Difference between expansionary fiscal policies and expansionary monetary policies


In this article we will analyze the differences between monetary policies and expansionary fiscal policies, detailing the theoretical effects they have in an open economy. That is, we assume that there is international capital mobility and the exchange rate is determined by the markets.

The graphs show two curves that indicate the relationship between the income of a country and the interest rate for the supply and demand of goods (red). Likewise, for the supply and demand of money (blue).

In an open economy, a policy of monetary expansion will increase the volume of circulating money, which will lower its price. In other words, interest rates will drop, having a double effect. On the one hand, economic activity will increase, since cheaper financing will boost business activity. However, the other impact is that international investors will see the return on their investments reduced and will move their capital to other countries.

To leave a country, investors will have to sell their balances in domestic currency and buy foreign currency, pushing down the exchange rate (that is, depreciating the currency). In this new context, the monetary devaluation will make imports more expensive and exports cheaper. This means that the country will begin to substitute imported products for national ones and will see its exports boosted, thus increasing production and employment.

An expansive fiscal policy, on the other hand, will seek to increase the demand for goods in the market, promoting business activity. However, financing these policies will also increase the demand for money, making it more expensive in financial markets (that is, raising interest rates).

This rate hike will also have a double effect: It will make it difficult for companies with higher interest rates to finance. Although international agents will also be attracted by the higher return on investments and will buy national currencies, pushing their prices up.

This exchange rate appreciation will mean cheaper imports and more expensive exports. In other words, national products will lose market both within the country and outside of it.

The final effect would therefore be a reduction in production and employment, in addition to the public debt generated by expansionary fiscal policies.

Other data to consider from expansionary policies

Additionally, although economic theory provides the arguments we have mentioned, there are also a number of fundamental questions that should not be overlooked.

Monetary policies are directed directly at the financial sector, whose multiplier effect is by definition the highest. This means that for each monetary unit injected into the economy, the financial sector will generate a much larger amount, which in turn will affect the other sectors.

In this sense, fiscal policy is more limited and has the added drawback of being subject to political decisions. Furthermore, expansionary fiscal policies (if they translate into increases in public spending and not in a reduction in tax revenues) produce the so-called crowding-out effect. In other words, the private sector is gradually displaced by the public, usually with negative consequences on productivity and employment.

Finally, it is important not to forget the debt process that usually accompanies expansionary fiscal policies. These generate debts that in the future must be compensated with policies in the opposite direction (spending reductions or tax increases).

See: Summary of expansionary monetary and fiscal policies

Restrictive monetary policy Contractionary fiscal policy

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