between output and inflation. For example, if the
monetary policy makers ( Bank of Canada or any other Central Bank) and government wishes to
expand the economy by shifting the aggregate demand curve (Increases in the money supply,
increases in government spending, or cuts in taxes expand aggregate demand), then that
increases output but that comes with increasing price level or inflation. On the other hand, if the
policymakers contract aggregate demand, that lowers inflation but that also reduces output,
temporarily. However, in the long run this trade off might not exist as In the long run, expected
inflation adjusts to changes in actual inflation, and the short-run Phillips curve shifts. As a result,
the long-run Phillips curve is vertical at the natural rate of unemployment.