Which is more effective monetary or fiscal policy?
In recent decades, monetary policy has become more popular because:
- Monetary policy is set by the Central Bank, and therefore reduces political influence (e.g. politicians may cut interest rates in desire to have a booming economy before a general election)
- Fiscal policy can have more supply side effects on the wider economy. E.g. to reduce inflation – higher tax and lower spending would not be popular and the government may be reluctant to purse this. Also lower spending could lead to reduced public services and the higher income tax could create disincentives to work.
- Monetarists argue expansionary fiscal policy (larger budget deficit) is likely to cause crowding out – higher government spending reduces private sector spending, and higher government borrowing pushes up interest rates. (However, this analysis is disputed)
- Expansionary fiscal policy (e.g. more government spending) may lead to special interest groups pushing for spending which isn’t really helpful and then proves difficult to reduce when recession is over.
- Monetary policy is quicker to implement. Interest rates can be set every month. A decision to increase government spending may take time to decide where to spend the money.
However, the recent recession shows that monetary policy too can have many limitations.
- Targeting inflation is too narrow. This meant central banks ignored an unsustainable boom in housing market and bank lending.
- Liquidity trap. In a recession, cutting interest rates may prove insufficient to boost demand because banks don’t want to lend and consumers are too nervous to spend. Interest rates were cut from 5% to 0.5% in March 2009, but this didn’t solve recession in UK.
- Even quantitative easing – creating money may be ineffective if banks just want to keep the extra money in their balance sheets.
- Government spending directly creates demand in the economy and can provide a kick-start to get the economy out of recession. Thus in a deep recession, relying on monetary policy alone, may be insufficient to restore equilibrium in the economy.
- In a liquidity trap, expansionary fiscal policy will not cause crowding out because the government is making use of surplus saving to inject demand into the economy.
- In a deep recession, expansionary fiscal policy may be important for confidence – if monetary policy has proved to be a failure.
