The state uses fiscal and monetary policies to maintain the functioning of the national economic system and ensure its stability and independence from existing factors. Fiscal policy is the measures taken by the government to stabilize the economy by changing the number of revenues and/or expenditures of the state budget. The object of regulation is the money market and, above all, the money supply. It is appropriate to use fiscal and monetary policies when necessary to boost the economy during a recession through expansionary measures or curb it during a boom through contractionary tools. The policies are, however, not applicable when the national economy is already stable and, thus, influencing the population’s purchasing power is inappropriate.
The impact of fiscal policy instruments on aggregate demand varies. From the aggregate demand formula: AD = C + I + G + Xn, it follows that government purchases are a component of aggregate demand (Hansen & Harris, 2018). Therefore, their change directly impacts aggregate demand, and taxes and transfers have an indirect effect on aggregate demand, changing the amount of consumer spending (C) and investment costs (I). In general, the contractionary measures aimed at increasing aggregate demand include an increase in government spending and transfers, social benefits, tax cuts, and subsidies. Conversely, contractionary tools such as increased taxes and decreased government spending reduce aggregate demand since consumption and investments are declining.
Three monetary tools can stimulate aggregate demand: reserve requirements, the discount rate, and open market operations. Stimulating monetary policy implies a reduction in the required reserve ratio, a decrease in interest rates, and the purchase of government securities by the central bank (Hansen & Harris, 2018). Hence, the number of money increases, leading to a rise in aggregate demand and trade supply. Overall, the stimulating monetary policy aims to generate enough money for the economy without provoking excessive inflation.
In general, a policymaker should note that monetary and fiscal policies pursue one purpose: to stabilize the economy through influencing consumption. However, fiscal policy is relatively easier to follow, but an incorrectly estimated level of optimal government spending may imbalance the government budget. The advantage of monetary policy is that the banking system reacts more quickly to monetary policy than fiscal policy. Stimulating monetary policy is also beneficial to the population and commercial banks since, with an increase in the money supply, banks can issue more loans. In general, the right strategy can be to balance the two approaches correctly to achieve stable, even results.
Hansen, A. H., & Harris, S. E. (2018). Monetary theory and fiscal policy. Papamoa Press.