Question

Monetary and fiscal policy instruments are used to affect the aggregate demand (AD) in the economy.

1. What is the difference between contractionary and expansionary monetary policy? What is the difference between contractionary and expansionary fiscal policy? How does each policy affect the AD in the economy?
2. What are the benefits and major problems of the fiscal policy and monetary policy?

Answer 1

a. Contractionary monetary policy is a macroeconomics tool used by central bank to control inflation by reducing the supply of money in the economy, while an expantionary monetary policy increases the supply of money.

A contractionary monetary policy shifts the LM to the left from LM₀ to LM₁. Output falls for all levels of prices.

As a result, AD curve shifts to the left. Vice-versa for expansionary policy.

b. Fiscal and monetary policy can be used to change the level output in order to control inflation in the economy. However, the problem is that they have no direct effect on output as output is determined by factors of production. They impact the interest rate through increased or decreased savings and increased or decreased money supply, which indirectly impacts the level of output.

Another issue is the problem of crowding out. The actual impact on output is lesser than the planned impact through the policies.