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Monetary policy and fiscal policy, objectives, consequences, graphs
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Unit 10 - Monetary policy and fiscal policyMonetary policy
Monetary policy refers to the government’s control and use of interest rates and the money
supply to influence the level of aggregate demand and economic activity. In practice, monetary
policy is overseen by the nation’s central bank.
A demand-side policy refers to any government strategy or plan to influence the level of
aggregate demand, such as reducing interest rates to reduce the costs of borrowing money to
finance household consumption expenditure (C) and corporate investments (I).
The money supply refers to the entire quantity of money circulating in an economy, including
notes and coins, loans and savings deposits at financial institutions and banks.
The goals (objectives) of monetary policy include:
1. achieving a low and stable rate of inflation (inflation targeting)
2. low unemployment
3. reducing fluctuations in the business cycle
4. promoting a stable economic environment for long-term growth
5. harmonizing the external balance
Expansionary monetary policy
Expansionary monetary policy (also referred to as loose or
easy monetary policy) aims to increase the level of economic
activity by reducing interest rates and/or expanding the
money supply. This makes borrowing for consumption and
investment purposes more attractive owing to the lower
interest repayments charged on credit, loans and mortgages.
Therefore, expansionary monetary policy will shift the
aggregate demand curve to the right, ceteris paribus (see
Figure 24.9), thereby helping to close a deflationary
(recessionary) gap.
In the case of expansionary monetary policy, lower interest rates will tend to shift the aggregate
demand curve to the right in order to close a deflationary (or recessionary) gap, because
consumption (C), investment (I) and government expenditure (G) are likely to rise due to the
cheaper costs of borrowing money to spend and invest. If the economy operates at less than
the full employment level, it is operating along its SRAS curve. Expansionary monetary policy
(such as through a cut in the base interest rate) will tend to increase the level of aggregate
demand, shifting the AD curve from AD1 to AD2, ceteris paribus. This increases real national
output from Y1 to Yf, thereby closing the deflationary gap (a deflationary or recessionary gap is
the difference between equilibrium national output and the full employment level of national
output).
However, a consequence of expansionary monetary policy is the potential emergence of
inflationary pressures. This can be seen in Figure 24.9 with the general price level rising from
1
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