Question

2.The simple models that we develop in class suggest that both fiscal and monetary policy work smoothly to eliminate short-run fluctuations in real GDP and achieve stable price growth. In reality, policy implementation may not be as effective as our model suggests. What obstacles might inhibit the effectiveness of fiscal and monetary policy? You should discuss one obstacle that both monetary and fiscal policy must overcome, one obstacle unique to fiscal policy, and one obstacle unique to monetary policy.

Answer 1

Fiscal policy is a policy controlled by the government and it has two tools: taxes and govt. spending. During recessions govt. decreases taxes and increases govt. spending which is called expansionary fiscal policy. During inflation govt. increases taxes and decreases govt. spending which is called contractionary fiscal policy.

Monetary policy is a policy determined by central bank and has two tools; interest rates and money supply. When there is inflation and central bank wants to reduce over consumption in an economy then it increases interest rates and decreases money supply. This is called as contractionary monetary policy. When there is recession and central bank wants to boost economic activity then it decreases interest rates and increases money supply. This is called as expansionary monetary policy.

Expansionary policies create more aggregate demand, decrease unemployment. It can be inflationary if all resources are fully used and there is no spare capacity.

Main problems with monetary policies are:

Time lags, ineffectiveness in deep recessions and possible conflicts with other poilicies.

To control inflation, contractionary policies are used and this may lead to unemployment as output reduces.

Main problems with fiscal policies are:

Time lags, political constraints and crowding out effect.

When government puts lot of money then it leads to higher demand for money and raises interest rates whcih leads to cwoding out of effciient private investments.