Effects of Conflicting Monetary & Fiscal Policies

Instructor: James Walsh

M.B.A. Veteran Business and Economics teacher at a number of community colleges and in the for profit sector.

When fiscal and monetary policies are not coordinated to achieve the same objective, an unstable economy results. This lesson will take you through an example that illustrates just how that happens.

Economic Goals

The great nation of Nad has just completed an election. It has a newly elected Prime Minister and Assembly. Nad's constitution specifies duties for the prime minister that are similar to those of a US president, while the assembly carries out duties similar to what Congress or Parliament does in other countries. The new prime minister wants to see the economy continue to grow and provide jobs for the citizens. He is also concerned about inflation. Inflation is rising prices for goods and services, and that erodes the purchasing power of the citizens. In his long and thundering inaugural speech, he called on policymakers to take action on both economic goals.

Fiscal Policy

Fiscal policy in Nad is the job of the assembly. Fiscal policy is the government's spending and taxing policy. When the economy is doing poorly, the assembly can perk it up with expansionary fiscal policies that stimulate the economy with increased levels of government spending and lower taxes. Both of those will create growth and jobs. Likewise, when the economy needs slowing down, spending levels can be reduced and taxes increased.

Fiscal policy is normally carried out by a legislative body; in the US that means Congress
Congress

The majority leader of the assembly is calling for more spending, especially on the military and building new roads and bridges. He told the assemblymen and women, ''The prime minister wants jobs and growth, and we are going to deliver! ... We need to think about a tax cut plan too,'' he concluded.

Monetary Policy

Monetary policy in Nad is carried out by the central bank. Monetary Policy regulates the supply of money available to the economy. The bank does this mainly by lowering interest rates to increase the supply of money, and raising interest rates to decrease it.

The central banking authority in the US is the Federal Reserve
Federal Reserve

The central bank's website has been getting a lot of comment lately from citizens concerned about rising prices. The chatty citizens of Nad have formed an organization on social media called #stopthisinflationnow! They are chirping loudly about the rising prices. Those on fixed incomes point out that they are not getting pay raises to cover the rising prices of groceries and gasoline.

When the head of the central bank addressed the assembly, she called for higher interest rates. ''The economy is overheating and that is what is causing this inflation,'' she told them. ''Higher rates will reduce the money supply and slow things down. That will keep inflation in check!''

Aggregate Demand

The prime minister called for the head of the economic council to get over to his office in the Brick House immediately. He told the chief economist that he couldn't understand why the economy was still not performing well even though both the assembly and the central bank were carrying out his wishes. ''The stock market is going up and down like a roller coaster, growth is weak and we still have some of that pesky inflation. What is going on!''

The head of the council decided to give the prime minister an economics lesson. ''You see, sir, growth and job creation are based on aggregate demand. Aggregate demand has three pieces:

  1. Consumer spending
  2. Business investment spending and
  3. Government spending on goods and services

''When aggregate demand increases, it creates a higher level of growth and that creates jobs.''

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