In a recession firms are very nervous that they may go out of business so they are unlikely to invest in capital so that they can meet future orders. Regardless of interest rates firms will be adverse towards investing. Therefore investment will be very insensitive to interest rates and this will make the IS curve very steep. Interest rates also have a level below which they are unlikely to drop. This makes the LM curve very flat to the left. If the IS curve lies on the very flat part of the LM curve (which is likely in a recession) then a loosening in fiscal policy would have a large effect as crowding out would be very small. In this instance monetary policy would have a very weak effect, as there would be massive crowding out {Hicks J. (1967)}.
In the UK the Bank Of England sets monetary policy. Its objective is to “Maintain the value of money in terms of the goods and services it can buy.” {Official Web site of the Bank of England (2002)} the target for inflation is set by the government at 2.5%.
During a ‘boom period expectations of the future are good and firms are willing to invest if they believe the gains outweigh the costs. If interest rates are low then the costs of investing are low. So low interest rates will stimulate investment. This means Investment is sensitive to interest rates and the IS curve is very flat. Because the economy is in a boom the Is curve will be situated on the steep part of the LM curve. To stop this inflationary gap pushing up prices the Monetary Policy Committee (MPC) will tighten monetary policy. A very small tightening in monetary policy will bring the aggregate demand curve back to the long run level because of the massive drop in investment cause by the rise in interest rates. {Web site of the Bank of England (2002)}
If Fiscal policy were to be used there would be a massive tightening required to cut the extent of a boom compared to the extent of monetary policy. This may require cutting spending on education and the NHS which could be very unpopular with voters. This shows that during a boom monetary policy is strong while fiscal policy is weak.
So far we have ignored the effect of the exchange rates however if we take them into account they can have a massive effect on monetary and fiscal policy due to exports. If a country works with in a fixed exchange rate regime monetary policy is powerless to influence national income.
Starting at the full equilibrium level of national income if monetary policy is loosened the LM curve will shift to the right. Now domestic interest rates will be lower than the world interest rates. Holders of bonds will sell their bonds to buy foreign bonds as they will expect the interest rate to go back up and they will make a loss. This will lead to an excess supply of the domestic currency in the foreign exchange market. The central bank/ government will have to buy this currency to stop the exchange rate falling. As they buy the domestic currency the money supply is reduced and this will shift the LM curve back to its original position.
If fiscal policy is increased in a fixed exchange rate regime, the increase in government spending will shift the IS curve to the right. To stay in general equilibrium the interest rates will have to rise. This will lead to a massive excess demand for the domestic currency from home and abroad. To stop the exchange rate from rising the central bank/ government must sell their currency and buy foreign currency. This will increase the money supply which will cause the LM curve to shift to the right counteracting the effects of crowding out this will make fiscal policy very strong {Lipsey R.G. and Chrystal K.A. (1999)}.
If a country has a flexible exchange rate regime the effects are reversed. If the government loosens fiscal policy by increasing government spending the IS curve will shift to the right. This will increase national income and interest rates. However this increase in interest rates will cause the exchange rate to appreciate and then exports will decrease. This crowding out through exchange rates will lessen the effect of fiscal policy. If monetary policy is increased the LM curve will shift to the right this will lead to higher national income and a lower interest rate. This lower interest rate will cause the exchange rate to depreciate. This will increase exports shifting the IS curve to the right. Therefore the effect of a loosening in monetary policy is increased by a shift in the IS curve making it very strong {Hillier B. (2002)}.
As this essay has shown the Strength of monetary and fiscal policy is dependent on the current position of the economy. If the economy is in a fixed exchange rate regime fiscal policy is very strong while monetary is powerless. While in a flexible exchange rate regime it is the opposite. If the economy is in a ‘boom’ then monetary policy is very strong and fiscal policy is weak. However if the economy is deep in a recession then Fiscal policy is very strong and monetary policy is very weak. This is because the different parts of the business cycle have different effects on the slope of the IS and LM curves
{Table 7.2 Relative Monetary and fiscal policy effectiveness and the slope of the IS and LM curves. Froyen R.T. Macroeconomics Theories and policies (2002) P.171}
Bibliography
Froyen R.T. Macroeconomics Theories and policies. Pearson Education. (New Jersey) 2002
Hicks J. Critical essays in monetary theory. Clarendon press (Oxford) 1967
Hillier B. The macro economic debate: Models of the closed and open Economy. Blackwell publishers ltd. (Oxford) 2000 2nd edition.
Lipsey R.G. and Chrystal K.A. Principles in economics. Oxford University press (Oxford) 1999 9th Edition
Mankiw N.G. Principles of economics. The Dryden press (London)
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Official Web site of the Bank Of England. (2002)
Sooran C. Fiscal policy. Victory risk management consulting, Inc. 2001
