2.9.1. Monetary Policy vs. Fiscal Policy, Monetary-Fiscal Policy Mix

In recent times, monetary policy has been gaining a lot of importance in management of economies. There has therefore been a constant debate on whether fiscal policy or monetary policy is more effective in making the desired impact on an economy. Some of the propositions have been discussed below:

Political compulsions and objectives: The experience of the 1960s, 1970s, and 1980s suggests that democratically elected governments have more trouble using fiscal policy to fight inflation. Fighting inflation requires government to take unpopular actions like reducing spending or raising taxes. Political realities, in short, may favor a bigger role for monetary policy during times of inflation.

On the other hand, fiscal policy is more suited to combat unemployment in the economy as the government can increase spending to create public infrastructure and process jobs.

Problem of Liquidity Trap: The monetary policy remedy to economic decline is to increase the amount of money in circulation, thereby cutting interest rates. But once interest rates reach zero, the Central Bank can do no more. Such a situation is referred to by the economists as the "liquidity trap”. The problems experienced by the Japanese in the 1990’s in trying to stimulate their economy through a zero-interest rate policy might be mentioned here.

With its economy stagnant and interest rates zero, many economists contended that the Japanese Government had to resort to more aggressive fiscal policy. In such a case monetary policy proved to be of no value at all.

But some economists disagree on this too. They argue that short term changes in monetary policy do impact quite quickly and strongly on consumer and business behavior. For example, the domestic demand in both the United States and the UK responded positively to the interest rate cuts introduced in the wake of the terror attacks on the USA in 2001.