13.3 Monetary Policy vs. Fiscal Policy

The primary advantage of monetary policy is that it can be implemented quickly. In fact, once a policy is formulated, it can be implemented the same day through open-market operations if the bond market is open. The major disadvantage of monetary policy is the long and variable impact lagThe time it takes for an economic policy or decision to produce visible effects in the economy. For example, a government spending program may take months before it boosts employment or growth. . The lag between the time the policy is implemented and the time it has the intended effect on GDP varies between six months and two years. Another disadvantage of monetary policy is that the Fed loses its ability to further stimulate the economy through lowering interest rates when short-term rates approach zero. It “runs out of room.”

The primary advantage of fiscal policy is that it affects GDP at the time it is implemented with government purchases, or soon after it is announced with personal income tax or transfer payment policy. The major disadvantage is the long implementation lagThe delay between deciding on an economic policy and putting it into action. For instance, passing a new law or budget takes time before it can start affecting the economy. . Because taxing and spending legislation must originate in the House of Representatives and be approved by the Senate and the president, it may take weeks or months for a policy to be implemented, or it may never be implemented because of political opposition. Fortunately, during extreme economic conditions, like the Great Recession or the Pandemic Recession of 2020, bipartisanship can facilitate a rapid fiscal policy response.

Macroeconomic stabilization policies are used to moderate short-run economic fluctuations to achieve the policy goals of full employment and price stability. But there is a third, long-run macroeconomic policy objective, namely adequate rates of economic growth. Both monetary policy and fiscal policy affect economic growth through their effects on interest rates. Other things equal, lower interest rates cause increased investment, which leads to higher rates of economic growth. Expansionary monetary policy leads to lower interest rates, while contractionary monetary policy leads to higher interest rates. Fiscal policy can also have interest-rate effects. Expansionary fiscal policy increases income and spending in the economy. When households have more income, they want more money to make additional transactions. The increased demand for money causes interest rates to rise. Conversely, contractionary fiscal policy reduces household income and demand for money, and interest rates fall. Other things equal, when an increase in aggregate demand is needed, expansionary monetary policy has the advantage of encouraging economic growth. When a decrease in aggregate demand is needed, contractionary fiscal policy has that advantage.

While monetary policy and fiscal policy can be used together to address any problem with aggregate demand, policymakers often worry about what will happen to interest rates as a result of countercyclical stabilization policy. Since monetary policy and fiscal policy move interest rates in opposite directions, by using them together, it is possible to achieve the objective of expansionary or contractionary stabilization policy while at the same time achieving an interest-rate target. The Fed is responsible for interest-rate policy. Suppose its target for the federal-funds rate is 4 percent, but expansionary stabilization policy is required to reduce unemployment. Expansionary fiscal policy would cause the interest rate to rise above 4 percent, and expansionary monetary policy would cause it to fall below 4 percent. Used together, the policies can achieve the expansionary policy while keeping the interest rate at the 4-percent target. In this case, Fed policy is called accommodating monetary policyMacroeconomic policy in which both monetary policy and fiscal policy are used together to achieve expansion or contraction while maintaining an interest-rate target..

Suppose the economy is at long-run equilibrium, but policymakers are worried about slow economic growth. How can macroeconomic stabilization policy lower interest rates to encourage economic growth while keeping the economy at long-run equilibrium? In this case, if expansionary monetary policy is used, it will lower interest rates but cause inflation. If contractionary fiscal policy is used, it will lower interest rates but cause unemployment. Used together in the right combination, expansionary monetary policy combined with contractionary fiscal policy will maintain long-run equilibrium while reducing interest rates and encouraging faster economic growth.