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Saturday, March 10, 2012

How Monetary Policy Works and Differs from Fiscal Policy

In the previous post, we've learnt that monetary policy refers to the actions taken by a central bank to change the money supply. Naturally, the next question to ask is how a change in the money supply affects the economy.

This post will answer this question and explain the transmission channels of monetary policy. Afterwards, we'll compare and contrast fiscal and monetary policy, the two broad types of macroeconomic policies.

The Transmission Mechanisms of Monetary Policy 

Monetary policy affects the economy through a number of channels. Here we'll discuss the most important ones. 

(1) The Interest Rate Channel: 
In a recession, the central bank, by increasing the money supply, creates an environment of low real interest rates to lower both the cost of borrowing and the return of savings. In response to these incentives, firms will invest more in capital and consumers will save less and purchase more, which stimulate national output through a multiplier effect. 

(2) The Exchange Rate Channel:
After a monetary expansion, the interest rates are lowered and the return on deposits falls. This motivates people to move deposits abroad. To do so, they first have to sell the domestic currency in exchange for a foreign currency in the forex market. As a result, supply of the domestic currency increases, and the price of the currency falls (i.e. depreciation). Since a currency depreciation promotes exports and discourages imports, monetary expansion raises output under the exchange rate channel. 

(3) Other Transmission Channels: 
Other transmission channels exist too. One channel is through asset prices. Expansionary monetary policy increases the prices of financial assets, creating a wealth effect that increases consumption. Another example is the credit channel. After expansionary monetary policy, more deposits will enter the financial system. To increase profits, banks will lend out more money, which increases investment and output.

How Fiscal Policy Works

In expansionary fiscal policy, the government increases public expenditure or launches tax cuts and rebates. This stimulates consumer spending and results in a multiplier effect to boost national income. Higher consumer spending means people will hold more money for consumption, which increases the demand for money and raises the real interest rate.

Since public spending results in a higher borrowing cost, it decreases investment in the private sector, a phenomenon known as the crowding out effect. Plus, a higher interest rate leads to an instant appreciation of the currency, which has a negative impact on net exports. 

The Benefits of Monetary Policy over Fiscal Policy 

Comparing the two, we can see that fiscal policy is unfavorable because it crowds out private investment and reduces net exports, while monetary policy facilitates both. Another downside of fiscal expansion is that it often requires borrowing. This may lead to a high level of public debt, which is dangerous since it can cause a range of problems from recession to price instability and a weakening currency.

Plus, economic research has shown that the effect of fiscal contraction can be largely compensated by the expansionary policies of an unconstrained central bank. Due to the above reasons, monetary policy is often considered a better stimulus tool than fiscal policy.

Moreover, if Ricardian equivalence is true, then fiscal policy is completely ineffective. Ricardian equivalence is a controversial concept proposed by some Chicago school economists. It holds that people anticipate future tax increases when the government increases spending or reduces taxes. Due to this expectation, consumers will save an additional dollar for every dollar spent by the state to stimulate the economy. As a result, fiscal expansion is completely offset by the decrease in private consumption, with no impact on the economy. 


Abel, A. B., Bernanke, B. S., & Croushore, D. (2007). Macroeconomics (6th ed.). Boston, MA: Pearson/Addison Wesley. 

Case, K. E., Fair, R. C., & Oster, S. C. (2009). Principles of economics (9th ed.). Upper Saddle River, NJ: Prentice Hall.

Mishkin, F. S. (2010). The economics of money, banking and financial markets (9th ed.). Boston, MA: Pearson Education.

(Entry 2 of 4 in the An Introduction to Monetary Policy series) 

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