The first rule of thumb is that monetary policy can generally
be implemented faster and more flexibly than fiscal policy.
So it is generally favored as a fine-tuning tool.
Just think about it this way,
particularly within the context of
any nation that has embraced a democratic system of government.
In order for that government to implement,
say a fiscal stimulus in the form of
increased government expenditures to expand the economy,
you must first get legislation passed in a congress or
a parliament and then also perhaps get approval from the president or prime minister.
In contrast, all the nation's central bank has to do is stimulate the economy,
is increase the money supply to lower interest rates and weaken the domestic currency.
Market forces then ensure at least some increase in investment
and net exports and therefore, increased aggregate demand.
You can see then from this scenario why
the tool of a fiscal stimulus is typically only implemented
in the case of a severe and prolonged session.
The second rule of thumb regarding monetary policy is that it tends to be much more
effective in contracting an economy to rein in
inflation than in stimulating economy back to full employment.
Particularly, an economy in a deep recession.
The problem here has to do with a phenomenon known
as pushing on a string versus pulling on a string.
To understand how difficult it is to push on a string in a monetary policy context,
suppose the economy has entered a severe recession.
In this case, the central bank can certainly cut interest rates sharply.
However, if businesses lack confidence in the prospects of a recovery,
they still may not be willing to invest and monetary policy will fail.
As the saying does indeed go,
"You can't push on a string."
In contrast, in the case of inflation,
when the central bank hikes interest rates,
that will almost certainly lead to reduced investment.
The analogy of pulling on a string much more apt here.
So that's another reason why fiscal policy may be
preferred in severe recessions whereas monetary policy
is generally used more as
a fine-tuning mechanism and the preferred tool to control the demand-pull inflation.
And with that key point,
let's move on to our next module and finish this lesson strong with
some great examples of how business executives and money managers can
strategically respond when the government implements discretionary monetary policies and
seeks to influence two of
the most important parameters for doing business and investing in a global economy.
Level of interest rates and currency exchange rates.
So when you're ready, let's move on and end this lesson with a flourish and some style.
Dr. Peter NavarroProfessor
