Question

Compare and contrast fiscal policy and monetray policy. is one better than the other? or are they both necessary? explain fully (include graphs with answer)

Answer 1

Both fiscal policy and monetary policy are necessary and they work together for the growth of an economy.

Fiscal policy is a tool which is used by the government of a nation for collection revenue and expenditure on an economy. The government can influence the economic conditions of a nation using fiscal policy such as demand for goods and services, employment, inflation and economic growth. According to Keynes, the government can stabilize the business cycle and also adjust the output of goods and services with the help of tax and expenditure policies. In the time of recession, the government can use expansionary fiscal policy, where the government can lower its tax rate, so that the disposable income increases in the hands of people who can in turn increase their demand for goods and services. More money in the hands of people would mean that the firms would get more work who would hire more people and hence the unemployment would also decrease. This would lead to increase in aggregate demand and hence increase economic growth. The government can also increase economic growth by spending more money in the economy, by spending more money on infrastructure and other goods, the money supply in the economy would increase which would in-turn push up the aggregate demand.The government can also use contractionary fiscal policy when there is too much inflation. The government can use contractionary fiscal policy by increasing the tax rate and cutting its spending on goods and services.

Graph when the Government uses Expansionary Fiscal Policy:

In the graph below, the Aggregate Demand curve shifts towards the right which in turn increases both the price level from P to P^' and the real output from Q to Q^'.

Monetary policy is a tool which is used by the Central Bank of a nation. By the help of monetary policy, the Central Bank can control the money supply and interest rates so that it can control inflation, consumption of goods and services, economic growth and liquidity of money. The central bank achieves its objectives with the help of government bonds, adjusting foreign exchange rates, specifying the reserve requirement the commercial banks should hold, etc. During times of recession, the central bank adopts an expansionary monetary policy which can increase economic growth. In expansionary monetary policy, the central bank lowers the interest rate and also it lowers the reserve requirement of the commercial banks, so that there is more lending by the commercial banks to individuals and firms and the money supply is increased in the economy. When the money supply increases, firms can invest more in capital goods which would lead to more production of goods and services in the future. When money supply increases, the unemployment is also reduced. At times of high inflation, the central bank can also adopt contractionary monetary policy where it can increase its interest rate, raise the reserve requirement of the commercial banks so that the money supply can decrease and the economy is stabilized.

Graph when the Central Bank uses Expansionary Monetary Policy:

In the graph below, the Aggregate Supply curve shifts towards the right which in turn increases both the price level from P to P^' and the real output from Q to Q^'.