Question

Some economists argue that policymakers can use monetary and fiscal policy to reduce the severity of economic fluctuations. In practice, however, there are obstacles to the use of such policies. What are the primary difficulties with using monetary and fiscal policy to stabilize the economy?

Answer 1

Primary difficulties with using monetary policy to stabilize the economy are as follows-

The Risk of Hyperinflation

When interest rates are set too low, over-borrowing at artificially cheap rates can occur. This can then cause a speculative bubble, whereby prices increase too quickly and to absurdly high levels. Adding more money to the economy can also run the risk of causing out-of-control inflation due to the premise of supply and demand: if more money is available in circulation, the value of each unit of money will decrease given an unchanged level of demand, making things priced in that money nominally more expensive.

Effects Have a Time Lag

Even if implemented quickly, the macro effects of monetary policy generally occur after some time has passed. The effects on an economy may take months or even years to materialize. Some economists believe money is "merely a veil," and while serving to stimulate an economy in the short-run, it has no long-term effects except for raising the general level of prices without boosting real economic output.

Technical Limitations

Interest rates can only be lowered nominally to 0%, which limits the bank's use of this policy tool when interest rates are already low. Keeping rates very low for prolonged periods of time can lead to a liquidity trap. This tends to make monetary policy tools more effective during economic expansions than recessions. Some European central banks have recently experimented with a negative interest rate policy (NIRP), but the results won't be known for some time to come.

Monetary Tools Are General and Affect an Entire Country

Monetary policy tools such as interest rate levels have an economy-wide impact and do not account for the fact some areas in the country might not need the stimulus, while states with high unemployment might need the stimulus more. It is also general in the sense that monetary tools can't be directed to solve a specific problem or boost a specific industry or region.

Primary difficulties with using fiscal policy to stabilize the economy are as follows-

It Can Create Budget Deficits

A government budget deficit is when it spends more money annually than it takes in. If spending is high and taxes are low for too long, such a deficit can continue to widen to dangerous levels.

Tax Incentives May Be Spent on Imports

The effect of fiscal stimulus is muted when the money put into the economy through tax savings or government spending is spent on imports, sending that money abroad instead of keeping it in the local economy.

May Be Politically Motivated

Raising taxes is unpopular and can be politically dangerous to implement.