Both monetary and fiscal policies are used to stabilize an economy. But the impact of one varies based on the other’s stance, and their interaction, as illustrated in the table below:
Note: convention in the table below
First line denotes the effect of fiscal policy
Second line denotes the effect of monetary policy
Third line denotes the overall effect on the economy
|Easy/Expansionary Fiscal Policy||Tight Fiscal Policy|
|Easy/Expansionary Monetary Policy||AD up.
Low rates → private sector demand up.Growing private and public sector.
Low rates → private sector stimulated.
The public sector will become a smaller percentage of the economy.
|Tight Monetary Policy||AD up.
High interest rates → private sector down.
Public spending will become a higher percentage of GDP.
High interest rates → private sector demand down.
Shrinking private and public sectors.
Section 4.1 in the curriculum talks about the factors influencing which quadrant to choose from the table above, i.e. what is the right mix of monetary and fiscal policy. Key points are listed below:
Section 4.2 talks about quantitative easing – an unconventional approach adopted by the U.S. and U.K. governments during the recent recession of 2008-09 to print money. As interest rates were already near zero level, there was no option of reducing it further to stimulate growth. The central bank (prints money) bought trillions of dollars’ worth of government bonds to increase money supply in the system, increase expenditure and avoid deflation.
Section 4.3 talks about the risk of large fiscal deficits that grow year on year. This increases the real interest rate, inflation expectations, and crowds out private investment.