Question

Define Fiscal and Monetary policy. Explain how each attempts to correct a recessionary and an inflationary gap. Analyze through the comparison and contrast the strength and weakness of each policy addressing 5 macroeconomic issues

Answer 1

Monetary policy is controlling the supply of money in circulation and interest rate by the central bank of the country.The tools of monetary policy are open market operations,reserve ratio and changing the discount rate.Fiscal policy is the tax policy and spending of the national government .

The gap between the level of real GDP and potential output where real GDP is less than potential is the recessionary gap.The gap between the level of real GDP and potential output where real GDP is greater than potential output is the inflationary gap.

When the economy is in inflationary gap the FED takes contractionary monetary policy to reduce the supply of money in the market by selling securities,increasing the reserve ratio and the increasing the discount rate.During recessionary gap the FED will take expansionary monetary policy to increase the supply of money in the market by buying securities,reducing the reserve ratio,and reducing the discount rate.

In an attempt to reduce inflationary gap the government will reduce government spending and increase taxes.As taxes increase ,disposable income of consumers decrease and they have less money to consume and invest.This reduces aggregate demand.To reduce recessionary gap government spending will increase and decrease taxes . As taxes are reduced consumers will have more money to consume and invest.

Both monetary and fiscal policy impact our economy. Both are used to keep inflation level low.Both aim to get full employment and economic growth.Fiscal policy affect aggregate demand due to changes in government spending and taxes.This effects employment and the incomes of the households and in turn affects consumer spending and investment . Monetary policy affects the supply of money in the economy and the supply of money has its influence on interest rate and inflation rate.Central banks can use monetary tools quickly but it takes sometime to materialize.Fiscal policy measures can influence spending in specific projects immediately but can also create budget deficit.