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Difference between Fiscal Policy and Monetary Policy

Explain the difference between fiscal policy and monetary policy. Show how each can be used to increase aggregate demand. [8]

Category:

Macroeconomic Factors and Policies

[CIE AS level May 2017]

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Answer

Tip: Knowledge and understanding are required of the distinction between fiscal and monetary policy and it is important to show how both types of policy could be used to increase aggregate demand. An explanation will be made easier by making use of an aggregate demand and aggregate supply curve.


Step ➊ : Define fiscal policy and monetary policy in the introduction.

Both fiscal policy and monetary policy can be used to increase aggregate demand. Fiscal policy is the use of taxation and government spending to manage aggregate demand in order to achieve the government’s macroeconomic aims whereas monetary policy refers to any policy measures or instruments to influence the price or quantity of money. The three instruments of monetary policy are the interest rate, the money supply and the exchange rate.


Step ➋ : Explain the difference between fiscal policy and monetary policy.


➤ 2.1 Fiscal policy involves changes in government spending and tax rates whereas monetary policy involves changes in interest rates and money supply.

➤ 2.2 Monetary policy generally involves the management of interest rates and the total supply of money in circulation and is generally carried out by central banks. Fiscal policy, on the other hand, is a collective term for the taxing and spending actions of governments.

➤ 2.3 Fiscal policy may have side effects on the government borrowing and budget whereas monetary policy will have side effects on the exchange rate and housing markets.


Step ➌ : Explain how fiscal policy can be used to increase aggregate demand. (application)


Expansionary fiscal policy is designed to increase aggregate demand. This can be achieved by a government increasing its spending or cutting tax rates.

➤ 3.1 Expansionary fiscal policy puts more money into consumers' hands to give them more purchasing power. It uses subsidies, transfer payments including welfare programs and income tax cuts.

All these measures increase aggregate demand since they encourage consumer spending.

➤ 3.2 Corporate tax cuts put more money into businesses' hands. They use it for new investment and employees. Since investment is a component of aggregate demand, there will be an increase in aggregate demand.


Step ➍ : Explain how monetary policy can be used to increase aggregate demand. (application)

Expansionary monetary policy is intended to increase aggregate demand. This may be achieved by a cut in the interest rate, an increase in the money supply and a reduction in the foreign exchange rate.

➤ 4.1 Expansionary monetary policy will increase the money supply and lower interest rates. If the central bank cuts interest rates, it will increase the overall demand in the economy.

Lower interest rates will make it cheaper to borrow, this encourages firms to invest and consumers to spend. For example, the cost of mortgage interest repayments will be lower, giving households greater disposable income and encouraging spending. Increased consumer spending will boost aggregate demand. Furthermore lower interest rates reduce the value of the currency, making exports cheaper and increase export demand.


Step ➎ : Explain the impact of monetary policy and fiscal policy on the aggregate demand curve.


The impact of both expansionary fiscal policy and expansionary monetary policy would be to shift the aggregate demand curve outwards from AD To AD1. This will result in an increase in real GDP from Y to Y1 and an increase in the price level from P to P1.

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Step ➏: Conclude

To conclude, fiscal policy and monetary policy are two different tools a government can access to support and stimulate the economy.

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♕ Mark scheme
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For knowledge and understanding of:
 Fiscal Policy (Up to 2 marks)
 and Monetary Policy (Up to 2 marks)
(4 marks maximum)
For application:
 Showing how fiscal policy can be implemented to increase aggregate demand (Up to 2 marks)
 Showing how monetary policy can be implemented to increase aggregate demand (Up to 2 marks)
(4 marks maximum)

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♕ Guidance
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Fiscal policy is sometimes called ‘budgetary policy’. It involves varying government spending and taxation to affect economic variables through changes in aggregate demand. Monetary policy refers to any government action to manage aggregate demand through control of the quantity of money, the rate of interest or credit terms. It is usually operated through the central bank.
Appropriate use of diagrams should be awarded due credit, but is not essential for full marks for application.

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♕ Examiner’s report
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This question resulted in many very strong answers that scored well. There was good knowledge and understanding displayed of the distinction between fiscal and monetary policy and there was also successful application to show how both types of policy could be used to increase aggregate demand. Although not essential to score full marks many candidates made good use of aggregate demand and aggregate supply curves to illustrate their answers.

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