Question

Q2. Fiscal policy, like Monetary policy, cannot change the natural level of output. Why then is MP considered neutral but FP is not?

Answer 1

When there is an implementation of a expansionary monetary policy following changes occurs:

In a short run:

(i) Fall in the interest rate.

(ii) Increase in the level of output (Higher than the natural level of output)

(iii) Price level increases

In a medium run:

(i) There is no change in the interest rate.

(ii) Output fall back to its initial natural level of output.

(iii) Price further increases

But when there is an implementation of fiscal policy, will lead to following changes:

In a short run:

(i) Rise in the interest rate.

(ii) Increase in the level of output (Higher than the natural level of output)

(iii) Price level increases

In a medium run:

(i) Interest rate further increases.

(ii) Output fall back to its initial natural level of output.

(iii) Price level increases

Therefore,

we can conclude that both expansionary monetary policy and expansionary fiscal policy have same effects on output and price level in the short run. Whereas in the medium run, both expansionary monetary policy and expansionary fiscal policy have no effect on the level of output (Output fall back to its initial position) but the price level rises.

But in contrast to the expansionary monetary policy in the medium run, the expansionary fiscal policy will lead to increase the interest rate.

Hence, the fiscal policy is not considered as neutral because in the medium run, it totally changes the composition of the AD on the goods market.