Question

Briefly discuss the differences in lags and other shortcomings of using monetary policy and fiscal policy in response to aggregate demand shocks. (Hint: make sure you discuss whether one works better than the other in certain economic circumstances and why)

Answer 1

1. Monetary Policy:- It is the policy assumed by the monetary authority of a country that directs either the interest rate payable on very short-term financing or the money supply, often targeting inflation or the interest rate to secure price firmness and general trust in the currency.

2. Fiscal Policy :- Fiscal policy is the tool used by the government to adjust its expenditure level and tax rates to monitor and influence a nation’s economy.

3. Aggregate Demand Shocks :- In economics, a demand shock is an unexpected and surprise event that dramatically increases or decreases demand for particular goods or services, usually on a short term base.

Demand shocks are often temporary disturbance that the market will balance to eventually by motivating more production of supply in a positive shock or the failure of producers in a negative shock.

4. Use of Monetary Policy in aggregate demand shock :-

Both fiscal and monetary policy refer the two most famous tools to influence a nations eceonomic activity. Monetary policy addresses interest rates and the supply of money in circulation and on the other hand fiscal policy addresses taxation and government expenditures.

Monetary Policy’s Pros and Cons:-

Pros :-

a) Interest rate targeting controls inflation.

b) Can be implemented fairly easily.

c) Central banks are independent and politically neutral.

d) Weakning the currency can boost exports.

Cons :-

a) Effects have a time log.

b) Technical Limitations.

c) Monetary tools are gneral and can affect an entire country.

d) The risk of hyperinflation.

Pros and Cons of fiscal policy :-

Pros :-

a) Can direct spending to specific purposes.

b) can use taxation to discourage negative externalities.

c) Short time Lag.

Cons :-

a) May be politicaly motivated.

b) tax incentives may be spent on imports.

c) can create budget deficits.

Conclusion:- Both fiscal and monetary policy play a very important role in managing the economy.

Monetary Policy is most widely used for the economy, because it is the easiest way to change the interest rates to influence the economic cycle.