Fiscal vs. Monetary
The real world
Conventional Wisdom about
Monetary and Fiscal Policy
• Monetary and fiscal policy are not tools to finetune the economy, but they can be useful in
guiding it toward the macroeconomic goals.
• Monetary policy is more important in the short-run
because it is more flexible and less influenced by
politics.
• Long-run consequences of expansionary policy
include:
– Inflation (monetary policy)
– Higher interest rates and crowding out (fiscal policy)
Conventional Wisdom about
Monetary and Fiscal Policy
• Monetary and fiscal policy are useful to
achieve high growth, low inflation, and low
unemployment.
Conventional Wisdom about
Monetary and Fiscal Policy
• Of the two, monetary policy is the more
important policy for short-run stabilization.
• It is more flexible and less influenced by
politics than fiscal policy.
Conventional Wisdom about
Monetary and Fiscal Policy
Option
Monetary Expansionary
policy
Contractionary
Advantages
Disadvantages
1. Interest rates may fall.
2. Economy may grow.
3. Decreases unemployment.
1. Inflation may worsen.
2. Capital outflow.
3. Trade deficit may
increase.
1. Helps fight inflation.
2. Trade deficit may increase.
3. Capital inflow
1. Risks recession.
2. Increases unemployment.
3. Slows growth.
4. May help cause short-run
problems.
5. Interest rates may rise.
Conventional Wisdom about
Monetary and Fiscal Policy
Option
Fiscal
policy
Expansionary
Contractionary
Advantages
Disadvantages
1. May increase output growth
in the short run.
2. May help solve short-run
political problems.
3. Decreases unemployment.
1. Budget deficit worsens.
2. Hurts country’s ability to
borrow in the future.
3. Trade deficit may increase.
4. Upward pressure on interest
rate, discouraging growth.
1. May help fight inflation.
2. May allow a better
monetary/fiscal mix.
3. Trade deficit may decrease.
4. Interest rates may fall,
stimulating investment and
growth in the long run.
1. Risks recession.
2. Increases unemployment.
3. Slows output growth in the
short run.
4. May help cause short-run
political problems.
Alternatives and Supplements
to Monetary and Fiscal Policy
• Monetary and fiscal policy aren’t the only
policies that affect aggregate demand.
• Any policy that affects autonomous
spending without having offsetting effects
on other expenditures can achieve the
same results.
Directed Investment Policies:
Policy Affecting Expectations
• Poor investor expectations can become
self-fulfilling.
• If they expect a recession, they might not
invest, driving the economy into a
Depression.
Rosy Scenario: Talking the
Economy into Fiscal Health
• Gloomy government pronouncements
may affect expectations and decrease
investment and consumption spending.
• Rosy scenario – government policy of
making optimistic predictions and never
making gloomy predictions.
Financial Guarantees
• Government guarantees or promises of
guarantees can bolster business
confidence.
Autonomous Consumption
Policy
• Making credit more available to
consumers can expand aggregate
demand.
• Economists watch indexes of consumer
credit and consumer confidence to gauge
the direction of the economy.
Trade Policy and Export-Led
Growth
• Export-led growth policies – policies
designed to stimulate U.S. exports and
increase aggregate expenditures on U.S.
goods.
• Any policy that restricts imports will have
the same effect on the economy.
Interdependencies in the
Global Economy
• Any time a nation attempts to restrict
imports, it is equivalent to getting another
country to follow an import-led decline of
its economy.
Interdependencies in the
Global Economy
• There is a risk of retaliation whenever a
nation applies trade restrictions against
another nation.
Exchange Rate Policies
• Exchange rate policy – a policy of
deliberately affecting a country’s
exchange rate in order to affect its trade
balance.
• A low value of a country’s currency
relative to other currencies encourages
exports and discourages imports, and vice
versa.
Credibility in Aggregate
Demand Policy
• Effective policy must be credible policy.
Rational Expectations
• People generally act rationally in the
sense that they are forward looking.
• Rational expectations – forward-looking
expectations that use available
information.
Rational Expectations
• For example, if the public is convinced
that the Fed is deadly serious about its
goal of cooling down the economy, the
policy will work.
Uncertainty About the Effects
of Policy
• The central role of expectations means
that there is a great deal of uncertainty in
the economy.
• There are a multiplicity of expectational
strategies which can shift rapidly.
Uncertainty About the Effects
of Policy
• This undermines the ability to develop
deterministic models of the economy
which gives the economy an
unpredictability that precludes fine tuning.
Uncertainty About the Effects
of Policy
• Depending on the beliefs that individuals
have, monetary and fiscal policy will work
in different ways.
Policy Regimes and
Expectations
• A policy regime is a rule.
• It is a predetermined statement of the
policy that will be followed in various
circumstances.
Policy Regimes and
Expectations
• A policy is a one-time reaction to a
problem.
• It is chosen without a predetermined
framework.
Policy Regimes and
Expectations
• Policy regimes can help generate the
expectations that make the government’s
tools work.
Rules versus Discretion and
Credibility
• The focus on credibility has led to a call
for rules to guide policy rather than giving
policymakers wide policy discretion.
Summary
• Fiscal policy is affected by the following problems:
– Interest rate crowding out.
– The government may not know what the situation is.
– The government may not know the economy’s potential
income.
– Government can not respond quickly.
– The size of the government debt does matter.
– Economic goals may conflict.
• Activist policy is now built into U.S. institutions through
automatic stabilizers.
• Economists’ challenge is to find the appropriate mix of
policy to balance the trade-off between low
unemployment, high growth, and low inflation.
Summary
• Three alternatives to monetary and fiscal policy are:
– Directed investment policies
– Autonomous consumption policy
– Trade policy
• Policy is a process, not a one-time event, and
policy regimes are often more important than any
particular policy.
• Credibility can be built by establishing policy rules,
but the trade-off is that policymakers will be unable
to respond to an unforeseen event.
Review Question 14-1 Identify three automatic stabilizers and explain how
they would lessen the severity of a recession.
Welfare payments, unemployment insurance, and income tax are automatic
stabilizers. In the case of a recession, unemployment increases, so welfare
payments and unemployment insurance increase, offsetting some of the
decrease in income. With lower incomes, people pay less tax. An increase
in government spending and a decrease in taxes is an expansionary policy
that will increase AD.
Review Question 14-2 What are the six assumptions of the AS/AD model
that lead to problems with fiscal policy?
1. Financing the deficit has no effect. (It can cause crowding out).
2. The government knows what the situation is. (The government uses
estimates of the mpe and other exogenous variables.
3. The government knows potential income. (There is a wide range of
estimates).
4. The government has flexibility in changing spending and taxes.
5. Size of the debt doesn’t matter.
6. Fiscal policy doesn’t affect other economic goals.