Modern developed countries lean towards a market economy, where the government’s involvement is limited. However, it still can influence certain financial processes through monetary and fiscal policy. Monetary policy controls the overall money supply, interest rates, and inflation level, while fiscal policy includes the government’s direct economic decisions on spending and taxation (European Central Bank, n.d.). Thus, if the market needs stabilization or stimulation, the government can implement one of these tools or their combination.
For efficient economic involvement, policymakers should understand when it is appropriate to use each of these policies. Both monetary and fiscal policies are appropriate to use during financial crises or a recession (European Central Bank, n.d.; Mathai, n.d.). However, in the case of a liquidity trap, when people are reluctant to spend and invest, monetary tools would be ineffective (Cambridge Dictionary). Another important observation is that fiscal policy is more politically dependent and inefficient if the government ignores economic indicators and pursues political goals (European Central Bank, n.d.). Thus, policymakers should constantly monitor the economic situation to decide which tools to choose.
Both monetary and fiscal policies can influence aggregate demand (AD). It is the economic index demonstrating the total demand for goods produced in the country or region (Kling, n.d.). When the AD decreases, central banks can cut interest rates to encourage people and businesses to be more economically active (Mathai, n.d.). To stimulate the AD, the government may also use fiscal tools: increasing government spending and decreasing tax revenue (Congressional Research Service, 2021). Therefore, both monetary and fiscal policies can be efficient for stimulating aggregate demand.
To sum up, monetary and fiscal policies can be useful or harmful, efficient or inefficient, depending on how and when they are implemented. Policymakers should carefully assess the economic situation and potential risks to decide whether their involvement is necessary and, if yes, to what extent. Therefore, if they believe that monetary or fiscal tools may stimulate aggregate demand in some particular circumstances, I think they should use one or both of them.
Cambridge Dictionary. (n.d.). Liquidity trap. Web.
Congressional Research Service. (2021). Fiscal policy: Economic effects. Web.
European Central Bank. (n.d.). Fiscal and monetary policy in a monetary union. Web.
Kling, A. S. (n.d.). Aggregate demand. EconLib: The Library of Economics and Liberty. Web.
Mathai, K. (n.d.). Monetary policy: Stabilizing prices and output. International Monetary Fund. Web.