Effects of Fiscal and Monetary Policies

This paper would seek to examine one of the most crucial issues faced by the governments of countries over; the economic state of their own respective countries and the state of the global economy. Economists have sought to identify different policies which could be used to rectify this situation by providing some sort of solution to the issue at hand.

Hence, different economic models and policies were evaluated in order to bring the economy out of its current state of recession and propel it towards growth. The basic forces of any economic model; demand and supply would need to be enacted accordingly in order to bring some stability to the current economic world.

Any economic recession results in obvious effects such as declining employment levels as was witnessed worldwide by the massive layoffs by giant corporations, declining profit and investments levels and the inflation levels reach new heights due to the added costs pressure. The current economic recession has been nothing but devastating due to massive worldwide economic collapses.

In such a scenario, when the market forces fail to act immediately to provide an apt solution to the matter the government needs to act in order to reestablish the economic order in a collapsing economy. The government intervention has to be monitored closely as well due to the lasting effects of these policies which are broadly defined as the fiscal and monetary policies.

The tools available on hand are taxes, interest rates, money supply and lastly, the exchange rate.

As worldwide economists continue to struggle with the notion of what is the right policy with which to tackle the current recession, this paper would seek to provide an insight into some of the possible solutions and their esteemed effects. As is the case whenever recession takes place government policies strongly depend on the expansionary monetary and fiscal policies to tackle the issue at hand.

The interest rates are decreased substantially as was witnessed across different nations and this is normally done in order to tackle the situation as best given the current situation of failing banks and declining stock levels.

The inflation rates vary substantially as in certain cases the output falls rapidly along-with the inflation levels while in other cases, the inflation rises substantially as a result of the rising costs of production.

The government makes use of certain important tools such as fiscal and monetary in order to stabilize the economy and in the case scenario of recession, the exchange rate depreciates as well resulting in the use of expansionary fiscal and monetary policies.

However, this paper would analyze whether these policies are the most apt to use considering the economic situation and its repercussions. The response to such expansionary moves is magnified during the recessions and especially considering the deep recession prevalent at current.

For the present recessionary gap, the impact felt would be much greater considering the fact that the recession is worldwide and its deepness is quite profound. But whether an expansionary monetary and fiscal policy are the solutions can be considered if one was to analyze the Gross Domestic Product in the absence of such policies. And what come across are the fact that the GDP would in fact have been much lower and the recovery speed substantially slower as well.

In order to realize the effects of any policy and its consequent effects, the economists need to show restraint due to the time lags in the policy implementation and the actual effects of the policy. Hence, the effects do not immediately start showing but in fact after a period of a number of years which makes the possibility of an immediate solution impossible.

However, if one was to identify the responses in the current recession, then what has come across have been significantly strong policy responses. If one was to merely analyze the Asian region as an example, in May 2009 alone, the median decline which took place in the policy rates across the countries in the region had exceeded by a substantial number of 200 basis points.

Even the median reflected sharp responses as the expected changes in the fiscal balances during the Fiscal Period of 2009, was about 3.5 percent of the Gross Domestic Product which was clearly more than double the normal response during any other recession. What can be identified from the above numbers is the fact that the use of expansionary fiscal and monetary policies had resulted in alleviating the recession and improving the economic climate overall.

Besides, the aforementioned facts, other notions also need to be considered. While this strategy might have paid off in the case of the Asian economies, in the case of other economies and countries that might well not be the case due to differing economic circumstances and different policies of varying policy makers. Though certain economists have been noted to defend the expansionary policies, other economists still believe in making use of deficit spending in order to fill the recessionary gap.

While there are still economists around who strongly adhere to the market system and hence, oppose such government moves. The global culture of the current recession has resulted in the economists studying and analyzing different possibilities including analyzing the previous solutions. Those recessions which come about as a result of financial issues and global downsizing have been of a long and consistent nature.

Such recessions have been six in number till now and hence, varying policies have been considered in order to resolve them. In all the cases, in the shorter period the expansionary monetary policy was used and was thought of as most adept. While the fiscal policy was mostly thought of as the best solution in the longer run and considering the current recession, fiscal one would be the best possible solution then.

However, fiscal policy is thought to be a policy which can have a more serious impact than otherwise could have been devised. In the cases of liquidity issues, the fiscal policy can have more serious effects than in the other cases. A monetary policy’s absence can be explained but the effect that the effectiveness of the interest rates is much less in such cases due to the financial liquidity crisis. Especially during the current recession in which banks are unwilling to lend money and any decrease in interest rates would not result in any economic recovery.

Some of the most developed economies today are facing the brunt of the economic recession and hence, worldwide the recession is quite severe and stronger than usual. Therefore, the economists worldwide have had to come up with possible solutions in order to resolve the current predicament.

What comes across is that in order to resolve the situation, the aggressive fiscal and monetary policies are used in order increase the aggregate demand levels. However, one issue which must be kept in mind is that whether the public debt can be used and sustained in these recessive times.

If one was to actually analyze the above proposed notions of deficit spending and tax cuts, not much difference would be found in their subsequent effects as both work at increasing the overall money supply within the economy. The causes behind the current economic recession were that of loss of consumer confidence and the spiraling interest rates. In the case of such a worldwide recession, oil also plays an important role as it is one of the most valuable resources available.

The worldwide impact of the energy prices and the consequent impact upon other industries resulted in the current predicament and the solution to such issues was keenly studied by economists worldwide especially considering the global impact of their decisions.

The US government was faced with one of the most difficult choices indeed in terms of its monetary policy as the reduction of the interest rates and the extent of that reduction was indeed a matter of considerable debate amongst all the economists. However, if one was to closely examine reality then what would come across is the fact that an interest cut will not do much to improve the current economic situation considering the current fear prevailing amongst all the financial situations. The fear of not being able to recover on investments and loans would not be offset by the interest cut hence, negating any positive effect to a great extent. Thus, creating a situation of considerable debate.

monthly change in non-farm employment

In the current situation, the consumers are all caught up in mounting debt levels and hence, their ability to borrow money is curtailed to a great extent as it is. Hence, what with prices of houses falling quite fast along-with the employment levels a lower interest rate does not seem to be the most optimal of solutions. However, what could be proposed instead is the possibility of tax cuts which could be used to alleviate the current financial crunch.

In the case of US, where payroll taxes cut deeply into the earnings, a deduction into these could help the consumer s to some extent.

This in turn would have a significant effect on the AS/AD model as any reductions in taxes would mean heightened levels of the ability to spend. This in turn would stimulate the aggregate demand which would motivate the suppliers to supply more and hence, a cycle would be created resulting in greater economic output.

Thus, in order to deeply analyze the effects of any monetary and fiscal policy, one needs to analyze its subsequent effects on the AS/AD model as well.

The following diagram depicts a situation which is prevalent across different economies today; that of low demand and falling costs of production which have resulted in greater supply. However, the overall output as can b deduced from the figure was lower and due to the falling price levels, deflation was a consequent result.

US Economy: 2008-2009
Diagram 1: US Economy: 2008-2009

According to the supply side economists, the optimal solution to this current predicament would be one in which the fiscal policy is used in a way in which the tax levels are reduced while the government expenditures are increased in order to increase the engine of economic growth; investment. The higher the investment levels, more the capital stock, lower costs of production, more supply and greater the employment which in turn develops into greater demand.

However, what cannot be ignored is the importance attached to the private investment levels as the government spending could oust the private investment resulting in negative economic output results. The supply-side economists defend this policy strongly on the basis of lower taxes resulting in more investment and higher growth.

The tax payers faced by the lower burden can spend more as it suggested by the Laffer curve which is used to demonstrate the relationship between the tax rates and the tax revenue.

The monetarists view inflation is as one of the results of recession as Milton Friedmna once stated:

““Inflation is always and everywhere a monetary phenomenon.”(Milton,1960)

Hence, what comes across is the fact that money is the actual tool which can be used to control the economy as this sort of inflation is caused by excessive demand. In the current situation, the competition to attract buyers has meant higher prices and inflation as a result.

US Economy: today-future
Diagram 2: US Economy: today-future

While the money supply has certainly increased, what has been seen is the fact that the banks are no longer willing to part with their funds due to the low return rates. The low employment rates and the the less usage of the resources could however, mean that demand-pull inflation would not be an actual cause of concern.

Due to the existence of the excess bank reserves, the rapid money growth has not been able to create current inflation. However, inflation would be a positive factor in the current situation as that would mean that the consumer has regained his lost buying power and confidence along-with a freer credit market etc. That in turn would translate into higher employment levels and economic growth in the long run.

The falling diagram would show the US economy with and without any sort of fiscal or monetary restraint.

US Economy with and witrout monetary and fiscal restraint
Diagram 3: US Economy: with and witrout monetary and fiscal restraint
Keynesian AD/AS Model
Diagram 4: Keynesian AD/AS Model

What can be seen that is tax cuts along-with higher inflation levels could be used to resolve the situation more than decreases in the interest rates as it is widely believed. On can also analyze the Keynesian model which as depicted below highlights a situation of low demand, unemployment and an overall depression.

According to the above model, the solution would be to increase government expenditure. This can be contrasted with the Classical Model, the policymakers believe that lower costs will result in self-improvement due to more employment and production.

Recession in the extended AD/AS model
Diagram 5: Recession in the extended AD/AS model

What has been experienced by the world economy in general and the US economy in particular recently has been a contraction of the GDP with lower levels of output. Employment has decreased and at the same time total price levels have fallen as spending power of consumers and investors have decreased. The recessionary trends presently are being tackled through combination of both monetary policy and fiscal policy. No one single policy can be depended upon to make any significant impact. As has been seen in the past the US government had been depending on tax cuts and minimal interest rates to encourage investment. this expansionary policy was not guided by strong measures and standards which would have kept check on different parts of the economy. Instead there was a lax attitude at best. Presently the US economy is experiencing stagflation and even a contraction of economy. There is a need to encourage investment and consumption but the government cannot follow a purely capitalistic approach in its different economic policy formulations, whether fiscal or monetary. There should be a balance and strong control and check and balances so that the government doesn’t have to step in every time a large company goes bankrupt. As we have seen in the recent past, after the fall of the large Wall Street companies and insurance giants like AIG, the government had to step in and invest in these organizations, in addition, the recent nationalization of GM which filed for bankruptcy is another area where the government has tried to play a positive role.

According to Conference-Board Leading economic index, (2009) there was a sharp rise in the leading indicates after a period of 7 months. The gains and strength of some of its components was more than the weaknesses of other components, this trend has changed after one and a half years. The biggest negative indicator was real money supply, which was lower. Presently the indicator stands at 99. It was 100 in 2004.

Therefore what is needed at this time are effective monetary and fiscal policy. Increased in government expenditure in terms of government expansion can lead to increased job opportunities and would lead to more investments. In addition for a more balanced growth of the economy there is a need to have increased money supply as increased lending could stimulate investment. with interest rates at their lowest level this could stimulate increased aggregate demand and supply of total GDP.


Sexton, Robert; Fortura, Peter (2005). Exploring Economics.

Sullivan, arthur; Steven M. Sheffrin (2003). Economics: Principles in action. Upper Saddle River, New Jersey 07458: Pearson Prentice Hall. pp. 307.Web.

Dutt, Amitava K.and Skott, Peter. “Keynesian Theory and the AD-AS Framework: A Reconsideration,” Working Papers 2005, University of Massachusetts Amherst, Department of Economics. 2005.

Palley, Thomas I. “Keynesian theory and AS/AD analysis”. Eastern Economic Journal, 1997.

Amitava Krishna Dutt and Skott, Peter. “Keynesian Theory and the Aggregate-Supply/Aggregate-Demand Framework: A Defense,” Eastern Economic Journal, Eastern Economic Association, vol. 22(3), pages 313-331,1996.

Heyne, P. T., Boettke, P. J., Prychitko, D. L. (2002): The Economic Way of Thinking (10th ed). Prentice Hall.

B.M. Friedman “Monetary Policy,” International Encyclopedia of the Social & Behavioral Sciences, 2001, pp. 9976-9984.
Conference Board. (2009). Leading Economic Indicators. Press Releas 2009. Web.

Forder, James. “”Credibility” in Context: Do Central Bankers and Economists Interpret the Term Differently?”

“Federal Reserve Act“. Federal Reserve Board.

Milton Friedman (1960), A Program for Monetary Stability. Fordham University Press.

Ben Bernanke (2006), ‘Monetary Aggregates and Monetary Policy at the Federal Reserve: A Historical Perspective’.

Edward Nelson (2007), ‘Milton Friedman and U.S. Monetary History: 1961-2006’, Federal Reserve Bank of St. Louis Review 89 (3), page 171

Shiskin, Julius (1974), “The Changing Business Cycle”, New York Times: 222

Achuthan, Lakshman; Banerji, Anirvan (2008). “The risk of redefining recession”. CNN. Web.

“Business Cycle Expansions and Contractions”. National Bureau of Economic Research. Web.

A Estrella, FS Mishkin. “Predicting U.S. Recessions: Financial Variables as Leading Indicators”. MIT Press.

Jeremy Siegel, Stocks for the Long Run

Signal or Noise? Implications of the Term Premium for Recession Forecasting

Labor Model Predicts Lower Recession Odds

Leading Economic Indicators Suggest U.S. In Recession, 2008

Find out the price of your paper