This article will help you to learn about the difference between monetary policy and fiscal policy.
Difference between Monetary Policy and Fiscal Policy
Monetary and fiscal policies differ in how effective they are in shifting aggregate demand.
Two important issues must be faced in determining the relative effectiveness of monetary and fiscal policies:
1. The sensitivity of investment demand and net exports to interest rates.
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2. The sensitivity of money demand to interest rates.
When is fiscal policy relatively weak?
An expansionary fiscal policy will have a relatively weak effect on aggregate demand if interest rates rise a lot and have a large negative effect in investment and net exports.
The fall in investment and net exports will offset the positive effect that government spending has on aggregate demand.
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The fall in investment and net exports will be large under two circumstances, corresponding to the two issues listed:
1. If the sensitivity of investment demand and net exports to interest rates is very large, its then a rise in interest rates will reduce investment and net exports by a large amount.
2. It the sensitivity of money demand to the interest rate is very small, then the increase in money demand that arises as a result of the increased government expenditures will cause a big rise in the interest rate. (The small interest-rate sensivity means that the interest rate has to move a lot.)
Another property of the economy that affects the strength of fiscal policy is the spending multiplier. A high spending multiplier means more effective fiscal policy. However, if the economy has a high interest sensitivity of investment and net exports and low interest sensitivity of money demand, then even a very large multiplier may not make fiscal policy strong and effective.
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When is fiscal policy relatively strong?
An expansionary fiscal policy will have a relatively strong effect on aggregate demand if interest rates don’t rise by much or have a small effect on investment and net exports. This occurs under circumstances opposite to those listed under weak fiscal policy.
When is monetary policy relatively weak?
An expansionary monetary policy will have a relatively weak effect on aggregate demand if the drop in interest rates that occurs when the money supply is increased is small or has little influence on investment and net exports.
This occurs under two circumstances:
1. If the sensitivity of investment demand and net exports to interest rates is very small, then investment is not simulated much by the decline in interest rates.
2. If the sensitivity of money demand to interest rates is very large, then the increase in the money supply doesn’t cause much of a drop in interest rates. (A small drop in interest rates is sufficient to bring money demand up to the higher money supply.)
When is monetary policy relatively strong?
An expansionary monetary policy will have a big effect if interest rates fall by a large amount and stimulate investment and net exports in a big way. This occurs under circumstances opposite to those listed under weak monetary policy.