Pros and Cons of Fiscal Policy vs. Monetary Policy

by Marjolein van der Veen

Fiscal Policy

Pros / Cons
If use Government spending, can direct spending towards areas in need (e.g. infrastructure, education, etc.), and make investments for the future. / Knowledge problems (regarding the current state of the economy; regarding the amount of an expansion or contraction needed, etc.)
Using a balanced budget can provide a stimulus without adding to the government budget deficit. / Government budget deficits (though there’s disagreement regarding the extent to which deficits are a problem)
While fiscal policy may lead to government deficits/debt, we should look at debt/GDP ratio. As only as GDP grows, it can bring down the debt/GDP ratio. / Time lags (particularly on the front end of the process)
Can use “green” taxes to discourage polluting activities. / Some crowding out (extent depends on how close the economy is to full employment)
Tax rebates may be spent on imports, thus leaking out of the circular flow.
Actions of state and local governments may counteract the federal fiscal stimulus (or contraction).
Growing the GDP to bring down the debt/GDP ratio can compromise environmental sustainability.
What if we have stagnation + inflation? Could exacerbate inflation


Monetary Policy

Pros / Cons
Can be initiated immediately / Knowledge problems (regarding the current state of the economy; regarding the amount of an expansion or contraction needed, etc.)
No government budget deficits / Time lags (particularly response lags)
Expansionary policy leading to depreciating currency can stimulate exports (at least for businesses that do not rely on importing their inputs). / Can’t direct the spending (to particular uses, e.g. infrastructure), and spending may be done in wasteful ways, e.g. speculation, mergers and acquisitions.
The Fed is theoretically insulated from the political process / Very low interest rates can foster speculative activities (such as Japan’s yen carry trade.)
Fed’s change in interest rate is applied nationally – some areas in the country might not need the stimulus, while states with high unemployment might need the stimulus.
Reluctant lenders (Banks may be unwilling to lend, especially if overwhelmed by bad loans on the books)
Reluctant borrowers (pushing on a string) (Firms may be reluctant to borrow, especially if expectations of future sales and profits are low.)
Limit of r=0%, liquidity trap
While government doesn’t incur debt, the private sector is encouraged to borrow and take on debt.
What if we have stagnation + inflation? Could exacerbate inflation