Question

As you have learned in Unit 8 (this week), 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?

e. What is your conclusion, should policymakers use the monetary and or fiscal policy to stimulate aggregate demand? Explain briefly.

Answer 1

a. When the economy is in a recessionary gap, a fiscal expansion (decrease in taxes, increase in government expenditure) can pull the economy out of this gap and bring the output back up to the full employment level. Or, a monetary expansion (increase in money supply) will have the same effect on the economy.

b. When the economy is facing a supply deficit and the output is lower than the potential level, and prices are high, an expansionary fiscal policy or monetary policy will increase the output but it will also further increase prices which will lead to high level of inflation in the economy. Hence, under this condition, a fiscal policy would be inappropriate to stabilize the economy.

c. In order to stimulate aggregate demand, the aim of the fiscal policy is to increase consumer expenditure. This can be done either by decreasing taxes which would lead to higher disposable incomes with the consumers and hence higher expenditure, or, this can be done by increasing government spending on infrastructure, consumer goods, healthcare, etc. which will also stimulate consumer expenditure.

d. An expansionary monetary policy involves increasing the money supply in an economy which leads to a lower rate of interest. At this lower rate of interest, borrowing becomes cheaper and this leads to an increase in private investment which stimulates aggregate demand.