Sunday, December 8, 2013

How can a change in monetary policy reduce the inflationary consequences of fiscal stimulus?

When a government uses fiscal policy to try to stimulate
the economy (by taxing less and/or spending more) aggregate demand tends to rise.  All
other things being equal, this increase in AD can lead to inflation.  A major goal of
monetary policy is to ensure that inflation does not become
excessive.


To prevent inflation, a central bank would need
to increase interest rates.  As the link below tells
us,



Monetary
policy works through the effects of the cost and availability of loans on real activity,
and through this on
inflation...



A central bank
that was concerned about inflation, then, would raise interest rates so that loans would
be less attractive and economic activity would slow.


There
is, however, a danger in doing this.  If the economy is in need of fiscal stimulus,
increasing interest rates could be harmful because an increase in interest rates
typically slows economic activity.


So, a central bank can
reduce the inflationary consequences of fiscal stimulus by increasing interest rates. 
However, this may not be compatible with the goal of stimulating the
economy.

No comments:

Post a Comment

What accomplishments did Bill Clinton have as president?

Of course, Bill Clinton's presidency will be most clearly remembered for the fact that he was only the second president ever...