Traditionally the role of fiscal policy within the confines of a balanced budget was to determine the distribution of income; and allocate resources between the private and public sector. This consequently meant that resources were allocated to the public sector away from the private sector. However since the 1940s the government’s main concern has been to establish high levels of employment, this has been done by using the budget as a means to control aggregate demand and employment in the economy. Furthermore since the 1970s, there has been growing concern over whether fiscal policy can actually achieve long-run changes in employment, the view that it can’t has been strengthened by the crowding out theory. An expansionary fiscal policy consists of either an increase in government expenditure or a reduction in taxation; the general effect of this is an increase in aggregate demand.
Monetary policy is the means by which the government controls the monetary system using a range of policies, the core of these are: i. Direct credit controls, ii. Interest rate changes and iii. Changing the quantity of money. A reduction in the money supply increases the rate of interest which in turn reduces private investment and also perhaps consumption expenditure. This is known as a restrictive monetary policy, the same outcome could also be achieved by increasing interest rates or imposing direct credit controls to restrict the amount of credit available to finance expenditure. With this in mind an expansionary monetary policy is therefore achieved by doing the opposite: increasing the money supply, reducing interest rates and removing any credit controls.
In order to compare both fiscal and monetary policy, they will be examined in the context of a Keynesian model with idle resources. This means that an expansion of aggregate demand will cause an increase in real output.
An expansionary, pure fiscal policy
An expansionary pure fiscal policy will shift the IS schedule upwards from IS0 to IS1 (as shown above), because we assume a pure fiscal policy, the resulting government budget deficit is financed by bond sales to the public. The assumption of an unchanged money supply allows us to assume that the LM curve does not shift as it would if the money supply were increased in order to finance the fiscal deficit. Output thus moves from Y0 to Y1. The rate of interest rises from i0 to i1. At interest rate i1, and an income level of Y1 the demand for money is once more equal to the supply of money.
There will be a greater increase in the interest rate following a fiscal expansion if the demand for money is more interest inelastic. This is due to the fact that a larger change in interest rates is needed to persuade people to hold a given money stock at a higher level of income. As shown below:
The size of the change in the rate of interest consequent upon a change in the demand for money increases as the demand for money becomes more interest inelastic.
The above diagram shows that the change in interest rates needed to maintain monetary equilibrium when output changes is greater, the more interest inelastic the demand for money. Because the increase in the interest rate is greater after an expansionary fiscal policy, it suggests that the demand for money is thus more interest inelastic, furthermore the resulting increase in output is smaller due to the larger contractionary impact of the interest rate on private investment.
If investment was perfectly unresponsive to interest rate changes, then the effectiveness of fiscal policy would not be impaired at all by an increase in interest rates. If investment was autonomous the IS schedule would be vertical. Only one level of income would produce the level of saving equal to the volume of autonomous investment.
The diagram below shows the case for when investment is perfectly interest inelastic, the fiscal policy multiplier diminishes as the interest elasticity of investment increases. With the same fiscal expansion, output only increases by Y0 to Y1 when investment is interest responsive and the IS function is sloping downward. We can therefore deduce that the fiscal policy multiplier is larger when:
- the more interest elastic is the demand for money, and
- the less interest elastic is the demand for investment goods.
Fiscal policy is more effective, the less interest elastic is investment
To increase the money supply the central bank would buy bonds from the public. In order to persuade the public to hold fewer bonds and more money, the government has to raise the price of bonds, that is, to lower the interest rate. This means that the interest rate falls in the process of monetary expansion and rises if there is a monetary contraction.
Monetary policy affects aggregate output. An increase in the money supply at the original level of output and interest rate would cause disequilibrium, since there would be an excess supply of real money balances over the demand for them. The demand for bonds increases, bond prices rise and the interest rate falls.
There are two points at which the Keynesian transmission mechanism may fail to transmit the effects of monetary change to the real sector. Firstly, the interest rate may be very unresponsive to changes in the money supply; this is because of the high interest elasticity of the demand for money. And secondly, the unresponsiveness of investment and consumption to interest rate changes. Therefore, the size of the money multiplier (that is, the increase in national income due to an increase in the money supply) is larger when:
- the less interest elastic is the demand for money, and
- the more interest elastic is the demand for investment goods.
When analyzing any change in monetary or fiscal policy, it is important to bear in mind that the policy makers who control these policies are aware of what the other policy is doing. A change in one policy, therefore, may influence the other and furthermore this interdependence may alter the impact of the policy change.
The role of fiscal policy as an instrument to stabilise aggregate demand remains somewhat controversial. A large number of economist feel that fiscal expansion is crowded out in the long run so fiscal policy cannot thus directly control the long run level of employment. However it should be remembered that fiscal policy can be used to influence either the distribution on income or output. Monetary policy, on the other hand, concerns itself with price stability, output stabilisation, manipulation of the exchange rate and reducing the swing in house prices.
In conclusion, any change in fiscal policy will have a monetary impact and vice versa. The effectiveness of either policy does not therefore depend on interest elasticity or a stable demand for money alone, but a number factors. It is fair to say that interest elasticity and a stable demand for money are two very important factors but one must also consider: uncertainty; levels of income; expected levels of income; inflation and the utility of holding money. It is for these factors that many governments of today use a mixture of both monetary and fiscal policy in order to maintain a stable economy.
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Crowding out theory: The reduction in investment that results when expansionary fiscal policy raises the interest rate.
Autonomous: Unrelated to income or the rate of interest.
