Question

Monetary and fiscal policy play important roles in economic stimulation and or stabilization. In this regard:

a. When is it appropriate to use monetary and fiscal policy to stimulate or stabilize the economy?

b. When is it inappropriate to use monetary and fiscal policy to stimulate or stabilize the economy?

c. What specific fiscal policy tools would you use to stimulate aggregate demand and how?

d. What specific monetary policy tools would you use to stimulate aggregate demand and how?

Answer 1

Monetary and fiscal policies are essential to maintain macro economic stablility of a nation.

1. If it wants to slow down the economy, they will introduce contractinary fiscal policies by decreasing government spending or increasing taxes and the monetary policies by which central bank increases money supply in the economy through a reduction in reserve rates. Similarly if they want to boost the economy, both expansionary fiscal and monetary policies can stimulate the economy.

2. Fiscal policy is inappropriate or ineffective when investment is highly interest inelastic. Similarly monetary policy is inappropriate when the economy is in a liquidity trap.. Both situations, fiscal policy and monetary policy may not have any positive effect to animate or stabilise the economy.

3. In order to stimulate aggregate demand or increase aggregate demand, expansionary policy is essential like increasing government spending or tax cut etc. It is more appropriate in the time of recession or depression in the economy.

4. In order to stimulate aggregate demand, the most effective expansionary monetary tool is to reduce reserve ratios like bank rate. it improves the lending capacity of the banks and firms can borrow more money from the bank at lower rate of interest. Investment, production, employment and output also increase which simulatieously increases consumption. As a result aggregate demand shifts to the right.