Interaction between Monetary and Fiscal Policies

Both monetary policy and fiscal policy can be utilized to influence the economy. These measures do not compete against each other. Instead, they complement each other. However, the impact of the two policies may vary or even cancel out each other.

Monetary Policy

The central bank applies monetary policy to change the cost, demand, and availability of credit. It controls credit through open market operations, bank rates, selective methods of credit control, and variable cash reserve ratio.

Fiscal Policy

Fiscal policy focuses on the government in relation to taxation, borrowing, and expenditure. These three elements mostly influence aggregate spending.

The Interaction Between Monetary and Fiscal Policies

Even though both fiscal and monetary policies can influence aggregate demand, their effect on aggregate demand may differ.

• When low interest rates and an expansion in monetary policy follow a contractionary fiscal policy, the private sector is encouraged. Therefore, the GDP increases, and the public sector contracts.
• When easy fiscal and monetary policies are merged, they will have an expansionary effect that will increase aggregate demand, reduce interest rates, and subsequently reduce the growth of the private and public sectors.
• An impact of monetary policy will cause an increase in interest rates and also reduce demand in the private sector. In addition, higher taxation and reduced government spending will lead to a decline in aggregate demand from both the public and the private sectors.

Question

Which one of the following will have the most important effect on aggregate demand?

1. Government expenditures.
2. Increased transfer benefits.
3. A reduction of personal income tax at all income levels.

Solution

The correct answer is A.

Direct spending by the government has a greater impact on GDP than taxes and transfer benefits.